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Washington Tax Alert February 5, 2018 (New 20% deduction for pass-through businesses)

Washington Tax Alert from Don Barnes, [email protected]

February 5, 2018

One of the key provisions in the new tax act is a deduction equal to 20% of the net business income that taxpayers (individuals, trusts and estates, but not C corporations) receive from pass-through entities (partnerships, S corporations and sole proprietorships) engaged in a trade or business. The 20% deduction is claimed by the owners of the pass-through business, and is available to owners whether they are actively involved in the business or are passive investors. Net business income received from pass-through businesses does not include reasonable compensation or guaranteed payments paid by the pass-through business to owners of the business for services rendered. The objective of the 20% deduction is to reduce the tax rate on business income earned from pass-through businesses because the tax rate imposed on C corporations was reduced from 35% to 21%.

For several reasons, owners of a pass-through business may obtain less than a 20% deduction with regard to their share of the pass-through entity's net business income. The 20% deduction is allowed only with regard to net business income of a pass-through entity connected with the conduct of a trade or business within the United States. The 20% deduction is not available with regard to the net business income of a pass-through entity connected with the conduct of a trade or business outside the United States.

In addition, the 20% deduction is subject to reduction for owners of the pass-through business that have taxable income greater than $157,500 (or $315,000 for married individuals filing joint returns). This potential reduction of the 20% deduction is phased in for owners of the business with taxable income above $157,500 (or $315,000 for married individuals filing joint returns), and fully phased in for owners that have taxable income greater than $207,500 (or $415,000 for married individuals filing joint returns). For these higher income owners of the pass-through business, their deduction equal to 20% of their share of the net business income of the pass-through business is subject to reduction to an amount equal to the greater of the following amounts:

  • 50% of their share of the W-2 wages paid by the pass-through business during the taxable year with regard to a trade or business conducted in the United States, or
  • The sum of (i) 25% of their share of the W-2 wages paid by the pass-through business during the taxable year with regard to a trade or business conducted in the United States, plus (ii) 2.5% of the original acquisition cost of their share of the depreciable tangible property (real and personal) held by the pass-through business at the end of the year in connection with a trade or business conducted in the United States.

If a pass-through business such as an S corporation has net business income of $10 million attributable to the conduct of a trade or business in the United States, and all of the shareholders of the S corporation are higher income taxpayers, the shareholders of the S corporation would be entitled to a 20% deduction (collectively, a deduction of $2 million) if the S corporation paid W-2 wages of $4 million or more during the year, or if the S corporation paid W-2 wages of $3 million and had depreciable tangible property at the end of the taxable year with an original acquisition cost of $50 million or more.

However, the shareholders of the S corporation would be entitled to a deduction of only 15% of the S corporation's net business income (collectively, a deduction of $1.5 million for all of the shareholders) if the S corporation paid W-2 wages of $3 million during the taxable year and had depreciable tangible property at the end of the taxable year with an original acquisition cost of $30 million.

Because of these limitations based on the pass-through business' W-2 wages and the original acquisition cost of its depreciable tangible property, it is likely that higher income owners of a pass-through business will have a deduction less than 20% of net business income if the pass-through business uses too many independent contractors rather than employees, or if the pass-through business' net business income is attributable to owning inventory, land or intangible assets, rather than owning machinery, equipment or depreciable real estate such as a building.

Even if the 20% deduction is available in one year, the deduction may not be fully available in a subsequent tax year if the pass-through business' net business income increases substantially without a commensurate increase in employees or depreciable tangible property.

Owners of pass-through businesses that have taxable income of $157,500 or less (or $315,000 or less for married individuals filing jointly) are entitled to a 20% deduction with regard to their share of the pass-through business' net business income without regard to the limitations based on the pass-through business' W-2 wages and depreciable tangible property. Consequently, lower income owners of a pass-through business may receive a 20% deduction with regard to their share of the net business income of the pass-through business, whereas higher income owners of the same pass-through business may receive a deduction that is less than 20%.

All taxpayers (not just higher income taxpayers) that own interests in multiple pass-through businesses must take into account their share of the net business income of all pass-through businesses in computing the 20% deduction. A taxpayer filing a joint return that has net business income of $150 from one pass-through business, a loss of $50 from a second pass-through business, and whose spouse has a loss of $40 from a third pass-through business would be entitled to a 20% deduction on net business income of $60 ($150 minus $50 minus $40), subject to application of the limitations based on W-2 wages and depreciable tangible property of the pass-through businesses.