The Tax Cuts and Jobs Act, otherwise known as the tax reform bill includes some provisions which should prove beneficial to pass-through business owners. For those unfamiliar with the concept of pass-through businesses, they are the most common form of business ownership in the United States, particularly when it comes to small businesses. Pass-through entities include limited liability companies, partnerships, S corporations and sole proprietorships. The good news for small business owners with pass-through structured businesses is that beginning in 2019 (for tax year 2018) and running up through 2026, unless extended, they will be allowed to deduct 20% of all “qualified business income” But, the question then becomes, what exactly is qualified business income?
Qualified business income is defined as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” Less than helpful on its face, the definition turns on the meaning of a number if items, including what items are qualified. Well, put as simply as possible, qualified business income includes all business income except for a number of items, like reasonable S corporation shareholder compensation or guaranteed payments to stakeholders in an LLC, for example. But, overall, the new deduction has the potential to reduce small business taxes for pass-through entities by 20%.
Of course, this is the Internal Revenue Code, so there are a number of caveats, carveouts and specifics to ensure that abuse is curtailed and at least some semblance of fairness is written into the provision, or at least appears to be.
For example, there are phased-in caps on total income that qualify a business for the deduction and the deduction is simply unavailable for certain service trades and businesses unless they fall under certain income thresholds. Professionals in fields like law, accounting, and financial advising are not permitted to claim the deduction unless they fall under certain income benchmarks ($157,500 for single filers and $315,000 for joint filers), showing an obvious policy preference for favoring the manufacturing sector (one of those places we really only see a façade of fairness in the code).
The deduction is also limited to 50% of the W-2 wages paid by the business. So, with those caveats, it’s clear that the exact amount of the deduction is going to depend on the specific facts and circumstances of each business. For a great illustration of how the deduction for qualified business income would apply in various scenarios, I’d recommend reading Mike Piper’s detailed post on the qualified business income deduction over at Obvious Investor. Mike does a great job of using real life examples to show how the various nuances of the deduction may come into play for certain small businesses.
Regardless of the specifics, one thing is clear—the majority of small businesses operating as something other than a C corporation are going to see a benefit from this provision of the new tax law.