What is a Pass Through Business Entity & When do they Get 20% Deduction Under TCJA ?

Special deduction under TCJA for Pass Through Business Entities

Tax Cuts and Jobs Act has brought good news for owners of pass through business entities as they can claim deduction up to 20% of their net business income from their income taxes, from the tax year 2018.So most important for claiming this additional deduction is to know – what is a pass through business entity, pass through income and what are the conditions for claiming a deduction of 20% by owners of such pass-through business.

What is a pass through business entity?

Any business entity that carries business in its name but is not liable for paying tax in its name is a pass-through business entity. In such case, owners pay taxes on total income of such entities. For example, tax is the liability of  following types of business entity are

  • a sole proprietorship
 (a one-owner business in which the owner personally owns all the business assets)
  • an S corporation
  • a partnership
  • a limited liability company (LLC), or
  • a limited liability partnership (LLP).

In case of all the aforesaid types of business entities, owners pay tax on the money on their individual tax returns at their individual tax rates on the profits of the businesses are passed through the business.

Who can claim 20 % pass through deduction under TCJA?

QBI is the net amount of income, gains, deductions and losses, exclusive of reasonable compensation, certain investment items and payments to partners for services rendered. Each qualified business income is computed separately and then aggregated. If the net QBI is positive, the deduction is allowed. The QBI deduction applies to taxable income and doesn’t come into play when computing adjusted gross income (AGI). It’s available to both itemizing and non-itemizing taxpayers. Further , capital gains are not taken into computation while determining the limit of 20% of total income.

For example, if the QBI for a Richard & Alice, a married couple,  is $400,000 and their taxable income is $250,000, the QBI deduction from total income is limited to 20% of $250,000, or $50,000.

What QBI Includes & What Not?

Section  199A of IRC defines Qualified Business Income ( QBI ) as the net income (profit) your pass-through business entity during the year. The Qualified Business Income includes rental income so long as your rental activity qualifies as a business (as most do), income from publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives

What does QBI not include?

Following type of income are not included in QBI

  1. short-term or long-term capital gain or loss—for example, a landlord would not include capital gain earned from selling a rental property
  2. dividend income
  3. interest income
  4. wages paid to S corporation shareholders
  5. guaranteed payments to partners in partnerships or LLC members, or
  6. business income earned outside the United States.

The threshold for Claim of 20% Deduction!

If the taxable income of an Individual owner of a pass-through business entity  exceeds $157,500 for single filers or $315,000 for married couples filing jointly, he can deduct only the lesser of

  •  20% of QBI or
  • 50% of their allocable share of W-2 wages paid by the business.

Alternatively, he  can deduct the lesser of

  • 20% of QBI or
  • 25% of wages plus 2.5% of their allocable share of the unadjusted basis of qualified business property (QBP)

Just in case you are wondering what is qualified business property, then suffice to say that it is essentially, the purchase price of tangible depreciable property held at the end of the tax year.

The wage limit phases out completely when taxable income exceeds $207,500 for single filers and $415,000 for joint filers.

There are other conditions which make the computation of deduction of QBI deduction cumbersome.

The QBI deduction is further limited for following types of businesses pass-through entities in law, financial, healthcare, brokerage and consulting services firms.  The QBI deduction for these types of pass-through entities begins to phase out at $157,500 in taxable income for single filers and $315,000 for joint filers, phasing out completely at $207,500 and $415,000, respectively.

 

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