IMPORTANT NOTE: This article is regarding the new 2017 tax bill, the Tax Cuts and Jobs Act. As of this writing the bill has not yet passed both houses of Congress, although it is expected to do so and to be signed into law, perhaps as early as the 2017 Christmas Federal Holiday.
The bill is at least 500 pages long and very complex, and it is not yet fully understood by nearly anyone. This article is an attempt to explain in simple terms the most important provisions of the bill that apply to small businesses.
For example, the bill has some provisions that may create additional advantages to forming a Limited Liability Company (LLC), C Corporation or S Corporation (subchapter S entity). This article will examine the most significant of those provisions.
This article is not being offered as (nor should it be taken as) tax advice, and no business decisions should be made based upon this information without consultation with the appropriate tax professionals.
The Pass-Through Income Deduction
This is probably one of the most significant and exciting provisions of the new tax bill, specifically with regard to owning/forming a business. There is a potential 20 percent deduction of off “qualified business income” for pass-through entities. A limitation on this deduction would be phased in based on W-2 wages above a threshold amount of taxable income, though what that threshold amount will be is currently unclear.
A pass-through entity is a company that does not pay taxes for itself. Instead, the net income (or loss) is divided among the owners and “passes through” to the owner(s) of the company, being added to their personal income. Thus, the income is still taxed, but it is taxed at the individual level on the personal income of each owner. Currently, for most pass-through businesses, 100 percent of the income that is passed through to the owners is taxed at the same rate as the ordinary income of each individual owner.
“Qualified business income” means the net amount of qualified items of income, gain, deduction and loss with respect to the qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the United States. They do not include specified investment-related income, deductions, or losses.
You can think of qualified income as the net profit that ultimately passes through to the owners, although there will likely be certain caveats and limitations to the amount to which the new deduction applies (see below).
Some Important Caveats and Limitations
First, this deduction does not apply to compensation that business owners might pay themselves. For example, it would not apply to any salary or other similar compensation that an owner would pay themselves for actual work/labor/services to the company — only to profits distributed to owners after all ordinary business expenses, including compensation, are accounted for.
There are also certain “specified trades or businesses” referenced in the bill that do not necessarily qualify for this deduction. Those include any trade or business in the fields of accounting, health, law, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees.
The exclusion from the definition of a qualified business for specified service trades or businesses phases in for a taxpayer with taxable income in excess of $157,500 (or $315,000 for a joint return).
For each qualified trade or business, 20 percent would be deducted from their qualified business income, though there is a limit on the amount of income that is eligible for the deduction. This limit is 50 percent of the W-2 wages (e.g., salary) that each owner is paid by the business.
Additionally, this provision in the new tax bill specifically references partnerships, S Corporations or sole proprietorships, which has lead some to assume that it does not apply to LLCs.
This assumption is almost certainly incorrect for a few reasons:
- First, those provisions are referencing the specific taxation status of certain entities. It’s reasonable for LLCs not to be referenced because there is not a specific federal tax status for LLCs. By default, an LLC is treated by the IRS either as a sole proprietorship or a partnership for federal tax purposes.
- Second, LLCs have constituted the majority of new and small business incorporations for many years at this point. It seems inconceivable that the sweeping changes contained within this bill would exclude the millions of current and future LLC owners.
- Third, even if this deduction inexplicably did not apply to LLCs, any existing and future LLCs could simply elect to be taxed under subchapter S of the federal tax code, and thus be treated as S Corporations for federal tax purposes.