October 25, 2018 en_US The Tax Cuts and Jobs Act was signed into law in December 2017, one of the more significant additions is the new provision allowing many owners of sole proprietorships, partnerships, trusts and S corporations to deduct 20 percent of their qualified business income. https://quickbooks.intuit.com/cas/dam/IMAGE/A7UJeYb6s/03c3cdc9e92aacb40dfeea378db10690.jpg https://quickbooks.intuit.com/r/taxes-money/whats-up-with-tax-reform-new-20-percent-deduction-for-pass-through-businesses Pass-through income tax reform: Where do things stand?

Pass-through income tax reform: Where do things stand?

By QuickBooks October 25, 2018

In December 2017, the United States Congress and President Donald Trump passed the Tax Cuts and Jobs Act (TCJA). One of the significant additions that came with this new tax law was a provision allowing many owners of sole proprietorships, partnerships and S corporations to deduct 20% of their qualified business income.

These owners are eligible because they own pass-through entities. Instead of paying income at the corporate tax rate, the businesses “pass through” the income to each owner’s personal tax return.

The law dramatically changed how many small business owners file their taxes. In this article, we’ll outline what pass-through income tax reform is and the impact it had after its first tax year. We’ll also give you a few key things to consider in case you own a pass-through entity and are interested in taking this federal tax deduction.

What is pass-through income?

According to the Tax Policy Center, “Most U.S. businesses are not subject to the corporate income tax. Rather, profits flow through to owners and are taxed under the individual income tax.” Pass-through businesses include:

Limited liability companies (LLCs) that have elected to be taxed as an S corp or a partnership would also fall into this category.

What was pass-through income tax reform?

Pass-through income tax reform is perhaps now better known as the qualified business income deduction (QBI). Passed into law in 2017, Section 199A of the U.S. Tax Code allows owners to deduct up to 20% of qualified business income from their taxes.

This new law redefined how self-employed workers, independent contractors and owners of pass-through business entities treated their tax returns. The bill amended the previously passed Internal Revenue Code of 1986. Once passed, the law took place immediately, impacting the 2018 tax year.

The Tax Foundation estimated that pass-through income tax reform would reduce taxes for more than 17 million households. The Foundation also predicted that the bill would result in a $414 billion reduction in revenue over the next decade.

This tax credit is scheduled to last through 2025. It will end immediately on Jan. 1, 2026, without a phase-out period unless Congress passes additional legislation.

Limits of the QBI deduction

Although many independent contractors and small business owners are eligible for the QBI deduction, not all of them are. As mentioned, you must own a business that passes through its income.

However, these are not the only limits. There are a few other restrictions in place that define who is eligible to deduct 20% of their business’s taxable income. We’ve outlined some of these restrictions below.

Qualified business income

According to the IRS, qualified business income is “the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business.” This, generally speaking, refers to your company’s net profit. But, it doesn’t include all business income. QBI does not include:

  • Income earned outside the United States
  • Capital gains
  • Capital losses
  • Dividends
  • Interest income
  • Guaranteed payments made to partners or shareholders

In these cases, you would not be able to take the new deduction on those portions of income. Let’s say, for instance, that you earn $8,000 in net profit and $2,000 in capital gains. $8,000 is eligible for the 20% deduction, which means you can deduct $1,600 and pay taxes on $6,400.

The $2,000 in capital gains income is not eligible for the 20% deduction, and you’d pay taxes on an unadjusted basis. When you add this back to your adjusted gross income (AGI), you’ll end up calculating your tax bill on $8,400 ($6,400 net profit + $2,000 capital gains) instead of the $10,000 that you earned. In this case, you took the deduction from eligible income and added it to your non-deductible capital gains income to figure out your total taxable income.

Income levels

In addition to the type of income that you earn, the amount of income that you make also matters. The income is based on your total taxable income, which is the figure you’ll report on your federal income tax return. This figure represents your overall earnings, including both personal and business income.

Single filers must report income at or below $157,500 to be automatically eligible for the business tax deduction. Those married filing jointly must report income at or below $315,000.

What happens if you report income higher than these amounts? Then, your eligibility depends on the type of business you conduct. Those in personal service businesses — including consultants, doctors, lawyers, tax professionals, financial planners and those who participate in actuarial science, among others — will have their deductions phased out after they exceed the income limits.

If you provide a personal service, your rights disappear entirely once single-filers earn more than $207,500, and joint filers earn more than $415,000. So, once you have income over $157,500 as a single filer, the deduction that you can take “phases out” and gradually decreases until you reach $207,500. At this point, it’s phased out entirely and the deduction you can claim equals 0%.

Other limitations

There are a few other limitations that immediately eliminate eligibility for the pass-through income deduction. If you provide services as an employee or if you earn income as a C corporation, then you are not eligible to take the deduction.

