The 2018 tax law included a potential perk for small business owners who operate as pass-through entities
Sole proprietorships and partnerships are typically pass-through entities, as are some LLCs and corporations
Tread carefully, as pass-through tax rules can get complicated depending on the type of business entity you own
Have you struck out on your own to open a new business, or are you considering it? Maybe you’re looking at a large-scale entrepreneurial venture, or something more modest, like a part-time gig. Either way, the revenue you generate may be small enough to be considered pass-through income. And the money you owe Uncle Sam may fall under the category of pass-through tax. If you’re not familiar with this tax category, then read on.
Under the new 2018 tax law, the corporate tax rate has been reduced from 35% to 21%. But the law also added a perk for small business owners: a potential deduction of 20% of “qualified business income” for any pass-through entity. This deduction may be good news for small business owners. The bad news is that it might make your tax filing just a bit more complicated.
But first, you should understand the general overview of this type of tax structure. But be warned: the rules can be rather complex. This article can’t cover every aspect, and the details are important. So when you’re done reading, you might want to pay your lawyer or tax advisor a visit to learn more about pass-through tax rules and how they might affect your business.
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.
These tax rules apply only to companies that are considered pass-through entities.
Pass-Through Taxation Under the 2018 Tax Law
Generally speaking, 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).
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As with most 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 terms 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 $207,500 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 of pass-through tax rules. 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 and taxation 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.