One of the more publicized provisions of the federal Tax Cuts and Jobs Act signed into law in December was the reduction in tax rates on C corporation net earnings to a flat rate 21 percent from an overall average 35 percent. Since its passage, this provision has been credited with promoting numerous economic benefits.
While those benefits are understandable, C corporations comprise only a percentage of the business returns filed. Based upon Internal Revenue Service data, roughly 6.5 million C corporation returns are filed annually.
However, over 33 million returns are filed by "pass-through" entities: S corporations, partnerships, limited liability companies and individual business activities.
These are the entities that create jobs and are the entities of choice of entrepreneurs. The Tax Cuts and Jobs Act also created tax benefits for these "pass-through" entities. The purpose of this article is to address one of those provisions: the "20 percent pass-through deduction" under the new Section 199A of the Internal Revenue Code.
The 20 percent pass-through deduction is intended to provide a form of tax relief to business entities that do not pay tax at the entity level, but "pass through" income to the business owners for reporting on their individual return.
Explaining the concept is where any simplicity ends. This provision applies to the taxpayer who is an S corporation shareholder, partnership partner, or a member of a multi-member or single-member LLC.
While this deduction on pass-through income provides tax relief, this provision and its application is extremely complex and may not be available to all individuals in all businesses at the 20 percent level. To reap the deduction related to this provision, the taxpayer must navigate a myriad of limitations, thresholds and caps.
Questions to be answered at the entity and individual level include:
- Does the business qualify as a "qualified small business"?
- What is the qualified business income of the entity?
- What wages were paid by the entity to the non-owner?
- What is the amount of qualified property applicable to the entity?
- What is the combined qualified business income of the individual taxpayer?
- What is the income of the taxpayer?
The provision has a phase-out between $315,000 and $415,000 of income for individuals filing a married-filing joint return. Those thresholds are $107,500 and $207,500 for single individuals. However, just because one's income may exceed those thresholds, they may still be able to avail themselves of a deduction.
Extenuating provisions take into account the nature of the type of business it is, the compensation paid within the entity and a capital factor considering the amount of fixed assets of the entity, the amount of depreciation claimed on those assets.
To have the information necessary to perform the complex calculations, S corporations and partnerships will be adding information to their K-1s. Business owners will want to evaluate compensation structures of business owners and staff.
During the period of this provision, which begins in 2018 and extends through 2025, business owners may want to consider the applicable depreciation method they use. This will not necessarily be a policy consideration but an annual decision based upon the facts and circumstances by year.
This deduction will not be applied in computing adjusted gross income but in arriving at taxable income. It is computed after application of passive activity loss rules. It will not reduce any self-employment tax and cannot be used to create a net operating loss. Any portion of this deduction unused in the current year will be carried over to subsequent years. It cannot be carried back.
As with many new tax provisions, there are issues associated that require further clarification and are sure to be subject to future regulation.
Michael A. Fee, CPA is president of Michael A. Fee, P. C. in Mansfield, Texas. He wrote this article on behalf of the Fort Worth Chapter of CPAs, a regular contributor to FW Inc.