This is David Groce, your Texas Tax and Law Man. Today we are tackling the Pass Through Deduction found in the 2017 Tax Cuts and Jobs Act.
Of all the provisions in the new law, I was most excited about this one. I won’t say I’m disappointed, but I sure was hoping that all pass-through Income would be subject to the same 21 percent tax rate as corporations. That would have been a game changer for my average client.
But alas, the small town business man did not win as much as wall-street. But in the modern marriage of Wall-Street and Washington, I guess I should not be surprised.
Nevertheless, small business owners paying tax as a partnership, S-corp, or sole proprietorship now receive a pass through deduction of twenty percent (20%) of their qualified business income.
The small business owners understand this, but let me simply state what pass-through income is. In a corporation, the corporation pays tax on its income at the corporate level. It then pays a dividend to its shareholders and the shareholder pays tax on the dividend. That is called double taxation. The corporation and the shareholder both pay tax.
In a pass-through entity like an S Corp, an LLC filing taxes as a partnership, or a sole proprietorship, the company itself DOES NOT pay taxes. The earnings pass-through or flow to the partner or owner’s tax return and the owner pays tax at the individual tax rate on that net income of the company. That is pass-through taxation.
The new law gives these business owners pass through tax deduction of twenty percent of the qualified business income. However, the new law provides three (3) qualifiers on this deduction:
First, this deduction does not apply to service businesses that make over $315,000, like attorneys, accountants, and doctors. Humorously, stock-brokers were specifically exempted. I guess wall-street had better lobbyists than the lawyers. Also, engineers and architects were exempted. I may be poking fun at the law, but this creates real questions for my clients - are they selling a product or a service. Think about your insurance agent. He sells you an insurance policy, but the insurance company pays the agent a commission for selling the policy. Is that a service or not? Arguing for the taxpayer, I of course would say it is not, but we do not know the position the IRS will take.
Second, the deduction is limited by the wages and capital of the business. The twenty percent deduction cannot exceed: 50% of the wages paid by the company or
25% of the wages paid plus 2.5% of the purchase price of the assets. Both of these limitations may totally limit the deduction for some taxpayers.
Third, the deduction applies to each business. Unless a taxpayer makes an election to combine the qualified business income of multiple entities, we will have to run this deduction on each business separately.
Finally, the 2017 Tax Cuts and Jobs Act tells what the pass-through-deduction is, but not exactly where we take it. We may claim it on line beside the standard deduction or on a separate line on the return. We do not know if this deduction reduces only taxable income or does it also reduce the self-employment tax. These are uncertainties that we will have to walk out and tease out in coming months. This is going to be an exciting year with lots of changes.
A couple of videos back, I shared Einstein’s amazement with the complexity of tax law. Today, let me share a little Einstein humor that I think applies to the math involved in calculating taxes: “As far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.”
Accountants crave certainty, but change and uncertainty is part of the wonder and adventure of life. Keep us in mind if you need help navigating the uncertainty of planning, running, and paying taxes on a business this coming year.
Thanks for tuning in to our tax video today. If it helped you, 'click' like and subscribe below and forward this link to a friend on Facebook, LinkedIn, Twitter, or YouTube.
Next week, we will unveil our long awaited tax comparisons between various taxpayers under the old law and the new. Make sure you stay tuned. You don’t want to miss it. Adios!