A secondary component: Real estate investment trust

There is a secondary component to consider when calculating the 20% deduction. There seemed to be a lot of confusion about this after the first tax filing season in April 2019, which prompted the IRS to release a clarification.

A real estate investment trust (REIT) is an investment management vehicle that allows you to put your money into real estate. The 20% deduction extends to REIT dividends and other income from publicly traded partnerships.

The IRS extends the 20% deduction to the lesser of:

  1. Qualified business income + real estate investment trust dividends and publicly traded partnership income
  2. 20% of taxable income – net capital gain

Another issue that seemed to confuse taxpayers was whether they could itemize and still take the pass-through deduction. This is indeed the case. Whether individuals itemize their deductions or take the standard deduction, the pass-through income deduction is still applicable.

Tax rates and brackets

Another critical thing to consider is that once you pass through income, you’ll pay taxes at the individual tax rate. By “passing through” your business income to your personal tax return, you’re not required to pay corporate taxes.

The IRS individual tax rates tend to change annually as the government adjusts for inflation and other living costs. The 2020 tax rates are listed below:

Single individuals

  • Taxable income over $0 = 10%
  • Taxable income over $9,875 = 12%
  • Taxable income over $40,125 = 22%
  • Taxable income over $85,525 = 24%
  • Taxable income over $163,300 = 32%
  • Taxable income over $207,350 = 35%
  • Taxable income over $518,400 = 37%

Married individuals filing joint returns 

  • Taxable income over $0 = 10%
  • Taxable income over $19,750 = 12%
  • Taxable income over $80,250 = 22%
  • Taxable income over $171,050 = 24%
  • Taxable income over $326,600 = 32%
  • Taxable income over $414,700 = 35%
  • Taxable income over $622,050 = 37%

Heads of households

  • Taxable income over $0 = 10%
  • Taxable income over $14,100 = 12%
  • Taxable income over $53,700 = 22%
  • Taxable income over $85,500 = 24%
  • Taxable income over $163,300 = 32%
  • Taxable income over $207,350 = 35%
  • Taxable income over $518,400 = 37%

Also, keep in mind that you’ll need to pay state and local taxes as well. The QBI may not apply when filing in your respective state.

Pass-through income example

Still a bit confused about how the pass-through income system works? Consider the following example.

You’re an independent contractor who earns $105,400 in income during the year. You don’t make any other income throughout the year as your independent contractor business is your only source of income.

You start by taking the standard deduction, which will be $12,400 in 2020. This leaves you with a taxable income of $93,000. You can then calculate your pass-through deduction by taking out 20% — $93,000 multiplied by 20% is $18,600.

This means that your total pass-through deduction for the year cannot exceed $18,600. It’s important to note that the QBI calculation takes place after accounting for the standard deduction.

Many people would believe that the QBI deduction would come first, calculated on the total gross earnings. For instance, in this case, the hypothetical QBI would be $105,400 times 20%, or $21,080.

However, your deduction is limited to adjusted gross income. Now, let’s say that you take the maximum QBI deduction, which reduces your adjusted gross income, so $93,000 – $18,600 = $74,400.

This is your total taxable federal income, which puts you in the 22% bracket. Remember that this does not account for self-employment tax, which you must pay as an independent contractor or small business owner. Self-employment taxes fund Social Security and Medicare, and are not included as part of the federal income tax rate.

How does pass-through income affect your business?

If you are a small business owner, you may want to consider restructuring your company to take advantage of the pass-through income tax reform. Remember that a C corp is not pass-through eligible. So, if you own a C corp, you may want to look into an alternative structure to take advantage of pass-through benefits.

Furthermore, even if you have an entity with pass-through benefits, you may want to consider the structure that you choose and the type of income subject to taxation.

For instance, switching from a sole proprietorship to an S corp could reduce the taxes you pay on earnings distributions. This, in turn, reduces how much you’ll need to pay in Social Security and Medicare taxes. S corp distributions are not subject to self-employment taxes, but the IRS has complex rules regarding the compensation paid to an S corp shareholder. Check with a tax accountant to find out more.

The fact of the matter is that no two businesses are the same. Pass-through income tax reform was wide-sweeping legislation. If you take advantage of it, you could end up saving a decent amount of money, but this will depend on your situation. Speaking with a reputable tax professional can help.

Stay on top of your financials

As a small business owner, staying on top of your financials can be challenging, especially when it comes time for tax season. If you own a business in multiple states, the issue becomes significantly more challenging.

You should make efforts to ensure you’re filing your taxes correctly. Not only will this help you avoid a potential IRS audit, it will ensure that you’re maximizing profits. You may be eligible for possible deductions that you are unaware of.

Hiring a tax professional could be in your best interest. You can consider these professionals as an investment that will help protect your company. Be sure to ask about things like the pass-through income tax credit to learn more about how your business is impacted.

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