The new year brings new tax laws, and one of the most prominent changes for many will be a new deduction for pass-through income.
What is the deduction?
Beginning in 2018, there will be an income tax deduction of 20% for "Qualified Business Income." Qualified Business Income will include taxable income attributable to a US trade or business, but does not include investment-type income, such as dividends, capital gains and losses, nor interest income that is not allocable to the trade or business. Qualified Business Income will not include amounts paid to the taxpayer from the trade or business as "reasonable compensation" nor will it include amounts paid to a partner as a guaranteed payment.
All non-corporate businesses will potentially qualify, whether as a partnership, limited liability company or sole proprietorship. But, performing services as an employee is not a trade or business; therefore, those individuals whose sole business is performing services as an employee will not be eligible for the tax deduction.
A significant exclusion from qualifying for this deduction applies to those who provide a "specified service." Individuals who perform "specified services" will not be eligible for the deduction attributable to income from those specified services unless their taxable income (i.e., income from all sources after deductions) is less than $315,000 for joint filers, $157,500 for single filers (with a phase-out of the deduction over the next $50,000 to $100,000.)
"Specified Services" are those services performed in the fields of law, health, accounting, actuarial science, consulting, financial services, athletics, performing arts, brokerage services, investment management, securities trading or any other business where the principal asset is the skill or reputation of its employees or owners. Note that, in a last minute legislative amendment, the services of architects and engineers were carved out of Specified Services; therefore, architects and engineering services will be eligible for the pass-through deduction, regardless of income level.
For eligible taxpayers whose taxable income is less than the $315,000 for joint filers, and $157,500 for single filers, the deduction is 20% of Qualified Business Income, (with a phase-out of the deduction over the next $50,000 to $100,000.)
For eligible taxpayer above these dollar thresholds, the 20% deduction of Qualified Business Income cannot exceed the greater of:
(A) 50% of the W-2 wages (and elective deferrals) paid by the qualified business, (based on the taxpayer's percentage ownership of the business.) OR (B) (1) 25% of the W-2 wages (and elective deferrals) paid by the qualified business, PLUS (2) 2.5% of the unadjusted basis (original undepreciated cost) of all "qualified property." Qualified Property is all tangible depreciable property used in the qualified business for which the depreciable period has not ended before the close of the year, subject to special rules in determining the depreciable period.
First, it should be noted that there are uncertainties in the new law that may be clarified by Treasury Regulations, but we do not have any such regulations at this time. For example, it remains to be seen which other types of personal services will fall under the "Specified Services" exclusion. In addition, regulations will have to spell out how to apply the deduction to tiered entities.
Also note that the new law excludes "performing services as an employee" from the definition of Qualified Business Income. Therefore, those who render services as an employee to another trade or business will have to do so as a non-employee, such as a partner or independent contractor. But being a partner or an independent contractor is not a mere label. These are legal relationships that are different than being an employee, and these relationships have consequences. For example, coverage under retirement plans and medical plans will not be available to independent contractors. Businesses that misclassify workers may expose themselves to penalties. In addition, the status as an independent contractor is determined not by a label but by a multitude of factors, especially the degree of control exercised over the employee/contractor.
Finally, it should be noted that this deduction is available only through 2025; after that, it is scheduled to expire