Understanding the Pass-Through Deduction as a Business Owner
When structuring your business as a pass-through entity, you may be hoping to cash in on one of the biggest changes from the Tax Cuts and Jobs Act – a 20% deduction for pass-through businesses.
Several provisions of the 2017 bill directly impact business owners. For instance, the top corporate tax rate is now lower for C corporations and all business owners can deduct the full cost of eligible business assets. But it’s the pass-through deduction that could be particularly important to the many small business owners who pass their business income through their personal taxes. However, figuring out who’s eligible has left both entrepreneurs and their accountants scratching their heads.
“It’s kind of convoluted,” said Logan Allec, CPA and founder of financial advice website Money Done Right. “Not everyone gets the deduction.”
If you’re the owner of a pass-through business, you may be wondering if you qualify for the deduction. We’ll try to help you determine whether you’re eligible for this savings before tax season.
- What is the pass-through deduction?
- Who qualifies – and who doesn’t
- What to do if the IRS pushes back
What is the pass-through deduction?
Businesses that don’t pay corporate income tax are considered pass-through businesses. Owners of pass-through businesses report company profits as their own income. Owners then pay income tax based on the individual tax rate.
Partnerships, limited liability companies, S corporations and sole proprietorships are the most common types of pass-through businesses. Under the old tax law, all pass-through income was subject to regular personal income tax. The new rule allows eligible business owners to deduct up to 20% of qualified business income.
The deduction is explained in Section 199A of the IRS code. The provision defines qualified business income as the net amount of any qualified income, gain, deduction or loss that is connected with a U.S. trade or business. Business owners can deduct up to 20% of this total if their business meets the IRS’ criteria. We’ll talk more about those income and industry criteria next.
Who qualifies – and who doesn’t
Section 199A requires businesses to meet certain income and industry criteria to be eligible for the pass-through deduction.
Any entrepreneur, regardless of industry, can take the deduction if you are single and your income is below $157,500 or if you are married with joint income below $315,000. With the average U.S. small business owner collecting a salary of $70,708, according to Payscale data, the deduction stands to benefit a lot of people. Annual income for small business owners generally ranges from $29,000 to $152,000.
If your income falls below the IRS’ threshold, you could claim the lesser of:
|20% of your qualified business income, plus 20% of your qualified real estate investment trust dividends and qualified publicly traded partnership income||20% of your taxable income minus net capital gains|
If your taxable income exceeds the $157,000/$315,000 threshold but is under $207,500 if you are single or $415,000 if filing jointly, you could get a reduced deduction. There could be additional limits placed on deductions for those business owners depending on factors such as W-2 wages paid to employees or property that the business uses.
Plus, the IRS excludes specified service trades or businesses, or SSTBs, from being eligible for the pass-through deduction if the owner earns that large of an income. Businesses that make tangible goods, like manufacturing companies, are more likely to qualify than service-based business. Businesses in the following fields may be unable to claim the deduction:
- Actuarial science
- Performing arts
- Financial services
- Investing and investment management
- Any trade or business where the main asset is the skill of one or more employees
You would likely be out of luck and unable to qualify for any pass-through deduction if your income exceeds the threshold amount and the IRS considers your business an SSTB, Allec said.
“If you make more than the threshold amounts and you’re in one of these service-based businesses, you’re dead in the water,” he said.
What if you’re not an SSTB but still make more than the $207,500/$415,000 threshold? Your deduction would be capped as a percentage of W-2 wages paid to your employees.
|You can apply for the deduction if…|
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What to do if the IRS pushes back
The pass-through deduction is designed to reward businesses that do not significantly benefit the business owner, Allec said. For instance, a lawyer with his own practice who earns a large income but doesn’t pay any employees couldn’t take advantage of the deduction. Attempting to claim the deduction if you don’t qualify, even if you think you do, could lead to trouble.
“If you try to take a tax deduction that you’re really not entitled to, you can be in pretty deep water with the IRS,” Allec said.
Even the IRS acknowledges it’s confusing to determine who is eligible and who is not. Health, law and consulting businesses, to name a few, are considered SSTBs. But what about a pharmacy owner — is she dispensing health? The IRS said it depends on the circumstances when it released final guidance on pass-through deductions in January.
Even if you’re certain you qualify, be careful when calculating your pass-through deduction, especially if you’re using a software program to file your own taxes, Allec said. You wouldn’t want to overstate your deduction, or you could face an audit.
You may want to hire an accountant if you exceed the income threshold, Allec said. The more money you make, the more complicated it can be to navigate the new IRS guidelines.
“If you’re over those income limitations, that’s when it gets really tricky,” he said. “That’s when it might be worth it to pay a professional.”
There are two types of IRS audits you could bring upon your business if you make a mistake claiming a pass-through deduction: a correspondence audit and in-person audit.
- A correspondence audit would require you to send the IRS additional information about your business, Allec said. The IRS could ask for further proof that your business is not an SSTB and therefore ineligible for the pass-through deduction, he said. You may need to send a copy of your business license or verify your income to prove your business status, Allec said. If the IRS needs to conduct a correspondence audit, the organization would send you a written letter with a due date for the required documents.
- An in-person audit would be more intense, Allec said. You may be required to visit an IRS office or someone from the IRS would need to visit your place of business to review your financial documents. Similar to a correspondence audit, the IRS would send you a written letter requesting that you call and schedule an appointment for your review. You could handle the audit yourself or hire a tax practitioner to represent you and help you gather the necessary information. You wouldn’t need to hire a tax attorney unless you’re worried about criminal issues.
The pass-through deduction started as a way for Congress to help small business owners, but the IRS has had to hammer out the details and will likely be watching taxpayers closely, Allec said. The deduction could benefit many small business owners, but refrain from bending the rules to get a deduction that you’re not fully qualified to receive, he said.
“It’s so attractive and can be tempting for folks who are not walking the straight and narrow,” Allec said. “You don’t want to be aggressive with this thing.”