New 20% Deduction for Pass-Through Entities

Starting in 2018, taxpayers are allowed a deduction equal to 20 percent of the lesser of a) their “qualified business income” from partnerships, S corporations, LLCs, and sole proprietorships, or b) their taxable income. The income must be from a domestic business. Therefore, investment income (i.e. interest, dividends, royalties, etc.) does not qualify. Nor do salaries or guaranteed payments paid to the individual by the pass through entity. The deduction is not used in computing adjusted gross income. Nor is it not an itemized deduction. Therefore it is allowed even to those who do not itemize. For individuals with taxable income above $157,500 ($315,000 for joint filers), the deduction is phased out for income from trading activities and services in health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. In addition, for those with higher taxable incomes, the 20% deduction for qualified business income is further limited to the greater of 50% of the individual’s share of W-2 wages paid by the entity or a factor representing the individual’s share of the capital of the business.

Planning Note: Needless to say, the new rules are complicated, even so, they are full of planning opportunities for those who jump on them early in 2018. Taxpayers should consider whether to restructure their businesses to take advantage of the new deduction. Restructuring may include changing the amount of W-2 wages paid by the entity, lowering taxable income without lowering the qualified business income to avoid the phase-out for higher income taxpayers, adopting deferred compensation plans, and creating a small business where one did not exist before.