Regarding pass-through entities, a pass-through entity (an S corporation, partnership or sole proprietorship) is not subject to federal income tax. Rather, owners of the entity report their shares of the entity’s income or loss on their individual income tax returns with the character passing through as well (as if the owners had realized or incurred the items of income or loss directly) and without regard to the amounts of distributions they receive from the entity.
In general, the pass-through deduction available to an individual (or other non-corporate) owner of an interest in a pass-through entity is limited to the lesser of (i) 20% of the qualified business income (“QBI”) allocated to the owner or (ii) the greater of (a) 50% of the owner’s share of the “W-2 wages” paid by the entity for the year or (b) 25% of the owner’s share of the “W-2 wages” paid by the entity for the year plus 2.5% of the owner’s share of the unadjusted basis of all “qualified property” of the entity.
What is Qualified Business Income? QBI is the net number of qualified items of income, gain, deduction and loss with respect to any “qualified trade or business” of the taxpayer to the extent effectively connected with the conduct of a U.S. trade or business and included or allowed in determining taxable income, but with exceptions.
What is a Qualified Trade or Business? In general, a qualified trade or business is any trade or business other than a “specified service trade or business” or the trade or business of performing services as an employee. A “specified service trade or business” is any trade or business involving the performance of services (i) in the fields of health, law, accounting, actuarial services, performing arts, consulting, athletics, financial services or where the principal asset of the business is the reputation or skill of one or more of its employees (but with a specific exception for architectural and engineering services), or (ii) that consist of investing and investment management, trading, or dealing in securities, partnership interests or commodities.
There are threshold considerations. The pass-through deduction of 20% of QBI is generally available to those taxpayers with taxable income below a threshold amount – initially $157,500 for individuals and $315,000 for married taxpayers filing jointly – regardless of whether their income is derived from a “specified service trade or business” or whether they satisfy the W-2 wage requirements discussed above. A phase out begins as income from the “specified service trade or business” exceeds the “threshold amount” and is eliminated at levels of taxable income of $207,500 for individuals and $415,000 for married taxpayers filing jointly.
As you approach these minimal thresholds or even exceed the upper limits, you can see a swing of $160, 000 in taxable income. Tax planning is crucial to making the most out of what is available under tax reform.