Pass-through Deduction Changes Explained - Davis Law Office

Pass-through Deduction Changes Explained

Pass-through Deduction Changes Explained

If it sounds too good to be true it probably is. That’s what we were all taught as kids, right? Well the lesson still applies. In recent days, as the tax overhaul legislation has rocketed its way through the US government, I have had more than one business owner (both LLC and S corporation owners) ask me if it means they are getting a big deduction now. And at first glance, it would seem that is the case. But as with anything that seems too good to be true (especially for small businesses), you have to dig a bit deeper to get to the truth.

The reason these business owners thought they might be getting a big deduction makes sense. The way the legislators writing the bill spoke about it and thus, the way most articles reported on it, certainly made it sound as if that was the case. After all, the final compromise bill that blended the House and Senate plans together kept the Senate’s plan to give owners of pass-through companies (most often LLCs and S-Corporations) a 20% deduction on their income. Sounds great, right? Not quite.

If you dig a bit deeper into the actual document that was released by the conference committee (really deep, like midway down page 553 of the 1097 pages in that document) you will see a small section titled “Reasonable compensation and guaranteed payments.” And the two sentences in that section have a huge effect on how big the deduction for pass-throughs will actually end up being.

“Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.”

So what, in plain English, does this mean?

It means that for most small business owners, who work in their businesses, they will not be able to take the new 20% deduction on ALL of the income they take from the business. They will only be able to take the deduction on QUALIFIED BUSINESS INCOME, which will not include anything that the IRS would treat as reasonable compensation (for an S corp owner) or as guaranteed payment for services rendered with respect to the trade or business (for an LLC owner). So the scenarios business owners were running in their head (and those online calculators may have been churning out) are likely an over-estimation of the deduction and subsequent tax savings they will actually see next year.

For example, if you own an S corporation, and next year you take $100,000 out of the business for your income, you will not get a deduction of $20,000 (20% of the total) but you will need to work with an accountant to figure out, according to established IRS regulations and Federal court precedent, how much of that amount should be counted toward “reasonable compensation” and how much can be “qualified business income.” If you already have an S corporation you’re probably familiar with this conversation with your accountant, and are likely splitting your income 70/30 or 60/40, with the larger amount being considered “reasonable compensation” and the smaller amount “business income.”

If you own an LLC you’ll face a similar situation, and will need to speak to your accountant about what portion of the money you take out of the company will be considered “a guaranteed payment for services rendered” and what portion, if any, may be considered “qualified business income.” You’ll only receive a 20% deduction on the QBI portion, NOT the guaranteed payments for services, and can expect that the percentages your accountant suggests will likely be close to the 70/30 or 60/40 of the S corporation example.

With either structure, you would likely be looking at a far more modest $6,000 or $8,000 (not $20,000) that would be deducted from your taxable income before calculating what you’ll owe. It may reduce your tax burden from prior years, but not as drastically as you may have been thinking – thus proving the old adage correct once again.

5 responses to “Pass-through Deduction Changes Explained

    1. Really great question. Generally speaking, if your combined income as a married couple is $315,000 or less (or $157,500 for single filers) as a sole proprietor, you will be entitled to the 20% deduction for your qualified business income (which will likely be most of the income you take from the business). However, if your combined income is MORE than $315,000/%156,500, you will not receive any deduction unless you are also paying W-2 wages to employees from the business. If you are, then your deduction is limited to 50% of the W-2 wages paid.

      1. So If my family household income is more than $315k, and lets says I have a distribution of $50k from my S-corp. I have FIVE employee wages including myself of $180k, of which, two are shareholders of the S-corp. Does that mean, I get a maximum $90k deduction (50% of W-2 wages) and the $50k will get a 20% tax rate? Thanks!

        1. This scenario is a little tricky, and we’ll apply the caveat that each situation is specific so you’d want to check with a tax preparer or accountant for sure, but the 50% of W-2 wages is not separate from the 20%. The 20% is the maximum deduction you are allowed to take under the revised law on your total personal income from the business, but if you have a total household income of $315K or more, the amount of this deduction is reduced. Having W-2 wages paid out of the company may help you keep some of the 20% deduction in this case, but you wouldn’t have a $90K deduction and a separate amount with a 20% tax rate – the 20% is a deduction, not a rate.

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