New Pass-Through Deduction Explained: How Small Businesses Will Save

The new tax code contains a 20 percent deduction for pass-through businesses — sole proprietorships, partnerships, LLCs and S-corporations. Here’s how it works:

What Does Pass-Through Mean?

Pass-through refers to how sole proprietorships, partnerships, LLCs and S-corporations are taxed. Instead of having a separate business tax return, the business’s profits or losses are passed through in full to each owner. The owners then pay their personal income tax rates on their share of the profit or loss.

What Are the Basics of the Pass-Through Deduction?

With some exceptions explained below, the pass-through business owner allows small business owners to reduce their taxable income by 20 percent of their business profits. For example, a sole proprietor making $100,000 per year will receive a $20,000 deduction and only pay income taxes on $80,000 in income.

It’s important to note that this deduction is not an adjustment to Adjusted Gross Income (AGI). It does not reduce self-employment taxes. It also has no effect on other tax items calculated based on AGI such as retirement contributions, healthcare subsidies and childcare credits.

Why Was This Deduction Added?

Before tax reform, non-pass-through businesses, such as C-corporations, paid tax rates ranging from 15 to 35 percent. These rates were similar to the 10 to 39.6 percent individual rates by paid pass-through businesses.

With corporate rates now reduced to 21 percent and individual/pass-through rates ranging from 10 to 37 percent, Congress felt that pass-through businesses would be disadvantaged by the changes. The pass-through deduction is designed to offset the difference in rates.

Calculating the Pass-Through Deduction: Owner’s Income

The first test for determining the deduction amount is each individual owner’s total income. If an owner has an AGI up to $157,500 ($315,000 if married filing jointly), they receive a deduction of 20 percent of their business income.

This test is per owner, so it can still apply if the business’s income is above the limits as long as each owner’s share leaves them below the cap. If some owners qualify and others do not because of owning a larger share or having other income, the owners that do qualify can still take the deduction.

Exception: Service Businesses

Designated service businesses have special rules. Designated service businesses are skilled professionals who largely rely on their own labor such as doctors, accountants and lawyers. The deduction depends on their income.

  • If they’re within the $157,500/$315,000 cap, they receive the full deduction.
  • The deduction gradually phases out and drops from 20 percent to zero percent as their income approaches $207,500 ($415,000 if married filing jointly).
  • For higher incomes, there is no deduction for service businesses.

Non-Service Businesses Above the Income Limit

If the owner of a non-designated-service pass-through has an AGI above the $157,500/$315,000 limits, the deduction is capped based on the business’s payroll and capital assets. The cap is the greater of

  • 50 percent of wages, or
  • 25 percent of wages plus 2.5 percent of capital assets.

Example: A single-owner S-Corporation has profits of $500,000 and paid wages of $100,000. Because 50 percent of wages ($50,000) is less than 20 percent of business income ($100,000), the owner’s pass-through deduction is limited to $50,000. If the business had paid $400,000 in wages, the pass-through deduction would still be 20 percent of profits or $100,000.

The purpose of these caps is to prevent pass-through business owners from taking unreasonably low salaries and high dividends to avoid payroll taxes. It also discourages high-salary employees from reclassifying themselves as 1099 consultants to take advantage of the deduction.

Does Your Small Business Qualify?

These rules serve as the general framework, and the new tax law gave the IRS the authority to set additional rules to meet the law’s intent while closing loopholes and filling in any gaps. Check with your tax accountant to see if any additional provisions apply to your business.

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