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The Tax Cuts and Jobs Act (TCJA) creates a new tax deduction of up to 20 percent of income from partnerships, sole proprietorships, and other pass-through businesses. But the size of the deduction varies, depending on the nature of the business activity and the total income of its owner. It may also depend on how much the business pays its employees and how much property it owns. It is…not simple.
To start, the TCJA divides pass-through businesses into two classes: Those that provide certain personal services, such as law firms, medical practices, consulting firms, and professional athletes; and all other businesses.
Then, it divides the business owners into three groups:
- Singles making less than $157,500 or joint filers making less than $315,000 in total taxable income may take the full 20 percent deduction on their pass-through income. For them, it does not matter if their business is a personal service firm or something else.
- Singles making more than $207,500 or couples making more than $415,000 are subject to different rules. They are allowed no deduction at all if their pass-through business is a personal service firm. If they own any other pass-through business, they may still get a deduction, but it will be limited (and perhaps even eliminated) based on the amount of wages their business pays and the property it owns.
- Those with incomes between these thresholds are only eligible for a partial tax benefit. It is available no matter the nature of their business, but the amount of business income eligible for the deduction phases out for personal service firms. (For more details on calculating the phase-out and the associated limits, see this report.)
How does the limitation work? First, the taxpayer calculates Qualified Business Income (QBI). This is, generally, the business’s net income. Joint filers making less than $315,000 in total taxable income can deduct 20 percent of their QBI, but life gets much more complicated for business owners who make more than that.
If they own a personal service business (called a specified service business), the amount of their QBI is phased-out on a pro rata basis until it disappears once their total taxable income hits $415,000. At that point, these business owners lose the benefit of the 20 percent deduction.
In addition, for all pass-through businesses, whether they are a personal service firm or not, the deduction may be limited based on a complicated two-part formula. The deduction is partially limited by the greater of either 50 percent of the wages the business pays its employees or 25 percent of wages plus 2.5 percent of the basis of the business’ qualified property. Business owners compare those calculations to 20 percent of their QBI. They may deduct only the smaller amount. (This limit phases in over the same taxable income range: between $315,000 and $415,000 for joint filers.)
Keeping those rules in mind, here are three sets of examples. Each shows both a personal service business and a business not subject to those special personal service rules. The examples show joint filers in each of the three income groups. To simplify matters just a bit, our examples only use the wage test and not the wage-and-capital test.
Assume that business income in each group is $75,000 and business wages are $20,000. The only thing that varies in each example is total taxable income. This table summarizes how each group fares.
Let’s start with a couple whose taxable income is $150,000, with half coming from a sole proprietorship. Imagine a husband who is a self-employed plumber and a wife who is an employee at a firm. In that case, they could deduct the full 20 percent of the plumber’s $75,000 in business income, or $15,000).
Now, imagine this couple has the same $75,000 in pass-through income, but their total income is $400,000. That puts them squarely in the phase-out range where they lose some of their deduction. However, the amount of the deduction will vary substantially — from $1,612 to $10,750 -- depending on the nature of their business.
Finally, imagine the couple has total income of $575,000. Let’s say one spouse is a high-paid employee who makes $500,000 and the other is a part-time financial adviser (a personal service business owner) who makes $75,000. Because their total income exceeds the $415,000 limit, they are not eligible for the 20 percent pass-through deduction.
Now assume, instead, that the second spouse owns a small woodworking shop (not a personal service business), makes the same $75,000, and pays an assistant $20,000. In this case, the allowable deduction is $10,000.
The TCJA’s 20 percent pass-through deduction is extremely generous—for those business owners eligible to receive it. However, the law’s complex phase-outs may limit the benefit for some businesses and encourage their owners to find ways to game the system. Clearly, this provision does not simplify the Tax Code.
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