It is been two months since President Trump signed the tax reform bill. The new Tax Cuts and Jobs Act (TCJA) offers some tax saving options for businesses, among others, the tax deduction for owners of pass-through entities.
What is Pass-Through Taxation?
It is the option that business owners have to be taxed on earnings from their business at individual tax rates. In other words, business owners are able to pay taxes on their earnings derived from their business, as if it will be a personal income tax return. It applies to partners in partnerships, shareholders in S Corporations, members of Limited Liability Companies, and Sole Proprietors. Special rules apply to specified agricultural or horticultural cooperatives.
The new law, authorizes a deduction of up to 20 percentage for pass-through entities on “qualified business income”, after 2017 and before 2026. It also applies to “qualified real estate investment trust” (REIT) dividends, “qualified property”, and “special derived trade or business”. So, to understand the restrictions, let’s define important terms.
What is Qualified Business Income (QBI)?
It is the net income from the business, excluding any amount paid by an S Corporation treated as compensation, any guaranteed payment for services in business, or any amount paid or incurred to a partner for services outside his or her capacity as a partner. The QBI is calculated on as per-business basis, instead on a per-taxpayer basis.
What is Qualified Property?
It is tangible property subject to depreciation and available for use in your business at the end of the tax year. This property must be used to produce qualified business income.
What is Specified Service Trade or Business?
It includes basically every business offering occupational services, EXCEPT engineering and architecture-services including partnership interests, investing and investment management, dealing with securities, or commodities, or any trade or business where the principal asset of such trade is the reputation or skill of one or more of its employees or owners. Qualified business for specified service trades or businesses phases out as follows:
- Individual taxpayers $157,500
- Married taxpayers filing jointly $315,000
Threshold Amount:
Is the amount limit, above which the limitation is applied.
How is the 20% passthrough income deduction applied?
The deduction depends on, if the taxable income is below or above the threshold amount. If the threshold is below, you are entitled to the full deduction; if the threshold is above, you are subject to limitation and exceptions on the deduction, which are determined by occupation and a wage limit.
The deduction is based on the wage and capital limits to the greater of:
- The 50% of the W-2 wages paid by your business, or
- The sum of 25% of W-2 wages paid by your business, plus 2.5% of the unadjusted basis of all “qualified property”.
This limit in phaseout range is prorated based on the same income (income, gain, deduction, loss, W-2 wages from the business) and:
- Business owners under the phaseout range will favor from the deduction, if they keep sole proprietorship or partnership taxation, instead S-Corporation taxation.
- Business owners under the phaseout range will have two tax rates for type of income:
- Normal taxable income at a normal marginal tax rate, and
- Pass-through business income at a lower marginal tax rate.
- Business owners in the phaseout range, will have two marginal higher tax rates, because each additional dollar of income will determine the phaseout of the deduction.
Corporate Tax Rate
The new tax bill made a major simplification to the corporate tax structure, in effect January 1, 2018, the corporate tax rate lowered to a flat rate of 21 percent. For a fiscal year regular corporation, with tax year ending in 2018, the new rate will be fused with the rates in place prior to January, 1, 2018.
Will you be affected by these changes? To find out more, contact Rosillo & Associates PA, a Florida Certified Public Accountant firm specializing in U.S. tax preparation for business.