With regard to the new tax law, by far the most common topic of questions from readers has been the new deduction for pass-through business income (i.e., income from sole proprietorships, partnerships, S-corporations, or LLCs taxed as any of the above). What follows is my best attempt to explain the new deduction clearly. Unfortunately, it is complicated. So if this deduction will be relevant to your personal tax planning, I’d encourage you to meet with a tax professional, read the applicable part of the new law for yourself, and/or read articles on the topic by other sources (e.g., Steve Nelson, Michael Kitces, Kelly Phillips Erb). One point before we get started: I’m simplifying here by assuming that you have no qualified cooperative dividends, qualified REIT dividends, or qualified publicly traded partnership income. Each of those types of income gets special treatment under this new Code section. If your taxable income* is under a certain threshold amount, the deduction is 20% of the pass-through income from your business(es), but it cannot be greater than 20% of your taxable income excluding net capital gains. The threshold amounts are $315,000 if you are married filling jointly or $157,500 if you are single, head of household, or married filing separately. (Of note, this is the top of the 24% tax bracket for each filing status.) When your taxable income exceeds the threshold, two potential complications kick in: If your taxable income exceeds a certain phaseout range (i.e., the threshold amount from above, plus $100,000 if married filling jointly or $50,000 if single/head of household/married filing separately), then your deduction for each business will be limited to the greater of: If your taxable income is in the phaseout range, the calculation basically says, “If you were past the phaseout range, how much would the wage (or wage + property) limit reduce the amount of your deduction? Now, instead of reducing your deduction by that whole amount, we’ll multiply that reduction by a percentage that is the percentage of the way you are through the phaseout range.” Example: You are single and you have $150,000 of pass-through income from a sole proprietorship. Your taxable income is $182,500 (i.e., halfway through the phaseout range). The business has no qualified property, and it paid $40,000 of W-2 wages over the course of the year. Without regard to the limitations, your pass-through business income deduction would be $30,000 (i.e., 20% of $150,000). But your taxable income is past the threshold amount of $157,500. If you were past the phaseout range, your deduction would be limited to $20,000 (i.e., 50% of the wages paid by the business). That’s a $10,000 reduction relative to what it would be without the limitation. But you aren’t past the phaseout range. You are halfway through it. So your deduction ($30,000) is reduced by half of that $10,000 — for a total deduction of $25,000. If your business is a “specified service business,” there’s another limitation that can come into play. A specified service business is: If your business is a specified service business, then we again calculate how far your taxable income is through the same phaseout range (i.e., the same threshold, plus either $100,000 or $50,000). —obliviousinvestor.com
