The “pass-through” status is a relatively new term to taxpayers and tax professionals alike. The new pass-through exception was created by the Tax Cuts and Jobs Acts of 2017—and has been utilized for one year of returns since its incorporation in 2018.
You may be thinking, what is the pass-through business status? And can you take advantage of this new deduction offered by the IRS? If you meet the correct conditions, this important deduction could save your business some significant tax liability moving forward.
What Is the Pass-Through Business Deduction?
The pass-through business deduction allows owners of sole proprietorships, partnerships, and corporations to deduct up to 20 percent of their qualified business income on federal income tax returns. It can also include some trusts or estates.
The pass-through status was created by the IRS to support businesses that are unable to take advantage of the lowered corporate tax rate (now just 21 percent). Pass-through business owners are individuals who get taxed at individual rates compared to a corporate tax rate. These individual rates are generally much higher—and can widely vary between 10 and 37 percent.
According to a report from the Brookings Institute, the majority of businesses in the United States (nearly 95 percent) can be defined as pass-through businesses, which includes a growing number of freelancers and independent contractors.
Since pass-through entities account for a significant portion of the business income generated in the United States, the Tax Cuts and Jobs Act added the pass-through deduction to help promote this type of earning.
While the new deduction is helpful to some pass-through businesses, not everyone qualifies. Higher earners face a number of limitations that may prevent them from receiving the tax waiver.
Who Qualifies for the Pass-Through Deduction?
In order to qualify for the deduction, you must represent a “pass-through” business. These include entities such as:
- Sole proprietorships
- Limited Liability Companies (LLCs)
- Self-Employed Freelancers
- Independent Contractors
However, you must also meet a certain income threshold. The total taxable income must be lower than the thresholds for your filing status. If this is the case, you can deduct 20 percent of your qualifying business earnings.
Single filers who had a taxable income of $157,500 or less qualified for the pass-through deduction in 2018. Married couples filing jointly with a taxable income of $315,000 or less also qualified.
Meanwhile, higher earners need to sort through nearly 200 pages of complicated IRS rules to determine if they can use a partial deduction or do not qualify whatsoever.
What Is Qualified Business Income?
Everything regarding the pass-through deduction is based on qualified business income. What exactly does that mean? Qualified business income, or QBI, is the “net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business.” In other words, it is the net profit of your business. QBI can include things like:
- Capital gains and losses
- Income that gains interest
- Income earned outside the United States
- Certain wages and guaranteed payments made to partners or shareholders
Claiming the Pass-Through Deduction
If you are a single filer with a business income of less than $157,500, or a joint filer with a total income of less than $315,000, then the process is pretty straightforward. You should be able to take advantage of the pass-through deduction. However, those who exceed these income thresholds will be required to pass a few other IRS tests.
Certain business enterprises that are labeled as a “specified service trade or business” cannot qualify for the 20 percent deduction. This includes professions such as doctors, lawyers, consultants, and financial planners.
Any business that hits a total taxable income of $207,500 (for single filers) and $415,000 (for married filing jointly) will be automatically disqualified from the pass-through deduction.
Moreover, any business that is not a part of the exclusion list (and has income limits between the thresholds of minimum and maximum allowed taxable income) have even more tests they must pass in order to qualify.
Business owners need to calculate the number of wages that are paid to employees (including yourself), and then connect it to the value of the property the business owns. If those figures are high, you have a better chance of qualifying for the pass-through deduction, but it does get complicated very quickly.
Contact a Tax Professional
The new tax break known as the pass-through business deduction can shelter 20 percent of your taxable income related to your business. If the qualified business income falls under the thresholds, you can easily take advantage of this deduction.
However, if your business earns more than the income thresholds, there are many different tests and criteria you must meet in order to receive the 20 percent deduction—or at least a partial deduction.
Contact Levy & Associates today for more assistance with the pass-through deduction. It can be quite complicated, but we are here to help. Call 800-TAX-LEVY, or visit us online at www.levytaxhelp.com.