The 2018 New Pass-Through Tax Strategy

This post is in: Blog, Business

You may have heard that we’re all going to pay a whole lot less tax on our pass through entities. That’s true, to a point.

If your taxable income is less than the threshold ($315K for married, filing jointly and $157,500 for single), you will have a tax break. Make one dollar more and your tax break becomes almost non-existent,

It’s a complicated formula and so let’s start at the beginning.

A pass through entity is a Sole Proprietorship, a Partnership or an S Corporation. (It also includes an LLC taxed as a Partnership or as an S Corporation.)

If you are a single taxpayer whose taxable income is $157,500 or less or married, filing jointly with $315,000 or less, you are exempt from the service/non-service qualifying tests and the calculation of how much is subject to the reduction. Your business net income will be reduced by 20% when calculating the tax. You win!

Over that, and your first test is whether you are a service or a non-service business. If you have a service business, you may still get a reduction. More on that later. This is NOT the same as the personal service corporation definition for C Corporations. It’s a brand new, clearly cut in stone, yes/no test. Are you a service business? You get nada, unless you are under the second threshold.

A service business is defined as any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of such business is the reputation or skill of 1 or more of its employees. In a last minute change, engineering and architecture were reclassified as non-service businesses. A service business also includes involves the performance of services that consist of investing and investment management, trading, or dealing in securities.

If your service business is less than the second threshold amount , $207,500 for single or $415,000 for married filing jointly, then you can do the calculation for the reduction of taxable business income under the same guidelines that follow for non-service business.

For non-service businesses, it still gets murky. The amount of business income reduction you can take is limited to the greater of 50% of wages (guaranteed payment or W-2 income) or 25% of wages plus 2.5% of the unadjusted basis of qualified property. Qualified property is depreciable property that is still in the depreciable period.

The lesser of those two calculations above mean that you can take that amount and reduce the taxable income amount by 20%


Let’s go through this one more time, step by step:

  1. Do you have a pass through business entity? If no, no need to read further. This isn’t applicable to you. If yes, go on to (2).
  2. Is your taxable income less than $157,500 (single) or $315,000 (married filing jointly)? If yes, you win! You get to deduct 20% of your business income for tax calculation purposes. If no, continue.
  3. Do you have a service business? If yes, go to (4). If no, go to (5).
  4. Is your taxable income less than $207,500 (single) or $415,000 (married filing jointly)? If yes, continue on to (5). If no, you’re done. You get no reduction in tax.
  5. If you have a service business under the adjusted threshold or a non-service, you can reduce your business income by the greater of 50% of wages paid or 25% of wages paid plus 2.5% of qualified property.
  6. If you have a partnership with a partner or another shareholder in an S Corporation, you will split the deduction amount based on how you split the profit of the company.

Some of the strategies to think about for 2018:

Make sure there are enough wages paid from your company to qualify for the loss. If you have a separate entity for payroll or are using a leasing company so that you actually have no wages, you may need to change that strategy for 2018. We’re currently waiting to see how leased employees will fit into this definition. For now, be aware.

If your income is lower than the threshold, you will likely get more of a reduction than someone with income just barely over. Plan carefully, make sure you’re taking into account all of the above the line deductions you can take, realizing that you may be losing your itemized deductions. A C Corporation used in conjunction with your flow through entity may be the best way to adjust your taxable income so you can qualify for the reduction in tax.

It has never been more important to have good and current financials prior to year-end. The year 2018 is when it all changes and it’ll be awhile before this feels natural. Don’t add to the stress by not having current financials.


  1. Cynthia Smith says:

    Very helpful. Can you reference the sections of the new code ( section and paragraph numbers). I would like to make sure I read the source of the information. Thanks.


  2. Diane Kennedy says:

    At this point, we have a new tax bill that is expected to pass into law. Once that happens, the IRS will write the Code that goes along with it. We are too early in the process to have Code sections. If you are used to reading code and law, though, you can go to for the document.

  3. Meredith says:

    In regard to the threshold incomes of $157k for single filers (service related business), is that $157k of just W-2 wages or W-2 wages and pass through business income combined?
    For example, an owner of a S Corp law firm takes a W-2 salary $111k a year and has pass through income of $70k. Is the income for the threshold test $111k or $181k?

  4. Diane Kennedy says:

    The $157,500 threshold for the pass through calculation is based on your taxable income. It’s not just income from one thing, but your total taxable income.

  5. Dan says:

    I am not sure if I qualify as a “service” or not. A “consultant” offers a service but “engineering and architecture” are not services from what was said above. I am an S-corp offering aerospace engineering consultation for aircraft drawings, design and analysis. I am not a “professional” engineer (did not take the exam) though I have two BS degrees in engineering. Thank you very much.

  6. Diane Kennedy says:

    You may need to talk to a tax professional who has expertise in the new tax definitions about the specifics of what you do. Engineering is NOT considered a service, as stated in the original blog post. But if you have a question as to whether you are in that category or not, that would have to be addressed.

