Tax reform impacts pass-through entities

Previously, net taxable income from pass-through business entities such as sole proprietorships, partnerships, certain LLCs, and S corporations was passed through to owners and taxed at their standard rates. Now, the Tax Cuts and Jobs Act creates a 20 percent deduction for this business income.

The proposals on pass-through business entities were a hot topic among lower and middle market businesses and were closely watched during the final months of negotiation over the tax reform bill. The end result, most experts agree, is complicated. The deduction is now based on an owner’s qualified business income (QBI) and subject to a variety of limitations and exclusions.

Most simply, small businesses will have no restriction on taking the deduction as long as taxable income falls below $157,000 for a single return or $315,000 for a joint return.

Tax filers above that threshold will not qualify for the deduction if they are a specified service business or a business that conducts investing or investment management. The rules specifically list a host of excluded businesses, effectively blocking all professional consultants, medical professionals, financial managers, athletes, and artists from taking the deduction. The law does, however, make an exception for engineers and architects.

Under the law, if your business isn’t a service business, you still have to jump through one more hoop to qualify for the deduction: Your business either has to have a certain amount of W2 wages or a certain amount in depreciable business property. Specifically, the owner’s QBI can’t exceed 50 percent of W2 wages or 25 percent of W2 wages plus 2.5 percent of the cost of qualified property.

Qualified property means depreciable, tangible property (including real estate), owned by a business and used for the production of QBI.

The pass-through entity deduction also applies to investments in REITS and publicly traded partnerships, and although the corporate tax law changes are permanent, the pass-through entity deduction expires in 2025, just like the individual tax cuts.