What You Need to Know About the New 20% Deduction for Pass-Through Income

The Tax Cuts and Jobs Act of 2017 (the Act) generally allows a non-corporate taxpayer (including a trust or estate) who has qualified business income (QBI) from a partnership, S corporation or sole proprietorship (pass-through entities) to deduct the lesser of:

• The combined qualified business income amount of the taxpayer; or
• 20% of the excess, if any, of the taxpayer’s taxable income for the tax year, less net capital gain.

QBI is defined as all domestic (U.S.-source, including Puerto Rico,) business income other than investment income.  QBI does not include any amount that is treated as reasonable compensation of the taxpayer for services rendered to the business (W-2 salary for S corporation) or any amount paid by a partnership that is a guaranteed payment for services performed. The 20% deduction is not allowed in computing adjusted gross income, but rather is allowed as a deduction reducing taxable income.

Limitations

For pass-through entities, the deduction cannot exceed the greater of:

• 50% of the W-2 wages attributable to qualified business income paid to the taxpayer; or
• The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis of all qualified property.

Qualified property is generally defined as tangible, depreciable property that is held by, available for use of, and used in the qualified trade or business at the close of the tax year.

For a partnership or S corporation, each partner or shareholder will be treated as having W-2 wages for the tax year in an amount equal to his or her allocable share of the entity’s W-2 wages for the tax year.

The W-2 wage limit does not apply in the case of a taxpayer with taxable income not exceeding $315,000 for married individuals filing jointly ($157,500 for other individuals). This limitation is phased-in for individuals with taxable income exceeding these thresholds over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals).

Exclusions

The deduction does not apply to “specified service businesses,” which means any trade or business that involves the performance of services for any trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owners.  The Act specifically excludes engineering and architecture services from the definition of “specified service business.”

This exclusion does not apply for a taxpayer whose taxable income does not exceed $315,000 for married individuals filing jointly ($157,500 for other individuals). The deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals).

New Limitations on Excess Business Loss

The Act implements a new rule, which states that “excess business losses” are not allowed for the tax year but are instead carried forward and treated as part of the taxpayer's net operating loss (NOL) carryforward in subsequent tax years. This limitation applies after the application of the passive activity loss rules. NOL carryovers generally are allowed for a taxable year up to the lesser of the carryover amount or 80% of taxable income.

An excess business loss for the tax year is the excess of the taxpayer’s aggregate deductions attributable to his/her trade and businesses over the sum of aggregate gross income or gain of the taxpayer, plus a threshold amount. The threshold amount for a tax year is $500,000 for married individuals filing jointly and $250,000 for other individuals, with both amounts indexed for inflation.

Expansion of Qualifying Beneficiaries of an Electing Small Business Trust (ESBT)

Effective January 1, 2018, a nonresident alien can be a potential current beneficiary of an ESBT.

Substantial Built-In Loss on Partnership Transfers

A partnership does not generally adjust the basis of partnership property following a transfer of partnership interest, unless the partnership has made an optional basis adjustment (§754 election) or the partnership has a substantial built-in loss. A substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds $250,000 of the fair market value of the partnership property.

After 2017, the definition of substantial built-in loss is expanded, as it affects transfer of partnership interests.  Under the Act, a substantial built-in loss exists if the transferee is allocated a net loss upon the hypothetical disposition of all the partnership’s assets in a fully taxable transaction.

The choice of entity type is critical in determining the most tax-efficient structure under the Act. As such, it is essential that you consult with your tax advisor to determine whether your trade or business qualifies for this new deduction.