  7. K S Boparai says:

    Can one reduce business income with SEP IRA or Solo 401K or Defined Benefit plan to reduce taxable income below the $157500?

  8. Diane Kennedy says:

    Yes, as long as you otherwise qualify with a business, etc.

    I think this will be a great strategy this next year.

  9. David Wang says:

    For S corp, W2 wages paid to owners would consider qualified wages of 50% wages for calculating business deduction? Thanks.

  10. David Wang says:

    Could you explain this statement of yours:

    A C Corporation used in conjunction with your flow through entity may be the best way to adjust your taxable income so you can qualify for the reduction in tax.


  11. Diane Kennedy says:

    That’s a dual corporation strategy. The very short answer is that the operations are held within a flow-through S Corporation and then a C Corporation is used to perform a task or sell a product (upstreaming) or holds a related income source (sidestreaming).

    There is a Home Study Course on this in the twice weekly coaching class I do and I think you can find some blogs here (search upstreaming) with more details. There isn’t enough room on a comment on a blog to explain fully.

  12. Bill Vance says:

    So the thought is that a sole proprietor operating a consulting business that files married and falls under the $315K is okay to have a single org?

  13. Gary Pryka says:

    Hi Diane,

    Could you provide a simple example? Does the $315,000 or $415,000 include the pass through income from a business or is that above those levels? For example, if my taxable income is $415,000 – $300,000 of salary and $115,000 of pass through would there be a 20% reduction in the amount over $300,000 Thanks!

  14. Diane Kennedy says:

    For purposes of the pass through reduction, at least at this time, the answer is “yes.”

    We’re never 100% sure until the IRS releases the Tax Code with more of the details. For example, my concern is the definition that salary paid to an owner will not get the reduction. If the definition of “salary” is any earned income on which payroll taxes are paid, then since 100% of the income is subject to self-employment tax, none of it would get the reduction.

    We just don’t have the details yet.

    My advice would be to form a single member LLC in January. Worst case, you get asset protection and it doesn’t matter for tax planning because my fear is unfounded. Best case, we’ll know in a few months and you can make a late election to an S Corp to avoid the issue.

    If you wait to form the LLC, you won’t be able to do a retroactive LLC election.

  15. Diane Kennedy says:

    Hi Gary,

    As I understand your question it is regarding the taxable income threshold of $315,000 (or $415,000 for service businesses.)

    The taxable income is found on your Form 1040 tax return. On the 2016 return, it’s line 43.

    It doesn’t matter how much is W-2 income, how much is business income, how much is capital gain, etc… It’s the total taxable income. I think the best way to understand what your amount will be is to look at your 2016 tax return. Your numbers will be different most likely, but the general principle will be the same.

    If I misunderstood your question, please let me know.

  16. David A Anderson says:

    No discussion on reduction in SS/MC on pass through. I am pretty certain this is just a tax deduction, 20%, and PR taxes are still paid on the pre-deduction amount.

  17. Diane Kennedy says:

    The SS/MC (self-employment tax) will stay the same. The only reduction you may qualify for is the 20% on ordinary income tax.

  18. Rich C says:

    Hi Diane,
    My business is an LLC. I’m married filing jointly, and the taxable income on our fed tax return would be less than $315K, so I believe I qualify for the 20% reduction. My question is this. Would the deduction be applied only to the amount on line 1 of my K1 (business income) or would it also include line 4 (guaranteed payments)? Thanks!

  19. A LeonGuerrero says:

    Thanks for the helpful information. I’ve had a single member LLC filing as sole proprietorship (no corporation elected, no employees) for several years, for my work as an independently contracted physician with various clinics/hospitals. So I believe this definitely puts my business into the “service business” category. I may fall under the second threshold of 415K total taxable income (married filing jointly) if I maximize my solo 401K contributions, which I intend to do. So I think I will qualify for the phased business income reduction. Not sure I understand what that means though in my scenario ie what does “wages paid” mean in my circumstance….not being a corporation nor having employees, I pay no wages to anyone. Or does the business profit that I report as business income on schedule C count as “wages paid”? If not, perhaps I should consider changing my election to s-corp or c-corp? Of course I will have my accountant weigh in on this decision too, but would be interested in your thoughts. Thanks in advance.

  20. Diane Kennedy says:

    The first thing I’d look at is see if your taxable income is under the $157,500/$315,000 threshold. If so, it doesn’t matter about the rest. You get the pass-through entity 20% reduction.

    The next question is whether you would qualify for the phase-out for a service business. If so, then you will get a partial reduction.

    And finally, if you are above both thresholds, you won’t get any reduction because, based on what you said here, it sounds like you are a service business and so don’t qualify for it.

  21. A LeonGuerrero says:

    Thanks for your response. My basic question was that if my LLC income is passing through to me as sole proprietor, is that considered “wages paid”. I do understand about the double threshold business and think I will be over the first one but under the second one so will have a phase-out partial reduction for service business.

