You’re not the only one. Just over 1 in 10 filers have claimed this break that took effect in January and is aimed at “pass-through” entities, businesses that pay no taxes themselves, but whose profits or losses pass-through the business and whose taxes are paid by the owner(s) of the business through their individual tax returns at individual tax rates. Pass-through entities include:
- sole proprietorships (one-owner businesses in which the owner owns all the business assets),
- S corporations,
- limited liability companies (LLC), and
- limited liability partnerships (LLP).
The majority of small businesses are pass-through entities, so this tax break is an important one. But have you even heard about it? If not, here’s what you need to know.
Do you qualify?
If you earn income through a pass-through entity, then you may qualify to deduct up to 20% of your QBI (qualified business income) for each pass-through entity that you own (IRC Section 199A). QBI is the net income or profit from your pass-through business for the year. To calculate your pass-through deduction, you have to determine your total taxable income for the year (not including the pass-through deduction), not just for your pass-through entities, but from all sources (business, investment, etc.), minus deductions (including the standard deduction), then you can take your pass-through deduction, if your taxable income is positive (not a loss). The maximum deduction you can take from the new pass-through rule is 20 percent of your taxable income.
The way your pass-through deduction is calculated depends on whether or not your taxable income exceeds an annual threshold (adjusted for inflation each year) of up to $321,400 (if married and filing jointly for 2019) or up to $160,700 (single filing for 2019). If you’re within this threshold, you qualify for the max deduction–20% of your QBI. If you exceed the threshold, things get a little more complicated.
What type of work do you do?
Once you break through the threshold, things start getting personal, and the IRS needs to know what kind of work you do. Does your business fall into one of the service care provider categories, such as:
- health (doctors, dentists, etc.),
- actuarial science,
- performing arts,
- financial services,
- brokerage services (not including real estate or insurance brokers),
- investing or investment managing (not including property managers), or
- trading and dealing in securities and commodities.
There’s one more wide-mouthed category that encompasses any business in which the main asset is the skill or reputation of one or more of its employees. Do you receive fees or other income for endorsements, or appearances at radio, TV, or media events, and/or do you license your name, likeness, signature, image, voice, or trademark? If you answered yes to any of these questions, there’s no pass-through deduction for you.
If you manage to escape the service-provider pothole, then your deduction depends on the amount by which you exceed the taxable income threshold.
How high is too high?
If your taxable income exceeds the threshold by $100,000 or more, and you’re filing married jointly, or $50,000 if you’re filing single, then your deduction depends upon a W-2 wage/business property limitation. This limitation applies if your married jointly filing taxable income is over $421,400 or $210,700, if single. Your maximum possible pass-through deduction is still 20% of your QBI, same as the lower income levels, but now your deduction has another limit: the greater of 50% of your share of W-2 employee wages paid by the business, or 25% of W-2 wages AND 2.5% of the acquisition cost of your depreciable business property (in this case, depreciable long-term property that is used in the production of income, such as real property or equipment used in the business). If you have no employees or depreciable business property, there’s no deduction for you. (Nudge, nudge. The government would like you to consider hiring employees or buying property for your business.)
If you have no employees, as is the case for so many pass-through businesses, then the 25% plus the 2.5% deduction is the one for you. Are you starting to see how this might be of value to you and your business?
What if you only broke the threshold a little?
If your taxable income is less than $100,000 over the threshold and you’re married filing jointly, or your taxable income is less than $50,000 filing single, there’s a phase-in process, and things get a little more complicated. Only part of your deduction is subject to the W-2 wage/property limit, and the rest is based on 20% of your QBI. Just as before, if you have no W-2 wages or business property, your deductions are done, but the rest of you will start calculating your phase-in deduction based on where you fall in the range ($100,00 for marrieds and $50,00 for singles).
How to calculate:
- First, pretend the W-2 wages/property limit doesn’t apply to you at all and calculate 20% of your QBI.
- Next, punch in the numbers as if the W-2 wages/property limit rule applies to you in-full.
- Finally, calculate the difference between these two numbers and multiply by your phase-in percentage. This is what your phase-in amount is based on.
Deductions for Service Providers
If you own a pass-through entity that provides a personal service, like a doctor, lawyer, accountant, performing artist, etc. (see list of service providers above), and you exceed the income threshold of
$321,400 (married filing jointly) or $160,700 (filing single), your pass-through deduction is gradually phased out up to $421,400 (married filing jointly) and $210,7000 (filing single). Once you reach $421,400 (married filing jointly) or $210,700 (filing single), you get no deduction. Here’s the reason why: This rule was created to prevent highly compensated employees who provide services (doctors, lawyers, etc.) from being reclassified by employers as independent contractors so that employers could then reap the benefits of the pass-through deduction.
Calculating your deduction as a service provider begins the same way as a non-service provider. Your maximum possible deduction is still 20% of your QBI, but your deduction cannot exceed the greater of 50% of your share of W-2 employee wages paid by the business or 25% W-2 wages PLUS 2.5% of the acquisition cost of the depreciable property used in the business. If you have no employees or depreciable property, then you get no deduction.
If you do have employees or depreciable property, then start calculating your phase-out deduction. For every $1,000 dollars that you exceed the $321,400 threshold, your deduction is phased out by 1%, and once your income reaches the $421,400 threshold, you receive no deduction. If you’re filing as a single, then your deduction is phased out by 2% for every $1,000 over the $160,700 limit. When you reach $210,700, there is no deduction.
The devil is in the details, as they say, and the details involved in this deduction can be confusing. Having read this, you may understand why this deduction was so underutilized this year, but it’s not a deduction you want to miss again because it’s only around until January 1, 2026. There have been a lot of changes since the Tax Cuts and Jobs Act (TCJA) took effect in 2018 and having a qualified tax professional walk you through those changes can make all the difference. At Fiducial, we have tax experts ready and waiting to help you through this process. Don’t miss another opportunity to take advantage of a deduction specifically meant to help small business owners like yourself. Call one of our tax professionals today, or, better yet, find a Fiducial location near you and find out if you’re eligible for this deduction.