One of the new aspects of the tax code
signed into law by President Trump is the 20% deduction available to "pass-through" businesses (i.e. LLPs, LLCs, and S-corps). It is a centerpiece of the tax bill, and one that most small business owners have heard about.
Nevertheless, it warrants a lot of explanation because it is a lot more complex than it sounds.
This article covers the basics. We'll follow with additional
Tax Reform Toolkit posts providing details relevant to taxpayers in different situations.
Let's start with the simplest situation-one in which a taxpayer owns a pass-through and has less than $315,000 of taxable income in given year (half of that amount for a single filer). This taxpayer will generally get to deduct 20% of his or her business income before calculating how much is owed in federal income tax.
However, a few wrinkles make it slightly more complicated than that.
The new deduction is not based on business income as we generally think of it. Instead, it uses what the law calls
qualified business income (QBI). But what exactly is that?
QBI is equal to the income you derive from your interest in a pass-through business minus any net capital gains. For these purposes, "net capital gains" is defined as long-term capital gains, such as a gain from the sale of stock owned for longer than one year, minus short-term capital losses, like a gain from the sale of stock owned for less than one year.
As mentioned above, the income thresholds of $315,000 for a couple and $157,500 for a single filer are based on
taxable income-that is income
after deducting the standard or itemized deductions from adjusted gross income. However, the 20% deduction cannot exceed 20% of your taxable income (without regard to the pass-through deduction).
Take the following example:
Joe is filing jointly and has $400,000 in adjusted gross income - all of which comes from a pass-through - no net capital gains, and has itemized deductions totaling $100,000. Thus, his QBI and taxable income are $400,000 and $300,000, respectively.
He calculates his pass-through deduction first using QBI, yielding $80,000 ($400,000 x 0.2). Then he calculates his maximum allowable deduction based on his taxable income, which is 20% of $300,000, or $60,000. Because the law says he may only take the lesser of the two, his deduction is limited to $60,000.
This example illustrates the basics of the new pass-through deduction, or what is known as the "199A deduction." The next Tax Reform Toolkit post will explain what happens when taxable income exceeds these thresholds.
Be sure to consult a tax professional before taking action.
