New Pass-Through Deduction Presents Tax Planning Opportunities for Pass-Through Owners
The Tax Cuts and Jobs Act (the “Act”) will dramatically change the tax treatment of income from many partnerships, limited liability companies, and S corporations. Beginning January 1, 2018, the owners of such “pass-through” entities may deduct up to 20 percent of their “qualified business income” from their taxable income each year. The deduction also is available to sole proprietorships (including owners of single member limited liability companies) but does not apply to non-owner employees.
The Act creates huge incentives for business owners to organize their businesses as pass-through entities that can qualify for the deduction, to pay wages and acquire business property that will allow them to maximize the deduction, and to characterize their business activities in a manner that will minimize their income tax liabilities.
Not all pass-through owners can or will benefit from the deduction, however. The deduction is limited, with certain exceptions, for pass-through entities that do not pay sufficient wages or purchase sufficient amounts of business property. Moreover, the deduction begins phasing out for certain service providers who earn more than $315,000 of taxable income (in the case of a joint return) and is eliminated completely once a service provider’s taxable income exceeds $415,000.
Here is a breakdown of how the new pass-through deduction works and which businesses will (and will not) benefit from the deduction.
Income from partnerships, limited liability companies, and S corporations is not taxed at the entity level, but instead is passed through to the partners, LLC members, or S corporation shareholders who pay tax on the income on their personal income tax returns. The character of the income generally flows through, i.e., ordinary income retains its character as ordinary income, and capital gains retain their character as capital gains.
Historically, pass-through entities were more tax efficient than corporations because income was taxed only once, at the partner or shareholder level, whereas, in a C corporation, income was taxed twice: once at the corporate level, and again when the income was distributed to the shareholder as a dividend. The Act minimized the inefficiency of C corporations relative to pass-through entities by dramatically reducing the corporate income tax rate from 35 percent to 21 percent. The Act also eliminated or narrowed several of the deductions on which businesses and their owners rely, including the deduction for interest expenses above certain thresholds, the deduction for business entertainment expenses, and the individual deduction for state income tax and real estate tax in excess of $10,000. At the same time, however, the Act made the tax advantages of pass-through entities even more generous, somewhat offsetting the loss of deductions, by creating a deduction of as much as 20 percent of a pass-through owner’s taxable income.
Qualified Business Income
Mechanically, the Act creates a new deduction for “qualified business income” of non-corporate taxpayers, including individuals, trusts, and estates. Earlier versions of these provisions excluded trusts, which would have significantly limited the benefits of the pass-through deduction in situations in which an owner may have transferred interests in a partnership, limited liability company, or S corporation to a trust for estate planning or creditor protection purposes. The deduction generally is 20 percent of a taxpayer’s qualified business income, subject to certain limits described below.
Qualified business income includes items of income, gain, deduction, and loss that are effectively connected with a U.S. trade or business and included or allowed in determining a taxpayer’s taxable income. The deduction does not apply to income from investment activities that do not rise to the level of a trade or business.
Qualified business income also excludes short-term capital gain, short-term capital loss, long-term capital gain, long-term capital loss, dividends, interest income, and amounts from annuities, among other items, nor does it include reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer, any “guaranteed payment” from a partnership, and any payment to a partner for services rendered with respect to the trade or business of the partnership (to be clarified in regulations, which have not yet been issued). As a result, partners and LLC members generally have a better chance to maximize the deduction than do S corporation shareholders.
Limitations on the Deduction
The 20 percent deduction is limited, however, if a pass-through entity does not pay sufficient wages or acquire sufficient business property.
Specifically, the deduction is limited to the lesser of (a) 20 percent of the taxpayer’s qualified business income with respect to a qualified trade or business, or (b) the greater of (1) 50 percent of W-2 wages paid with respect to such business, or (2) the sum of 25 percent of W-2 wages paid with respect to the business plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.
W-2 wages generally refer to wages paid to employees, and qualified property generally refers to depreciable business property. In the case of real estate, it appears that only buildings and other depreciable improvements (but not the cost of the land on which the building and improvements are located) will be treated as qualified property. Note the qualified property includes the unadjusted (non-depreciated) cost of the property so long as it still has a depreciable life, was new property when acquired by the taxpayer, and is located the United States. Interestingly, the Act does not limit benefits to depreciable property acquired after the enactment of the Act or to the basis of property adjusted for depreciation previously claimed with respect to the property.
