The Tax Cuts and Jobs Act passed in December 2017 includes provisions impacting the taxation of pass-through businesses. A pass-through business is one in which the taxable income or loss is passed through to the business owners (not taxed to the entity) and the business owners then report the taxable income or loss as income on their personal individual tax return. Pass-through businesses are often structured as LLCs, S Corporations or sole proprietorships. 

Under the new tax law, owners of pass-through businesses will be able to take a 20% deduction on their individual tax return, subject to limitations.  

Here is how the deduction is calculated:

• 20% of an individual’s “qualified business income” (net income from the business, excluding reasonable compensation and guaranteed payment for services) can be deducted if the taxpayer’s individual income is less than a threshold amount of $157,500 for single taxpayers or $315,000 for taxpayers married and filing jointly (subject to inflation). 
• If the taxpayer is in a specified service trade or business and the taxpayer’s income exceeds the threshold amount plus $50,000 (for single taxpayers) or $100,000 (for married filing jointly taxpayers), then the taxpayer cannot take the deduction. Specified service trades or businesses include, but are not limited to, businesses providing health, legal, financial, brokerage and consulting services.
• In the case of a pass-through business which is not a specified service trade or business, if the taxpayer’s individual income is greater than the threshold amount, then the amount that can be deducted “phases in” (meaning that the amount that can be deducted decreases as the taxpayer’s income increases). The phase-in formula used to determine the amount of the deduction takes into account, among other factors, the business’s W-2 wages, the taxpayer’s net taxable income and the unadjusted basis of capital owned by the business. The formula is especially advantageous for pass-through entities with large amounts of wages and capital investments because these factors increase the amount of the deduction. The deduction cannot exceed the greater of 50% of the taxpayer’s W-2 wages from the business, or in the alternative, 25% of the taxpayer’s W-2 wages plus 2.5% of the taxpayer’s share in the unadjusted basis of capital owned by the business.

In the past, pass-through businesses were considered to be more tax efficient than C Corporations. This is because C Corporations are taxed at two levels: the Corporation itself pays tax as a business and then the shareholders pay individual taxes on dividends (at 15% or 20% depending on the tax bracket, plus 3.8% medicare tax) from the business or a shareholder-employee might receive wages taxed at ordinary rates (this is sometimes referred to as the “double tax”). 

The question of whether it is preferential for a taxpayer to structure a business as a pass-through entity or a C Corporation will now require careful analysis of the tax consequences under the new tax law. Under the new tax law, the highest individual tax rate is 37%. Contrast this with the new tax rate of 21% for corporations. The tax consequences of being taxed once as a pass-through entity at an individual tax rate (factoring in the pass-through deduction that is available, if any) should be weighed against the tax consequences of the double tax incurred by a C Corporation, albeit at lower rates. 

Clients with questions regarding the pass-through deduction are advised to contact their accountant.  Your Brody Wilkinson attorney can advise you on business structure considerations and implement any changes you might wish to make.  For more information, please contact a BW attorney.