By Michael Law
One of the changes implemented by the Tax Cuts and Jobs Act of 2017 is the section 199A deduction, also known as the pass-through deduction. This provision is designed to help alleviate the tax burden for a variety of small business owners. Let’s take a quick look at what the pass-through deduction is, how it works, and potential complications with the new law.
What is the pass-through deduction?
The majority of American businesses aren’t subject to the oft-discussed Corporate Tax. Instead, any business owner that files taxes on Schedule C or Schedule K1 pays taxes on their individual tax return. For these business owners, their business earnings “pass through” to their individual return.
Starting in 2018, some of those business owners are eligible to deduct up to 20% of qualified business income (QBI) from their individual taxes.
How does the pass-through deduction work?
In order to calculate the pass-through deduction, you first have to determine your client’s QBI. In this case, QBI is simply the client’s ordinary business expenses minus profit. To calculate your client’s pass-through deduction, you deduct the lesser of:
- 20% of the client’s QBI
- 20% of the client’s ordinary income
The deduction begins phasing out at $157,500 for individuals and goes away completely at $207,500. For married taxpayers filing jointly, the deduction begins phasing out at $315,000 and goes away completely at $415,000.
There are a myriad of exceptions and specifications that can make calculating the pass-through deduction extremely complicated. If you want to examine all the complexities of the deduction in more detail, check out this post by Kelly Phillips Erb.
Not all small businesses will qualify for the pass-through deduction, and not all business expenses count as QBIs. The law states that “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees,” does not qualify for the deduction.
As you can see, this definition leaves a great deal of room for interpretation, and the IRS hasn’t yet provided any clarifying guidance. The final “reputation or skill” clause is particularly vague as it’s unclear at what point reputation or skill becomes the “principal asset” of the business.
Thankfully, the business expense restrictions are more clearly laid out. QBI doesn’t include either short or long-term capital gains, dividend income, or interest income.
Michael Law earned a master’s degree in taxation from Golden Gate University and has more than 20 years of experience in accounting and tax. Currently, he works as a CPA Subject Matter Expert Manager at Canopy, leading a team to develop world-class tax software. Prior to Canopy, he served as the Vice President of Tax Operations for the Salt Lake City branch of Goldman Sachs. Connect with him @canopytax . Want more info on how tax reform will affect your clients? Click here.