  22. Diane Kennedy says:

    So far, all we have is the Tax Act’s term “W-2 wages”. Until we get the IRS code, we won’t know how that is interpreted for sure.

  23. I act as a consultant to several family businesses. My income is 1099. I plan to expand my consulting to other companies.

    Can I set up an LLC or a C corporation and claim pass through income.

  24. Diane Kennedy says:

    A C Corporation is not a pass-through entity.

    As far as whether you can take the pass-through reduction, you would first need to know how much your total taxable income is. If it is under the threshold amounts, then you can take the reduction. If it is not, and you have a service company, then you cannot.

  25. I am an S Corporation and under the threshold with married, filing jointly. I quality because of this. I have not taken any W-2 wages for a few years and instead am using up my outside basis.
    Should I start paying myself wages again in order to get this deduction?

  26. Diane Kennedy says:

    If you’re under the $315K threshold (married, filing joint), you aren’t required to qualify with the 50% of W-2 wages.

    However, make sure you aren’t required to take some kind of salary. Typically, you are required to take a reasonable salary from your S Corp. Otherwise, if the IRS looks at it, they may charge you 15.3% self-employment tax on the entire income of the S Corp.

  27. Richard says:

    I have been a Sole Prop (financial services) for many years, simply subtracting my expenses from commissions. This year I could earn $300,000+. Should I become an S-Corp or continue as a Sole Prop? Thank you.

  28. Diane Kennedy says:

    I would never suggest that someone operate as a Sole Proprietorship. You’ll pay more in taxes and put all of your personal assets at risk.

    The question is rather whether you should be an S Corp, an LLC electing S Corp status, a C Corp, an LLC electing C Corp status or a combination of two.

    This is the kind of question that really needs to be answered based on your own personal circumstances, what kind of business, whether you have assets, what your personal needs are from the income, what you’re doing with the excess, what your goals with the company are and more. I strongly suggest you have a consultation with a qualified CPA.

    If you’re interested in a consultation with me, please send an email to

  29. Tony Raty says:

    I have stock in an S-Corporation that is a non-service business. 50% of wages is greater than the net profit of the business, so under the rule, would this create a loss for tax purposes?

  30. Diane Kennedy says:

    I’m not quite sure what you mean by “50% of wages is more” and then later that it would create a loss.

    The idea is that it’s 50% of the net income of the S Corp. So if the total net is $100K and there are two working partners, you would both take a salary of $25K (or whatever you decide amongst yourselves). That would leave taxable income of $50K.

  31. Frances E says:

    Hi Diane, I am a recruiter. Getting ready to file for an LLC in California. I will not be hiring employees. Just me. I just got married. My husband works for another company. To gain the best benefits. How should I file? Individual/sole or a single member. Under tax classification should I use S-S corporation S?
    Thank you Frances

  32. Diane Kennedy says:

    That has become a much more complicated question because of the Tax Cuts and Jobs Act. If your taxable income is under $315K, it won’t matter. You’ll get the tax reduction. If it’s more than that, you have to then look at whether you are a service business under the new definition (probably) and whether your taxable income is under the second threshold.

    There isn’t a straightforward answer without looking more indepth at a lot of other things. I’d recommend talking to a CPA about your specific circumstances.

  33. Diane Kennedy says:

    Rich, we don’t know for sure how it will be applied. Most likely “guaranteed payments” will be treated the same as if you took a salary from your S Corp. It would not be subject to the tax reduction.

  34. David Tromble says:

    Hi Diane, my real estate sole proprieter LLC passes income to me from commercial investment property rentals. Is this considered earned or non-earned income and will the 20% reduction apply to me if I am under thresholds stated (I actively participate in managing but not a real estate professional)? Thank you.

  35. Diane Kennedy says:

    Real estate rental income is typically passive income. If you hold it in a single member LLC, it would report on Schedule E. The thing that gives me pause is that you said it was a Sole Proprietorship.

    This is definitely something to discuss with your tax preparer. Why is your passive income being reported as earned income? It’s possible that this is actually a real estate business, such as a fix-n-flip type of business or hotel or motel. Otherwise, it should be on Schedule E.

  36. David Tromble says:

    Hi Diane, my real estate income is reported on Sch E. Not a true sole proprietership but a single member LLC. Sorry for any confusion on my part. Given that, will I be able to reduce this income 20% if under thresholds? This is unearned income right? So would it qualify for the 20% tax break. Thanks again.

  37. Jane M says:

    I have a S-Corp non service business Married filing Jointly. I have Total S-Corp income of 600,000.00. Plus W-2 Income of 200,000.00. Am I correct in thinking that I do not qualify for the 20% tax reduction. Thank You

  38. Diane Kennedy says:

    Jane M,

    If you have a non-service business, you’re subject to the wage limitation rules. As an example, let’s say the $200K W-2 are wages paid by the S Corp. There are no other wages. (Just for this example)

    You could deduct $600K x 20%, but are limited to 50% of wages, or $100K. So your deduction would be $100K.

    If you have a service business, though, you can’t take the deduction.

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