Have you struck out on your own and opened a business, or are you considering doing so? Maybe it’s a full-time entrepreneurial venture, or just a part-time gig. Either way, you may receive what’s known as “pass-through income,” and you may benefit from the new tax law.
Under the new law, the corporate tax rate has been reduced from 35% to 21%. But the tax law also added a perk for small business owners: a potential deduction of 20% of “qualified business income” for a pass-through entity. If you own your own business, that deduction may be good news. The potentially not-so-good news is that, depending on the kind of business you operate, your tax filing may have gotten just a bit more complicated.
What is a pass-through business, or pass-through income? We’ll sketch a general overview of pass-through entities, what might qualify as pass-through income, and a few other things you may need to know if you’re considering such a business structure. But be warned—pass-through structures, and the rules that apply, can be complex. This article can’t cover every aspect of the new tax reform law. The details, including how the new law might affect your situation, may be best handled by your lawyer and/or tax advisor.
What Is Pass-Through Income?
Pass-through income refers to any business revenue that must be reported on an individual return as personal income. This means that your business will not be taxed separately. Instead, the tax burden will be “passed through” from your business to you as an individual.
This form of taxation applies only to companies that are considered pass-through businesses.
What Kinds of Businesses Are Pass-Through Entities?
According to the IRS, if you own your own business, it will likely be formed as one of the following four entities:
- Sole proprietorship. An unincorporated business with a single owner. Typically a pass-through entity.
- Partnership. Two or more people operate as co-owners, but the entity is not separate from its operators. Also a pass-through entity.
- Limited Liability Company (LLC). A distinct legal entity with its own tax identification number. For income tax purposes, an LLC is typically treated like a sole proprietor if it has a single owner, or a partnership if it has multiple owners. LLCs, too, are typically structured as pass-through entities, although exceptions exist.
- Corporation. Also a separate legal entity, with the main difference being that the profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. A corporation may be an “S Corp” or a “C Corp.” An S Corp is typically a pass-through entity, whereas a C Corp isn’t.
Pass-Through Taxation Under New Tax Law
In general, your deduction is typically 20% of your qualified business income (QBI), as long as your deduction amount does not exceed 20% of your taxable income (minus any net capital gains you may have accumulated). And as with many tax rules, there are income thresholds, above which a pass-through tax deduction may phase out. If your QBI is above the threshold—$315,000 if you’re filing jointly, or $157,500 if you’re a single filer—a few complications will kick in, namely a wage limit and a phaseout that limits your deductions if you operate what’s called a “specified service business.”
What do all these term mean? Here’s a quick rundown, according to the American Institute of Certified Public Accountants:
- Qualified business income (QBI). This is the net income or gain (also deductions and losses) from your business. QBI does not include qualified publicly traded partnership income, qualified cooperative dividends, or qualified REIT dividends.
- Specified service business. Essentially, this is any type of business whose primary trade consists of performing services and whose primary asset is the reputation or skill of its owner or employees. This definition extends to the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading, or dealing in securities, partnership interests, or commodities.
- Wage limit (WL). Your deduction is limited to the greater of:
(a) 50% of W-2 wages paid by your business, or
(b) 25% of W-2 wages paid by your business, plus 2.5% of the unadjusted basis immediately after acquisition of all “qualified property” (tangible property held or used by the business).
- Phase-in rule. The phase-in begins at $157,500 for single filers ($315,000 for those filing jointly), and deductions are completely phased out by $207,000 for single filers ($415,000 for those filing jointly).
What Might This Mean for My Small Business?
In general, taxpayers with QBI below the threshold could be eligible for the full 20% deduction. Some professions with historically higher incomes, such as attorneys and physicians, may be subject to the phase-in rule.
We’ve just scratched the surface regarding the ins and outs of pass-through income. There are exclusions, exceptions, and additional limitations that can make an individual situation differ considerably from the general information offered here.
Again, the rules surrounding pass-through entities can be complex. But if you own a small business, and think you might be eligible for a 20% reduction in your tax burden, it may be worth a call to your tax consultant.
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
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