Prior to the recently enacted Tax Cuts and Jobs Act, owners of partnerships, S corporations, and sole proprietorships – “pass-through” entities – paid tax at the individual rates, with the highest rate at 39.6 percent for 2017 and prior. The highest rate is reduced to 37 percent under the Tax Cuts and Jobs Act. The Act also allows a temporary deduction in an amount equal to 20 percent of qualified income of pass-through entities, subject to a number of limitations and qualifications. Conversely, the Tax Cuts and Jobs Act limits the deduction for excess business losses from pass-through entities.
Pass-through Income Deduction
Noncorporate taxpayers may deduct up to 20 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship (Code Sec. 199A deduction). A similar deduction is allowed for specified agricultural or horticultural cooperatives. A limitation based on wages paid, or on wages paid plus a capital element, is phased in for taxpayers with taxable income above a threshold amount. The deduction is not allowed for certain service trades or businesses, but this disallowance is phased in for lower income taxpayers. The deduction applies to tax years from 2018 through 2025.
Limits and Thresholds
The amount of the deduction may be reduced by two limits that are phased in for taxpayers whose taxable income does not exceed the applicable threshold.
(1) The deduction is generally limited to the greater of (a) 50 percent of W-2 wages paid by the business, or (b) the sum of 25 percent of the W-2 wages paid plus 2.5 percent of the unadjusted basis of certain property the business uses to produce qualified business income. This limit may be phased-in or eliminated for lower-income taxpayers.
(2) Qualified business income generally does not include income from a service trade or business.
The taxable-income threshold amount for these phase-in rules is $315,000 for taxpayers who file joint returns, and $157,500 for other filers. The phase-in rules work as follows:
- W-2 wages limit – The wages limit applies only if the taxpayer’s taxable income exceeds the $315,000 (or $157,500) threshold. Once taxable income exceeds the threshold, the limit is phased in over the next $100,000 (or $50,000). The limit applies in full once taxable income exceeds $415,000 (or $207,500). The phase-in calculations are discussed below.
- Service income exclusion – The exclusion of service income from qualified business income is phased in for taxpayers whose taxable income is less than $415,000 for joint filers, or $207,500 for other taxpayers.
The Code Sec. 199A deduction applies to income from many types of trades or businesses, but not to specified service trades or businesses (with exceptions). Performing services as an employee is not a qualified trade or business.
A specified service trade or business is any trade or business:
- that involves the performance of services in the fields of accounting, actuarial science, athletics, brokerage services, consulting, financial services, health, law, or the performing arts; or
- that involves the performance of services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities; or
- whose principal asset is the reputation or skill of one or more of its employees or owners.
A taxpayer carrying on a specified service trade or business can claim a modified qualified business deduction if taxable income is less than:
- $415,000 for taxpayers filing a joint return ($315,000 threshold amount + $100,000); or
- $207,500 for all other taxpayers ($157,500 threshold amount + $50,000).
In computing qualified business income, W-2 wages, and unadjusted basis of qualified property, a taxpayer with taxable income below the applicable limit takes into account only a percentage of qualified items of income, gain, deduction, or loss, and W-2 wages and unadjusted basis of qualified property, that are allocable to the specified service. The applicable percentage equals 100 percent reduced (not below zero) by the ratio of (1) the taxpayer’s taxable income for the tax year in excess of the $157,500 threshold amount ($315,000 for a joint return), over (2) $50,000 ($100,000 in the case of a joint return). The Tax Cuts and Jobs Act provides rules that prevent pass-through owners from converting their compensation income taxed at higher rates into profits taxed at the lower rate.
For individual taxpayers, the Code Sec. 199A deduction is not allowed in determining adjusted gross income. Further, it is not an itemized deduction, but it is available to individuals who itemize deductions and to those who claim the standard deduction. However, the deduction amount cannot be more than the taxpayer’s taxable income (reduced by net capital gain) for the tax year.
The Code Sec. 199A deduction is similar to the domestic production activities deduction under Code Sec. 199, in that both allow taxpayers to deduct a portion of their “taxable income” if it is less than a portion of their relevant business income. Also, neither deduction can be claimed if the taxpayer has no relevant business income. It is anticipated that the IRS will provide a new worksheet or form for calculating the Code Sec. 199A deduction, similar to Form 8903, Domestic Production Activities Deduction.
Limit on Excess Business Losses for Noncorporate Taxpayers
Under the Tax Cuts and Jobs Act, excess business losses of noncorporate taxpayers are not allowed for tax years beginning after December 31, 2017, and before January 1, 2026. Any excess business loss that is disallowed is treated as part of the taxpayer’s net operating loss (NOL) carryover to the following tax year.
Noncorporate taxpayers must apply this rule for excess business losses after applying the passive activity loss rules. For partnerships and S corporations, the limit on excess business losses is applied at the partner or shareholder level.
An “excess business loss” is the excess, if any, of
(1) the taxpayer’s aggregate deductions for the tax year from the taxpayer’s trades or businesses, determined without regard to whether or not such deductions are disallowed for such tax year under the excess business loss limitation; over
(2) the sum of:
(a) the taxpayer’s aggregate gross income or gain for the tax year from such trades or businesses, plus
(b) $250,000, adjusted for inflation (200 percent of the $250,000 amount in the case of a joint return).
The $250,000 amount is adjusted for inflation for tax years beginning after December 31, 2018.
Example: For 2018, Ned Brown has $1,000,000 of gross income and $1,400,000 of deductions from a retail business that is not a passive activity. His excess business loss is $150,000 ($1,400,000 − ($1,000,000 + $250,000)). Brown must treat his excess business loss of $150,000 as an NOL carryover to 2019.
The result of this provision is that an individual taxpayer is limited to offsetting a maximum of $250,000 of business loss against other income for the tax year. In the example, if Ned Brown reported wages of $400,000 (and no other income) in 2018, his adjusted gross income would be $150,000. Under previous law, all of the $400,000 of losses can be used to offset wage income to arrive at adjusted gross income of $0.
If you have any questions on how the pass-through income deduction or excess business loss limitations affect your tax liability, please call our office. We are here to assist you in understanding these new rules and making sure you are getting all of the benefits to which you are entitled.