While most of us are used to waiting for Christmas day to open our gifts, Congressional Republicans got to tear into their biggest present early this year. On December 22, the President signed the Tax Cuts and Jobs Act (“the Act”) into law, effecting enormous changes to the way the Tax Man goes about his business of collecting from the American taxpayer. Given that the Act amounts to the largest overhaul of the American tax code in more than three decades, it’s unsurprising that the Act has left many Americans wondering just how the change will impact them financially.
As with any topic or issue in 2018, the political undertones and inherent urge to debate the partisan values enhanced or diminished by political change is just as present in the topic of taxation. Debate and political allegiance aside, however, we all need to recognize that the Act is not some mere legislative decree from Washington that affects us in abstract and intangible ways; it is a new financial reality. Just as in nature, the most effective way to handle sudden and drastic changes is to learn and adapt to the new reality as best as possible.
Perhaps the tone of this article is coming off a touch too ominous. The fact is that most Americans will end up paying less in taxes over the course of the next 8 years. Additionally, the Act has enacted measures to reduce or eliminate the alternative minimum tax for businesses and individuals, as well as increasing the child tax credit from $1,000 to $2,000 per child. Regardless of the purported benefits and burdens affected by the Act in general, the key thing for businesses and individuals to remember is that their situation likely varies significantly from other taxpayers, and they should plan accordingly. Having the right understanding can make all the difference in maximizing the value of one’s tax season.
One of the most significant changes brought on by the Act is the large tax cut afforded to both large corporations and small businesses alike. However, unlike the straight rate cut from 35 to 21 percent for American corporations, the tax cut for other business types is more nuanced. This nuance is a product of many of America’s non-corporate businesses consistently taking advantage of the tax-savvy option of electing a pass-through entity structure. Pass-through entities are those business types that allow the owners of the business to report income from the business on their own personal 1040s, thereby avoiding the costly phenomenon known as double taxation. Double taxation, which is common among most corporations, is where income is taxed both on the corporate and individual level. Consider the following scenario as an illustration:
Quinn, Chris and Allie all own a stake in a pass-through entity. At the end of the fiscal year, their business generated a profit of $300,000. Fortunately for the trio, their business’ pass-through status accounts for the allocation of the profits among the three owners and each then has $100,000 of taxable income on their individual tax returns. This allows them to avoid having that $300,000 taxed against the business itself prior to the division and distribution of the profits, which would effectively reduce the amount of profit retained by each owner.
The most common types of pass-through entities include sole proprietorships, partnerships, limited liability companies, and S corporations. Prior to the passage of the Act, the profits that owners derived from the operation of their pass-through entity were simply subjected to the tax rate of each particular owner. Returning to the example above for a moment, imagine the following:
The pass-through business is the only source of income for Quinn and Chris, while Allie is an active investor with stakes in various other businesses that generated an additional $110,000 for her during the fiscal year. Under the old rules, Quinn and Chris’ income from the pass-through business would be subject to a 28 percent tax; whereas Allie’s annual income of $210,000 would be subject to a 33 percent tax.
Things are quite different under the Act. Namely, the biggest change is that owners of
pass-through businesses get the additional tax benefit of a substantial deduction on the income allocable to their share of ownership. How big of a deduction, you ask; how does 20 percent sound? All things considered, that’s a pretty significant slice off the top of the ole taxable income. As with any tax issue, however, things aren’t that clear-cut under the Act. There are limitations to the deduction that come into play.
In general, so long as an owner-filer of a pass-through makes less than $157,500 in individual income ($315,000 for married filing jointly), the applicability of this 20 percent deduction is unlimited. Perhaps the biggest limitation to this rule is that the deduction is unavailable for owner-filers that hold stakes in what’s known as a “specified service trade or business.” This category essentially includes those businesses involving the performance of services in the fields of health, law, accounting, consulting, and other services—excluding architecture and engineering businesses—that operate as pass-through entities. The point of this limitation is to prevent deductions for owner-filers in businesses where, by virtue of the pay-for-services dynamic, owner-filers are basically being paid wages, and therefore should be taxed accordingly.
The second limitation centers more on the income threshold of the owner-filer. Even if the owner-filers don’t operate these types of service businesses, the 20 percent deduction will be limited when their income exceeds $157,000 (or $315,000 married filing jointly). Specifically, the deduction is limited to the lessor of the standard 20 percent deduction AND the greater of A) 50 percent of wages paid by the business, or B) 25 percent of wages paid plus 2.5 percent of the business’ tangible, depreciable property.
If the language here on the limitation isn’t painting the quintessential picture of clarity, don’t worry, you’re not alone. Let’s set up another example to illustrate how the limitation on this deduction operates. This time, our business owners have expanded their operation and enjoyed an incredibly profitable year.
Quinn, Chris and Allie’s business produced total ordinary income in the amount of $3,000,000, it spent $1,000,000 on W-2 wages for its employees, and the total adjusted basis of the property held by the business is $1,000,000. At these financial thresholds, it’s clear that our business owners are going to be subject to the limitation on the Act’s deduction for pass-through entities. Looking at the tax consequences of the business’ successful year, we can see how the Act’s limitation prevents our owners from taking advantage to the full extent of that 20 percent deduction. Since our owners’ are each entitled to 1/3 of the profits—and the numbers work out nicely—the tax consequences are the same for each owner. So, in terms of a deduction, each owner is entitled to the LESSOR OF:
Total: $3,000,000 – Owner’s Share (1/3): $1,000,000 – 20% Deduction: $200,000
And the greater of:
W-2 Wages: $1,000,000 – Owner’s Allocable Share (1/3): ≈ $330,000 – 50% limitation: $165,000
W-2 Wages: $1,000,000 – Owner’s Allocable Share (1/3): ≈ $330,000 – 25% limitation: $82,500
Adjusted basis of property: $1,000,000 – Owner’s Allocable Share (1/3): ≈ $330,000 – 2.5% limitation: $8,250
Therefore, while each owner would love to be able to take advantage of the 20 percent deduction of $200,000, the limitation kicks in and restricts the owners to a $165,000 deduction. That is, the owners are each entitled to a deduction of $165,000, which is the lesser of $200,000 and the greater of $165,000 or $90,750.
Once these calculations on the applicable deduction are completed, the remaining income is taxed according to the Act’s new tax brackets. Here, because the taxable income of our owners from the example above would be $835,000 after applying the available deduction, each owner would be subject to a 37 percent tax. Apparently ample financial success is nearly as costly—tax wise—under the Act as it was under the old code. This costliness is precisely why Congress sought to introduce the deduction into the pass-through entity context.
Ultimately, the Act presents a variety of new challenges, benefits and burdens that every American business and individual will have to learn and adjust to. For owners of pass-through businesses it is especially important to know just how to calculate the applicable deduction under the Act. Applying the incorrect deduction could lead to an overpayment of taxes or worse, a tax deficiency. Understanding precisely how the Act’s new pass-through provisions will impact your personal and or professional financial circumstances will not only lessen the monetary blow of tax season, it will also help you set a foundational plan for approaching your tax management goals for years to come.
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