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Can You Win From the Pass-Through Deduction?

By Dan Caplinger – Jan 3, 2018 at 8:03AM

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Employees aren't eligible, but a wide range of others are.

The new tax reform bill was a big winner for businesses, with the biggest news coming from the drop in the corporate tax rate from 35% to 21%. Yet a more complicated provision could mean a much bigger difference for the vast majority of small businesses set up as sole proprietorships, partnerships, or limited liability companies and which elect what's known as pass-through tax treatment for their earnings. The ability to deduct a fifth of business income not only has small businesses scurrying to take advantage of the provision but also has some regular workers looking for ways to get their piece of the tax savings pie.

What pass-through entities are

Pass-through entities refer to the business entities for which the tax laws essentially ignore the separate existence of the business. Instead, any income, deductions, credits, and other provisions get passed through directly to the owners of the business. Most corporations, in contrast, have to pay a corporate tax at the entity level and then leave business owners with a potential second level of taxation when they take out profits in the form of dividends.

Partnerships and LLCs are quite familiar with pass-through status, because business owners generally pick those forms specifically because of their tax benefits compared to corporations. Sole proprietors, however, often don't really consider the idea that they're a pass-through entity, and so many didn't realize that the tax reform benefits would potentially apply to them as well.

Metal clockwork gears nested together, with one engraved with the words Tax Reform.

Image source: Getty Images.

What tax reform did for pass-through entities

Section 11011 of the tax reform law created new Section 199A of the Internal Revenue Code, which provides for a deduction of up to 20% of a pass-through entity's qualified business income. Qualified business income means simply the net amount of income, gain, deduction, and loss that are effectively connected with the conduct of a trade or business.

However, there's a huge exception that aims to prevent abuse of the provision. Qualified trades or businesses don't include specified service trades or businesses. The law refers to an existing provision of the tax code, which excludes the performance of services in

health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.

The tax reform provision also excludes performing services as an employee from the definition of a qualified trade or business. If the exception applies, then your 20% deduction is limited to the greater of either 50% of W-2 wages paid by your business, or 25% of W-2 wages plus 2.5% of the tax basis of qualified property owned by the business. In other words, if you work on your own and your business generally involves services rather than capital-based work, then the odds are good that this exception applies and you generally won't get any deduction from the provision.

To make things more complicated, there's an exception to the exception. If you're a specified service business but your income is less than $157,500 for single filers or $315,000 for joint filers, then you can still claim the 20% deduction. If your income is up to $50,000 higher for singles or $100,000 for joint filers, then a partial deduction is available.

Does it pay to go the pass-through route?

Tax experts are seeing a big rise in interest from clients about how best to use the business provisions of the tax reform law. On one hand, corporate tax rates are much lower now, making it more beneficial to use corporations than it used to be. Yet the pass-through deduction also makes the simpler structures of partnerships, LLCs, and sole proprietorships attractive as well.

Some analysts even believe that employees might be tempted to become independent contractors, making them sole proprietors of their own service businesses in order to take advantage of the 20% deduction. However, the rules governing the employee vs. independent contractor relationship are complex, and it's far harder than just making a decision to shift from one to the other. In order to make the switch, employees would at least have to give up all their employee benefits, such as health insurance, vacation, and 401(k) participation. Whether losing those benefits would be worth the deduction should be determined case by -case.

If you already have a side job that treats you as an independent contractor, though, you'll want to take the rule's provisions to heart. The opportunity to get a fifth of your income essentially tax-free is a powerful incentive to make some money outside your main job.

Keep your eyes on tax reform

Anytime tax laws change, people seek to take advantage of them. If pass-through tax treatment turns out to be too good to be true, you can expect lawmakers to try to rein in on the benefits. For now, though, it's worth looking closely at your situation to see if you can qualify for the valuable deductions that pass-through treatment can provide.

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