New small business/pass-through rules

Your Guide to State, Local, Federal, Estate + International Taxation

pass-through, small business, tax reform, corporation, partnershipoMy head hurts – here’s how to determine if your business bank account will too

If you’re like me, and require one (or four) cups of coffee to get going in the morning, you may want to put on a fresh pot for this blog. While I was under the impression that homework over winter break ended with my graduation, Congress handed me (and all tax accountants) a nice 1,097-page reading assignment over the holiday. Our task? Inform our clients about the new tax laws and regulations handed down by the likely passing of the Tax Cuts and Jobs Act of 2017. Without further ado, here are the things you need to know about one of the most complicated areas of the new law – small business and pass-through entities.

Under current law, small businesses and pass-through entities’ (S Corporations and Partnerships) taxable income is taxed at the proprietor’s marginal rate, with the top rate nearing 41% when accounting for phase-outs and surtaxes. Given that the new corporate tax rate is a flat 21%, and new individual rates up to 37%, there was an obvious gap between C Corporations and the pass-through entities that make up much of the American economy. The tax law had to provide some sort of incentive for these companies, and thus, these new rules were written

Conceptually, the new code sections give pass-through and small business owners a 20% deduction of “qualified business income” right off the top. As with all things tax related, it is never quite that simple, though. Let’s break it down in parts.

Qualified business income

Qualified business income (QBI) is the base for which the special deduction is calculated. It does not include investment income from the activity (though certain investment income may still enjoy favorable capital rates). QBI also does not include W-2 wages paid to an S Corporation shareholder or guaranteed payments made to a Partner of a Partnership. Foreign income is also not included. At its most basic level, QBI is ordinary income from the business activity passed to the shareholders individually based on the required allocations. Talk to your CPA if you still have questions on what constitutes QBI.

Taxable income + deduction calculation

Much of the complexity revolves around the individual taxpayer’s taxable income. Historically, the tax code has used Adjusted Gross Income (AGI) as the basis for income-based phase-outs and provisions, so this is a departure from the norm. The pass-through deduction is not taken at the entity level – it is taken at the individual level. Thus, it is possible for two shareholders of the same company to see completely different results from this deduction. For taxpayers with taxable income (after the new standard deduction or itemized deductions, plus other adjustments) under $315,000 for married filing joint (MFJ) ($157,500 for single), the QBI deduction is calculated as the lesser of:

  1. 20% of QBI, or
  2. 20% of taxable income, without regard to net capital gains or this deduction.

For those taxpayers whose taxable income exceeds $315,000 for those filing jointly ($157,500 for single), the QBI deduction must jump through some more hoops. The introduction of a new W-2 limitation takes place, and thus, the calculation is the lesser of:

  1. 20% of QBI, or,
  2. The greater of:
    1. 50% of W-2 wages paid by the company, or
    2. 25% of the W-2 wages paid by the company, PLUS 2.5% of the unadjusted basis of newly acquired qualified property.

Confused yet? Me too. I needed to read the summary articles many times over to grasp this concept, and I think the best way to illustrate the concept is with an example.

And that is it for today! Come back tomorrow for Part 2 of this cool new feature for some actual examples.

Brock R Yates, CPA, MT