The 20% Tax Deduction for Pass-Through Entities Explained
On December 22, 2017, President Trump signed the new tax act officially named “An Act to Provide for Reconciliation to Title II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” (the “Tax Act”). The Tax Act substantively revised the Internal Revenue Code. The most discussed change is new Internal Revenue Code §199A, which creates a 20% deduction for qualified business income for owners of pass-through entities. This article summarizes new Internal Revenue Code §199A and provides multiple comprehensive examples to better explain the provision’s complexity.
I. Application; Mechanics.
New Internal Revenue Code §199A applies to pass-through entities. Pass-through entities are S corporations, partnerships, sole proprietorships, and limited liability companies that are taxed as an S corporation, partnership, or reported as a disregarded entity on a taxpayer’s Schedule C. The deduction will only apply to “Qualified Business Income” derived from a qualified trade or business operated in the United States or Puerto Rico. Foreign income will not qualify as Qualified Business Income, and therefore will not receive any deduction. The deduction will not apply to C corporation owners.
The deduction is applied at the partner level for partnerships and the shareholder level for S corporations. This means the deduction calculation is made at the individual’s level based on his or her interest in the entity and not at the entity level. For individual taxpayers with income less than $157,500.00 and married taxpayers with income less than $315,000.00, the deduction is equal to 20% of Qualified Business Income. If a taxpayer qualifies for the 20% deduction, then the taxpayer will be taxed only on 80% of his or her Qualified Business Income rather than 100% of the Qualified Business Income. The deduction is a “below-the-line” deduction reducing the taxpayer’s taxable income, but not his or her adjusted gross income. The deduction applies regardless of whether the taxpayer itemizes his or her deductions.
Example – Keith and Heather are married. Keith’s distributable share of income from an S corporation on a K-1 is $250,000.00, which is qualified business income. Heather earns $50,000.00 from an unrelated employer. Their combined income is less than $315,000.00. Accordingly, Keith receives the full 20% deduction and can deduct $50,000.00 ($250,000.00 x 20% = $50,000.00).
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