Stefan E. Greenberg, CFP®, CFS, CLTC
March 26th, 2019
Many families use pass-through entities — including partnerships, limited liability companies and S corporations — for financial-, estate or succession-planning purposes. If you own interests in any such entities, it’s important to familiarize yourself with the new 20% “passthrough” deduction contained in the Tax Cuts and Jobs Act (TCJA). There may be opportunities to maximize the benefits of the deduction and reduce your tax burden.
LEVELING THE PLAYING FIELD
The new deduction, found in Section 199A of the tax code, is designed to level the playing field between passthrough entities and corporations, which now enjoy a dramatically reduced 21% income tax rate. By contrast, pass-through income is taxed at only slightly lower individual rates of up to 37%.
Eligible pass-through owners (as well as sole proprietors) may now deduct up to 20% of their allocable share of the entity’s qualified business income (QBI). Generally, QBI means net U.S. business income, excluding certain investment income — such as capital gains, dividends and nonbusiness interest — plus reasonable compensation or guaranteed payments received by shareholders or partners.
In a nutshell, the amount of your deduction is the lesser of:
- 20% of your share of QBI, or
- 20% of your taxable income (less net capital gains).
The deduction is taken against adjusted gross income. It is not an itemized deduction.
LIMITS FOR HIGH-INCOME EARNERS
If your taxable income exceeds $157,500 ($315,000 for joint filers), your pass-through deduction may be reduced or eliminated. Once income exceeds this threshold, two limitations begin to kick in:
- The deduction becomes unavailable to “specified service businesses,” including health care providers, accounting, consulting, law and certain investment firms, and businesses whose “principal asset … is the reputation or skill of [one] or more of its employees.” Architecture and engineering firms aren’t included in this group.
- The deduction is limited to the greater of 50% of your share of the entity’s W-2 wages, or 25% of your share of the entity’s W-2 wages, plus 2.5% of its unadjusted basis in qualified depreciable property.
Both limits are phased in beginning at the taxable income threshold and apply fully once income reaches $207,500 ($415,000 for joint filers).
If your taxable income exceeds the threshold, your pass-through deduction may be reduced or eliminated, either because the entity is engaged in a specified service business or because you have an insufficient share of W-2 wages or depreciable property to support a full deduction. However, it may be possible to maximize the deduction by transferring interests in the entity to family members whose income is below the threshold.
One technique for maximizing the deduction is to transfer interests in an entity to several nongrantor trusts for the benefit of your children or other family members. These trusts are subject to the same threshold as individuals and avoid the limits discussed above so long as their taxable income is less than $157,500. To calculate the QBI deduction, business expenses, W-2 wages and the unadjusted basis of qualified depreciable property are allocated between the trust and its beneficiaries in proportion to the amount of income the trust retains and the amount distributed to beneficiaries.
Note that proposed regulations authorize the IRS to treat multiple trusts as a single trust if the trusts have substantially the same grantors and primary beneficiaries and their principal purpose is tax avoidance.
At the very least, you should designate a different beneficiary for each trust. Because this strategy will be subject to IRS scrutiny and many factors may affect it, consider waiting until final regulations and guidance are released.
DEDUCTION IS COMPLEX
If you own interests in pass-through businesses, talk with your tax professional and Lenox Advisor. This deduction is complex and the IRS has issued nearly 200 pages of proposed regulations on the subject. Your Lenox Advisor will help ensure you maximize the deduction. If your ability to claim it is limited, you may be able to enhance the benefits by transferring interests to family members — either outright or in trust. Finally, keep in mind that the deduction is temporary. Unless Congress acts, it expires at the end of 2025.