Editorial · December 25, 2017
Pass-Through Deduction: What the New Tax Law Says
Pass-through deduction is the name many tax writers give to a new 20 percent break for owners of small and mid-size businesses. Congress passed it in the tax bill, H.R. 1, and the President signed the bill on December 22, 2017. It is Section 199A of the tax code. This note explains what the text says, in plain words.
What the deduction does
The law lets a person who is not a corporation deduct part of the income from a business. The deduction is up to 20 percent of "qualified business income." That is the net profit from a trade or business that you run in the United States. It applies to owners of sole proprietorships, partnerships and S corporations, because their business profit is taxed on the owner's own return. These are the "pass-through" businesses.
The deduction is taken after adjusted gross income. The law says you can claim it even if you do not itemize deductions. It also lowers taxable income only. It does not lower the self-employment tax base.
When it starts and when it ends
The deduction is open for years that start once 2017 has ended. For most owners, that means the tax year that starts next month. You will not claim it on a 2017 return. The law also sets an end date. The section stops applying after eight tax years, unless Congress acts again.
What counts as business income
Only income from the business itself counts. The bill says items of capital gain and capital loss are left out. So are most dividends and interest income that is not tied to the business. Income earned as an employee is not eligible either.
Pay you give yourself is also left out. The law removes "reasonable compensation" paid to the owner by the business. It removes guaranteed payments to a partner for services as well. If the net total for the year is below zero, the loss carries into the next year as a loss from a qualified business.
The limits on high earners
The law sets a "threshold amount" of $157,500 of taxable income. For a joint return, the amount is $315,000. Under the threshold, the deduction is generally 20 percent of qualified business income, but it can never be more than 20 percent of taxable income after net capital gain.
Above the threshold, a wage and property test starts to apply. The 20 percent figure for each business cannot be more than the greater of two amounts. The first is 50 percent of the W-2 wages the business pays. The second is 25 percent of those wages plus 2.5 percent of the original cost of qualified property, such as equipment, that the business still holds.
The test phases in over a range of $50,000 of taxable income, or $100,000 on a joint return. A business with few employees and little equipment can lose much of the deduction at the top of that range. The threshold amounts will rise with inflation in later years.
Service businesses are treated differently
The bill sets a special rule for a "specified service trade or business." It points to the existing list in section 1202(e)(3)(A) of the tax code. That list covers services in fields such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services. The new law removes engineering and architecture from that list for this purpose. It adds investing, trading and dealing in securities.
Below the threshold, owners of these service firms can still claim the deduction. Over the next $50,000 of income ($100,000 on a joint return), the share they can count shrinks to zero. Past that point, a service business gets no deduction. Because of this, a doctor or lawyer with high income may get nothing, while an owner of a similar-size shop or factory may keep it.
What owners can do now
The text leaves some questions open. Agencies have not yet said how some terms will be read, so check each point with a tax professional before you plan around it. A few steps are safe today.
- Keep clean books that show profit for each business you own.
- Track W-2 wages and the cost of equipment, because the limit uses both.
- Estimate next year's taxable income against the $157,500 and $315,000 marks.
- Ask your preparer how pay to owners should be set, since that pay is left out of the base.
For the 21 percent rate that now applies to regular corporations, see section 13001 of the same bill. Owners of C corporations do not use Section 199A at all.