The 2018 Pass-Through Tax Reduction Might Not Be as Helpful as You Hoped

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The 2018 Tax Cuts and Job Act has created some big changes to how Americans approach taxes. One of the biggest changes is in how pass-through entity income is taxed.

A C Corporation is not a pass-through entity. It pays tax on its own income. The others, partnerships, LLCs (that haven’t elected another tax treatment), S Corporations and Sole Proprietorships all are pass-through entities.

If your taxable income is under $315,000 (married, filing jointly) or $157,500 (single), then you get a 20% tax reduction on your pass through income. All of the income from the pass-through entity, excluding any salary you draw, will not be subject to the reduction. It’s just the income from the entity after those expenses.

If your income is over the thresholds ($315,000/$157,500), you need to then look at whether you have a service or non-service business. If you have a service business, you have a second threshold to manage. If your taxable income is over $415,000 (married filing jointly) or $207,500 (single) with a service business, you don’t get any reduction. For the service business only, the amount that is subject to the reduction will be reduced as you approach the second threshold.

If you have non-service business, you get some kind of reduction.

Now, let’s look at the next little gotcha. Once your taxable income is over the first level thresholds ($315,000/$157,500), your reduction is limited to either 50% of your W-2 expenses or 25% of your W-2 expenses + 2.5% of qualifying depreciable assets.

The phrase “W-2 expenses” has been the subject of a lot of conversations. In the original Senate Bill, there was an addition of “guaranteed payments” which are paid to owners in an LLC. The fact that guaranteed payments were not included in the final Act, after having been thoroughly discussed in a draft, leads a lot of people to believe that ONLY W-2 wages will be used for this calculation. The same is true for Sole Proprietorships. If you are the owner, you can’t draw a salary from the Sole Prop and it looks like the amount paid to you through the Schedule C will not qualify for the calculation.

We won’t know until we get further information from the IRS when they write the code that goes along with the new Act.

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