The new Tax Cuts and Jobs Act provides a 20% non-itemized deduction for “qualified business income” (business income received by an owner of a pass-through entity) beginning in 2018.
Such pass-through income - reduced by this new deduction - is then taxed at the pass-through owner’s normal marginal rates, which have also been reduced under the new law. This deduction can result in significantly lower effective tax rates on pass-through income. With the new maximum tax rate of 37% for individuals, pass-through income that qualifies for the 20% deduction will now be taxed effectively at a maximum federal rate of 29.6% (down from 39.6%).
South Carolina already has a reduced tax rate (3% as opposed to the 7% rate on other income) for “active trade or business income” received by the owner of a pass-through business. If South Carolina also adopts the new 20% federal deduction to calculate South Carolina taxable income, South Carolina residents will enjoy an even lower effective tax rate on their South Carolina pass-through income.
The rules are set out in new Internal Revenue Code § 199A, which contains a Byzantine series of overlapping limitations, qualifications and definitional provisions that will not win any awards for tax simplification.
The key provisions of the new deduction are summarized as follows:
Types of Entities That May Generate Qualified Business Income.
The 20% deduction applies to business income generated by any business entity other than a C corporation. Accordingly, the deduction will apply for pass-through income from partnerships, limited liability companies that are taxed as partnerships or as disregarded entities, S corporations and even sole proprietorships.
The new deduction may prompt C corporations to consider whether they should convert to S corporation status. There are numerous factors that must be analyzed in connection with such a conversion, but there are two countervailing points in the new tax law that may make C corporation status more attractive. First, the new tax law reduced the maximum rate for C corporations to 21% (down from 35%). The markedly lower rate reduces the impact of double taxation for C corporations that distribute income to their shareholders. Moreover, certain businesses that retain their income might consider converting to C corporation status. Even with the lower rates on pass-through income (potentially 29.6% maximum), a C corporation’s taxable income is taxed only at 21%, unless and until that income is distributed to its shareholders.
Second, the 20% deduction (like most of the individual income tax provisions of the new act) will expire (or “sunset”) after 2025. In other words, beginning in 2026, tax rates on pass-through are scheduled to revert to their pre-2018 levels. Taxpayers considering a change in status must weigh the potentially temporary benefit of the conversion against the costs of the conversion and the costs of a possible second change of status in 2026.
Types of Pass-Through Income That Are Eligible for Deduction.
The 20% deduction applies to any income from a business, so long as that income is effectively connected with the conduct of a United States business. So generally speaking, Section 199A applies to business income generated from operations in the United States.
The deduction does apply to rental income (assuming that the rental operations amount to a business). But the deduction does not apply to certain types of investment income generated by a pass-through entity.
“Qualified business income” generally does not include compensatory payments received by pass-through owners. Consequently, the deduction does not apply to (i) reasonable compensation paid to the taxpayer by any qualified business of the taxpayer for services rendered with respect to the business, (ii) any guaranteed payment paid to a partner (or member) for services rendered with respect to the business, or (iii) to the extent provided in regulations (there are no regulations yet), certain other payments to partners for services rendered with respect to the business.
The exclusion of guaranteed payments may cause partnerships and LLCs to reconsider compensation arrangements with their owners. A guaranteed payment received by a partner will not be eligible for the deduction (and incidentally will decrease the amount of income subject to the deduction). It may be possible for partnerships and LLCs to structure the payment as a priority profits allocation, which may qualify for the deduction.
Limitations Based Upon Type of Business.
- Specified Service Businesses. The owners of certain service businesses will only be able to use the deduction if their income does not exceed specified levels. A specified service business is any business involving the performance of services in the fields of health, law, actuarial sciences, accounting, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such business is the reputation or skill of one or more of its employees or owners.
A taxpayer who receives pass-through income from a specified service business can fully use the 20% deduction if the taxpayer’s taxable income is less than $315,000 (if married) or $157,500 (if single). The deduction phases out as taxable income increases, so that there is no deduction for a taxpayer whose taxable income exceeds $415,000 (if married) or $205,500 (if single). For these purposes, “taxable income” is determined without the 20% deduction.
- Other Businesses. Other types of pass-through businesses including non-service businesses (for example, a manufacturing business or even a rental real estate business) can benefit from the 20% deduction. Owners of such pass-through entities can utilize the 20% deduction without regard to their asset or employment levels so long as their taxable income is less than $315,000 (if married) or $157,500 (if single) (with phase-out occurring over the next $100,000 or $50,000 of taxable income).
But such businesses may also use the deduction even when their taxable income exceeds such limits. The owners of such other pass-through businesses may use the deduction up to the greater of (a) 50% of the W-2 wages paid by the business (including to the owners) or (b) the sum of (i) 25% of W-2 wages paid by the business and (ii) 2.5% of the business’s capital (i.e., the unadjusted basis of the depreciable assets of the business). It is the last test (2.5% of unadjusted basis) that allows real estate businesses to benefit from the deduction, even in cases where they have few employees.
In sum, the new 20% pass-through income deduction can add up to big tax savings for business owners and should also prompt businesses to reconsider their business structures to ensure that they are obtaining the most benefit from the new tax law.