For example, assume Partner A’s share of the AB partnership’s 2018 qualified business income is $1 million. The AB partnership paid wages of $600,000 in 2018 ($300,000 of which is allocable to A as a 50 percent partner) and owned qualified property with an unadjusted basis immediately after acquisition of $400,000 ($200,000 of which is allocable to A). In this example, A’s deduction is limited to the lesser of $200,000 (20 percent of qualified business income allocated to A)), or the greater of (1) $150,000 (50 percent of W-2 wages allocated to A) or (2) $80,000, which is the sum of $75,000 (25 percent of the $300,000 of W-2 wages allocated to A) plus $5,000 (2.5 percent of the $200,000 of unadjusted basis of qualified property allocated to A). Thus, A’s deduction will be limited to $150,000, even though her qualified business income was $200,000. Consequently, under the Act, A pays federal income tax on only $850,000 of the $1 million of AB partnership income allocated to her. Under prior law, A would have paid tax on the entire $1 million of income allocated to her.
By limiting the deduction in a manner that is connected to a pass-through entity’s payment of W-2 wages and its acquisition of depreciable business assets, the Act creates incentives for pass-through entities to hire employees and/or to purchase new business property. A special rule, however, allows taxpayers to claim the deduction for qualified real estate investment trust dividends and qualified publicly traded partnership income, without regard to the wage or unadjusted basis of property limitations.
Special Rules for Service Providers
Taxpayers in service businesses, such as healthcare professionals, attorneys, accountants, actuaries, performing artists, consultants, professional athletes, financial services and investment professionals, or any other business in which the principal asset of such business is the reputation or skill of one or more of its employees or owners (except for architects and engineers) may claim the deduction and are not subject to the W-2 wage limit or the unadjusted basis of property limit, so long as their income does not exceed a threshold amount. The deduction begins to phase out, however, once a service provider’s income exceeds $315,000 (or $157,500 for an individual return) and phases out completely once a service provider’s taxable income exceeds $415,000 ($207,500 for an individual return). Those amounts will be indexed for inflation and will increase annually.
The ability of service providers to claim the pass-through deduction, at least up to the threshold amount, is surprising because, historically, individuals have been taxed at ordinary income rates on all income from personal services. By allowing the deduction for service provider-owners of pass-through entities, the Act treats some similarly situated individuals differently.
For example, assume that X and Y are accountants who perform virtually identical services and earn identical compensation of $150,000 per year. Historically, X and Y would have been taxed in a similar manner on their personal services income, meaning that all of their income would have been taxable at ordinary income rates. Under the Act, however, X and Y may be taxed very differently if X is a partner in an accounting partnership or a sole proprietor and Y is an employee of a corporation, i.e., X may be able to deduct up to 20 percent of his income, while Y will be taxed on his entire income.
Under the Act, the deduction for qualified business income will expire in 2026.
The new pass-through deduction presents pass-through businesses and their owners with myriad tax planning opportunities. Pass-through entities that arguably provide services, for example, and would otherwise be unable to benefit from the deduction, will have a huge incentive to characterize their activities in a way that will qualify for the deduction, or to split up their business activities into two or more pass-through entities, at least one of which qualifies for the deduction. Some businesses may adjust their W-2 wages or purchase additional business property to maximize the deduction. And certain individuals, particularly professional service providers who earn up to $315,000 per year, may find it advantageous to characterize themselves as sole proprietors or independent contractors, thereby cutting their tax bills by up to 20 percent.
The Act also creates some uncertainty about how far pass-through owners of businesses involving a significant service component can go in claiming the deduction. There already has been significant speculation about the extent to which service providers in particular may be able to reorganize their affairs so as to qualify in whole or in part for the new deduction. This is inevitable given the somewhat arbitrary manner in which the Act identifies those businesses that qualify for the deduction and those that do not. Service providers face the triple whammy of not receiving significant tax rate reduction, the loss of the deductions for business entertainment expenses and certain other business expenses, and the loss at the individual level (at least in higher taxed states) of deductions for state and local taxes, among others. It may be some time before definitive guidance is provided by the U.S. Department of the Treasury or the Internal Revenue Service (IRS). But the table clearly is set both for incentivizing creativity and the potential for disagreements between taxpayers and the IRS.
 A related issue is whether owners of pass-through entities or sole proprietorships will find it advantageous to incorporate their business activities and be taxed as traditional C corporations in order to qualify for the 21 percent rate. We will address this issue in a future article, but suffice it to say that the pros and cons of doing so will require a highly fact-intensive analysis taking into account, among other things, the fact that the pass-through deduction currently expires in 2026.