Pass-Through Entities and the 20 Percent Tax Break

Small-business owners and partners are scratching their heads over the Tax Cuts and Jobs Act and how the new 20 percent tax deduction for pass-through entities will work.

Here’s a little background

A pass-through entity can be a partnership, S corporation, limited liability company or partnership, or sole proprietorship — basically, most of the country’s small businesses. Owners and shareholders of these entities are taxed on earnings based on individual, not corporate, tax rates. Effectively, company earnings, losses and deductions pass through to the individual’s personal tax rates, which, in the past, were typically lower than corporate rates. The pass-through deduction was a nice tax break.

But things have changed.

In 2017, the U.S. corporate tax rate was 35 percent, one of the highest in the industrialized world. The new bill slices that rate to a flat 21 percent, which is lower than the top individual tax rate of 37 percent. Earners who fall into that top tax tier would be silly to claim a pass-through deduction, because their individual rate is now higher than the corporate rate. Say bye-bye to that tax break.

Not so fast. To even things out, lawmakers have allowed pass-through owners to deduct 20 percent of their qualified business income, or QBI, from their personal income taxes, whether or not they itemize. Unlike the corporate tax cut, which is permanent, this pass-through deduction lasts only through 2025, unless Congress extends it.

A 20 percent pass-through deduction is nothing to sneeze at. If you have, say, $100,000 in pass-through income, you can reduce your income taxes by $4,800 if you’re in the 24 percent income tax bracket.

What is QBI?

QBI is, essentially, the profit a pass-through business makes during a year.

QBI includes:

  • Rental income from a rental business.
  • Income from publicly traded partnerships.
  • Real estate investments trusts.
  • Qualified cooperatives.

QBI does not include:

  • Dividend income.
  • Interest income.
  • S corporation shareholder wages.
  • Business income earned outside the United States.
  • Guaranteed payments to LLC members or partnership partners.
  • Capital gain or loss.

Here’s the hitch

In order to take advantage of the pass-through deduction, you must have net taxable income from your businesses. If you don’t make any profit, you can’t deduct 20 percent from nothing.

The QBI from each business is calculated separately. If you have several businesses, and one or more loses money in a given year, you will deduct that loss from the QBI from the profitable businesses.

More considerations

Hey, if there weren’t always more considerations, you wouldn’t need us. Whether you can take advantage of all, some or none of the pass-through tax deduction depends on how much money you earn and how you earn it.

For instance, if your taxable income falls below $315,000 if married filing jointly or $157,500 if single, you can take full advantage of the pass-through deduction. But if your taxable income is more than $315,000/$157,500, taking the deduction will depend on your total income and the kind of work you do. If you perform a personal service, such as doctor or consultant, you’ll lose the deduction at certain income levels. The details are still unclear, and we’re looking forward to reviewing future guidance.

The new pass-through deduction can be a nice tax break for folks who qualify. Not sure if you do? Contact us at info@cpa-wfy.com, and we’ll help you navigate the murky waters surrounding the new tax law and pass-through deduction. We’ll see if you’re entitled to anything and, if so, how much.

© Copyright 2018. All rights reserved.

Extraordinary Estate Tax Opportunity

By Cheryl J. Schaffer, CPA, MST, AEP®

Estate and Trust Partner

 

January 9, 2018

You may recall that President Trump promised to repeal the Estate and Gift Tax and their cousin, the Generation Skipping Tax.   However, the enacted version of the Tax Cuts and Jobs Act signed just before Christmas 2017, left these three taxes intact.   The outcome is surprising, given that the Republican Party has often condemned these taxes, and given that the House, Senate, and White House are all on the same side of the party divide.   Yet, complete repeal was not accomplished.   Thus, these taxes remain a huge liability for high net worth individuals and families.

What the Act does accomplish is a doubling of the Estate, Gift, and Generation Skipping Tax Exemption.   Starting on January 1, 2018, the exemption is $11,200,000 for individuals and $22,400,000 for married couples, up from $5,490,000 and $10,980,000 in 2017, respectively. On January 1, 2026, the exemption amounts are scheduled to revert to the 2017 levels, adjusted for inflation. The rate remains the same, at 40%.

If you should pass away before 2026, your Estate will benefit from this historic change in the exemption.   Mortality tables show that if you were born after 1947, you have a 50% chance of outliving the 2026 date, when the Estate Tax comes back at full force.   History tells us that if we have a change of parties in power to Democrats, that 2026 date for reducing the exemption might be accelerated.   Thus, it remains critical that high net worth individuals take proactive steps to reduce their exposure to the Estate Tax.

Many tools are at our finger tips to help you reduce your taxable estate through gifting.   The Gift Tax Exemption doubled, allowing an extraordinary opportunity for you to gift substantial appreciating assets without paying a dime of Gift Tax.   Making substantial gifts can be a little frightening: it may bring up issues of control over assets, creating “Trust Babies” who have unrealistic expectations of entitlement, and reducing cash flow.   Careful consideration must be given to these non-tax aspects.   However, these issues can be addressed via strategies involving special types of trusts, such as Dynasty Trusts, Grantor Retained Annuity Trusts, and nontaxable sales to grantor trusts, just to name a few.

You may have noticed that the media has given little mention to the effect of the Act on the income taxation of Estates and Trusts.   Under the new rules, the highest Federal tax rate for a Trust or Estate is 38% on income over $12,500.   Compare this with the highest Federal tax rate for individuals: 35% on $500,000 of taxable income.   Thus, planning distributions to escape the extremely high rate of tax imposed on Trusts and Estates remains critically important.

Since 1916, The Estate Tax Exemption has changed more than 60 times! Despite complete control by Republicans and their repeated aversion to the death tax, the Estate, Gift, and Generation Skipping Tax remains a threat to high net worth families.   Should we have a change in parties over the next few years, what might Democrats do to accelerate that critical 2026 date? One thing you can bet on: Uncertainty is certain!

We have guided our clients through hundreds of Estate Planning transactions resulting in millions of dollars in savings.   We remain ready to point you in the right direction. Please give us a call to see how Wright Ford Young & Co. can help you!

© Copyright 2017. All rights reserved