We are working diligently to provide you with the most current information about the Tax Cut and Jobs Act (TCJA) which has ushered in new tax laws. As part of this effort, we are sharing this overview of how the new pass-through deduction can be calculated.
Please note that this information includes examples, you may wish to ask us questions about this or any other tax reform provisions, so please contact us
for tax planning advice.
Here are the basic rules of the new pass-through deduction which applies to sole proprietorships, S-corporations partnerships and LLCs (that did not elect to be taxed as a corporation):
1. It is not based on the definition of business income as most of us are used to. Instead, it uses “qualified business income” (QBI) to calculate any deduction to which you may be entitled.
2. There is an income-based limitation on the amount of the deduction.
3. Some types of businesses, referred to as a Specified Service Trade or Business (SSTB) in the new tax law are not eligible for the deduction once certain income thresholds are met.
Let’s look at each of these rules as it applies to a freelance business:
1. QBI, from the IRS’ standpoint, is equal to the income you derive from your pass-through business minus any net capital gains or short-term capital losses. In addition, QBI does not include pass-through income from W-2 wages received from an S-corporation or from the guaranteed payments received from a partnership.
The amount you can deduct is also subject to caps of either 50 percent of the wages your business pays its employees or 25 percent of wages plus 2.5 percent of the basis of the business’ qualified property-whichever is higher. These calculations must be compared to the 20 percent of your QBI, then you may deduct whichever amount is less. This limit also phases in over the same $315,000 and $415,000 taxable income range for joint filers.
2. The income-based limitation applies to non-corporate taxpayers who exceed the $315,000 income threshold. If you own a personal service business (called a specified service business), the amount of your QBI is phased-out on a pro-rated basis your total taxable income hits $415,000. At this income level and above, you no longer qualify for the benefit of the 20 percent deduction. Businesses that are not specific service business are still eligible for the deduction.
3. A specific service trade or business defined by the IRS is any trade or business providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletic, financial services, brokerage services and other industries. Also included are any trades or businesses involving investing and investment management, trading or dealing in securities. Engineers and architects are not defined as a specific service trade or business and thus are excluded from this limitation.
4. Businesses that are capital intensive were taken into account under the new law with an increase in the wage limit to include a qualified property calculation. According to the IRS, qualified property is tangible depreciable property that used by your business to earn QBI. These deductions can be taken on your individual return and the calculations would apply to each business that you operate separately.
So how do business owners calculate the TCJA’s 20 percent pass-through deduction?
a) You should first determine if your business is an SSTB as mentioned above. The first two examples below assume that your business is not an SSTB. In both of these cases, you would calculate the Qualified Business Income (QBI) from your business. This is simply the net income of your business excluding any salary, wages or payments made to you, the owner. If you have a sole proprietorship, this would be your Schedule C income.
b) If your business is under the income-phase out threshold described above, then you simply calculate 20 percent of the pass-through income from your business(es) and take the deduction as long as it is less than 20 percent of your taxable income excluding net capital gains.
c) If your business is not an SSTB and you are over the maximum income threshold amount, then your calculation is more complex in order to account for the deduction phasing out.
You will need to determine the ratio of the income you may have over the threshold limitation of $157,500 for single taxpayers and $315,000 for Married Filing Jointly taxpayers.
Keep in mind also that if your taxable income reaches $207,500 (single filer) or $415,000 (married joint filer), the QBI deduction is limited to 50 percent of your W-2 wages from that business or the sum of 25 percent of W-2 wages from the business, plus 2.5 percent of any qualified property. Then, using the income threshold stated above and the phase out amount of $207,500/$415,000 to calculate the limitation on a prorated basis.
Here is an example of how to do it assuming:
- You have $425,000 in taxable income (Married, Joint Filing), including $300,000 in QBI earned through a non-SSTB LLC.
- You paid two employees a total of $100,000 in W-2 wages.
- You own the building where your office is located, which has an unadjusted acquisition basis of $250,000.
Given this hypothetical situation, your maximum pass-through deduction is 20 percent of your $300,000 QBI, which equals $60,000. With your taxable income being over $415,000, any pass-through deduction you claim is limited to the greater of (i) 50 percent of the W-2 wages paid to your employees, or (ii) 25 percent of W-2 wages plus 2.5% of your office building’s $250,000 basis. (i) is $100,000 (50% x $100,000) = $50,000; (ii) is (2.5% x $250,000) + (25% x $100,000) = $31,250. Since (i) is greater than (ii) you would have to take the greater amount of $50,000 as the pass-through deduction.
A Non-Specified Service Trade or Business would calculate the deduction this way:
For our example, assume:
- You are a consultant (one of the service provider categories subject to the phase out limits) and a single taxpayer with taxable income of $227,000.
- Your taxable income is $69,500 or 31 percent over the single filer income threshold.
- You paid your employees $60,000 in wages.
To calculate, multiply your deduction prior to the phase-out-in this case it is limited to 50 percent of the W-2 wages you paid since there is no qualified property. This is equal to $30,000 (50% x $60,000 W-2 wages = $30,000). With your phase-out percentage being 31 percent you get 69 percent of the full deduction which is equal to (69% x $30,000 = $20,700).
This new pass-through deduction may offer significant tax savings for your freelance business, but it is also somewhat complicated. Could it save you 20 percent? Maybe…it depends on how the specific rules of this deduction apply to your situation.
We are happy to answer any questions you may have in regard to this information or any other tax reform questions, so please don’t hesitate to contact us