A new game in town: How businesses can maximize the 20% pass-through deduction

The recently enacted Tax Cuts and Jobs Act (TCJA) is one of the largest pieces of federal tax legislation since 1986. Many of the provisions in the act are not permanent and are scheduled to expire after Dec. 31, 2025.

One of the more controversial income tax topics and the one with the most potential impact, could be the new Internal Revenue Code Section 199A deduction, also referred to as the 20 percent pass-through deduction.

In an effort to keep the tax rates of pass-through businesses somewhat in line with corporate tax rates (which were reduced to 21 percent under the TCJA), individuals, trusts, and estates who are eligible owners of pass-through businesses can deduct 20 percent of qualified business income (QBI). Taxpayers who are eligible for the deduction are owners of sole proprietorships (Schedule C), sole owners or tenants in common owners of rental real estate (Schedule E), partnership or LLC owners (Form 1065), and S-Corporation owners (Form 1120S).

Qualified business income

The term “qualified business income” means, for any taxable year, the net amount of income, gains, deductions, and loss with respect to any qualified trade or business of a taxpayer. The term “trade or business” is not defined by statute or regulations, but is rather determined by a “facts and circumstances” test.

In general, to qualify as a trade or business, an entity must show profit motive, continuous and regular activity that has begun, and the sale of goods or services.

To prevent abuse of the deduction, the new QBI rules include certain limitations. A limitation on the amount of the pass-through deduction is imposed on income derived from certain specified service businesses (including lawyers, doctors, accountants, consultants, and financial advisors but excluding engineering and architecture firms).

The pass-through deduction for owners of these personal service businesses begins to be phased out when the owner’s taxable income (from all sources and not from just the personal service business) exceeds $315,000 for married taxpayers filing jointly ($157,500 for a single person) and is completely eliminated when taxable income reaches $415,000 married filing jointly ($207,500 for a single person). The deduction cannot exceed the taxpayer’s taxable income and is available even to taxpayers who take a standard deduction.

For non-specified service businesses, the QBI deduction may also be limited if the business does not employ a substantial number of employees or invest in a substantial amount of property (this limitation is referred to as the “wages and property” limitation).

Taxpayers who are able to take advantage of the full 20 percent QBI deduction will effectively be taxed on only 80 percent of each dollar. This savings could reduce their top marginal tax rate on income from pass-through entities from a 2018 top tax rate of 37 percent to a reduced rate of 29.6 percent (37 percent x 80 percent).

Plan ahead

Given the substantial tax benefit available for those who are eligible taxpayers, there may be significant planning opportunities to explore to take advantage of the deduction.

Appropriate strategies could include:

• Reducing income through pension contributions or expensing capital purchases to reduce the amount of income exceeding the threshold amounts and increase the deduction.
• Increasing business income by paying off debt or increasing W-2 wages in non-specified service businesses.
• Adding qualified property or spinning out practice buildings or equipment into separate entities.

With the QBI deduction set to expire on Dec. 31, 2025, now is the time to explore possible opportunities to maximize the 20 percent pass-through deduction and generate income tax savings over the next eight years.