Pass Through Deduction Under Tax Cuts and Jobs Act (the “Act”)

General

A.  Under the Act a new deduction is introduced effective for tax years beginning after December 31, 2017, available to individuals, trusts, and estates. The deduction is equal to 20% of “qualified business income” from income earned directly by the taxpayer, and income from so-called pass through entities.  Pass through entities are essentially defined as partnerships (including limited liability companies or other entities treated as partnerships for tax purposes) and S corporations, where the taxable income or loss of the entity is generally reported by its partners or shareholders.  Qualified business income also includes certain dividends from real estate investment trusts and other defined entities (including certain cooperatives and publicly traded partnerships).  Unless it is extended by Congress, the deduction expires for tax years beginning after December 31, 2026.

B.  In general, the pass through deduction is limited to 20% of the taxpayer’s taxable income with certain adjustments. Thus, where a taxpayer has reduced taxable income through other adjustments, the benefit of the pass through deduction may be limited.

C.  The benefit of the 20% “flow through” deduction obviously depends upon the taxpayer’s tax bracket. For example, for a taxpayer in a 35% bracket the 20% deduction in effect reduces the tax rate on the taxpayer’s qualified business income, from 35% to 28%.

Qualified Business Income – Exclusion for Services

A.  As indicated, the 20% deduction relates to qualified business income. Generally, qualified business income means income from any trade or business, but it excludes certain service trades or businesses.  Disqualified service trades or businesses include any trade or business in accounting, health, law, consulting, athletics, financial services and brokerage services.  Service trades or businesses also include any business, if the principal asset of the business is the “reputation or skill of one or more of its employees”.

B.  The exclusion for services income is phased in based upon the taxpayer’s taxable income. Taxpayers with income below a certain level are not subject to the exclusion – for a single taxpayer the limitation on services income does not apply unless the taxable income of the individual is in excess of $157,500, and in the case of a joint return, the limitation does not apply, unless the taxable income on the joint return is in excess of $315,000.  For taxpayers with taxable income in excess of those amounts, the exclusion for services income is phased in, so that the deduction is eliminated entirely for single taxpayers with taxable income in excess of $207,500, and married taxpayers with taxable joint return income in excess of $415,000.

Calculation of the Deduction

A.  As noted, for each qualified trade or business, the deduction is equal to 20% of the qualified business income from that trade or business. However, except for taxpayers with taxable income below certain levels, as discussed below, the deduction is limited under two methods.  The first method, defines qualified business income as 50% of W2 wages paid with respect to the business.  The second method provides that qualified business income is equal to 25% of the W2 wages paid with respect to the business, and a portion of the tax basis of the business, in depreciable property owned by the business.  Thus, for capital intensive businesses, the second method would typically produce better results.

B.  The limitations on the pass through deduction based on W2 wages, or W2 wages and tax basis in depreciable property as discussed above, are phased in, in the same manner as the exclusion of service trades or businesses, depending on the level of the taxpayer’s taxable income. Thus, if a single taxpayer has taxable income not in excess of $157,500, or a married taxpayer has joint return income not in excess of $315,000, the pass through deduction is 20% of qualified business income, without any limitation based on W2 wages or tax basis in depreciable assets.

C.  In determining the 20% deduction, qualified business income does not include investment income, such as capital gains, dividends and interest.

Open Questions and Planning Possibilities

A.  A number of questions with respect of the application of the pass through deduction will need to be clarified. Indeed, the Treasury Department recently advised that guidance with respect to rules for determining whether a pass through entity generates income qualifying for the pass through deduction, is a high priority area.  One area which is likely to receive attention, relates to the exclusion of certain specified service businesses from the benefits of the deduction.  In particular, the treatment as service businesses, if the principal asset of the trade or business is the “reputation or skill of one or more of its owners or employees”, will need to be clarified.

B.  Depending on the nature of the business, to the extent the limitations on the pass through deduction, based upon W-2 wages, or based upon W-2 wages and capital investment, may apply, planning may be available to maximize the deduction. For example, it may be appropriate to increase the amount of W-2 wages paid, by converting independent contractor relationships to employee relationships.

C.  There has been some discussion as to the benefits of operating a business as a C Corp rather than as a pass through S corporation, to take advantage of the new low corporate tax rate – 21% – under the Act, which may be lower than the S corporation shareholders, individual tax rate. However, in many cases the benefit of the lower corporate tax rate may be offset by the pass through deduction available to S corporations shareholders (which is not available to C Corps or their shareholders) and of course, by the additional tax, which may apply, when a C Corp makes distributions to its shareholders.

D.  Obviously, the particular circumstances would need to be examined to determine if operating as a C Corp rather than an S corporation, may be beneficial.