One aspect of the new Tax Cuts and Job Act is the 20% income reduction for pass-through entities. If your taxable income is under the income threshold, it’s easy. You get the deduction. If your taxable income is over the income threshold, you need to then determine if you have a service business or a product business and whether your business is over the wage limitation.
It gets even more complicated if you’re in a partnership. You and your partner may be completely equal, but have wildly different taxes on the same amount of income.
Here’s a situation that I talked about in the last Business Tax Coaching session.
Let’s say you and Jennifer are partners in a product-based business. You are married and have taxable income above the threshold. Jennifer is also married, but her taxable income is not above the threshold.
There are no employees in the business, which nets $500,000, or $250,000 each.
Since Jennifer’s taxable income is under the threshold, she and her husband will receive a Section 199A income reduction of $50,000 (20% * $250,000).
In your case, though, your taxable income is above the threshold, so you will be subject to the wage limitation. Since your partnership doesn’t pay any wages, you will not receive any Section 199A reduction.
The determination for the pass-through income reduction is done individually. Each partner’s taxable income will determine how much benefit they can receive.
Guaranteed payments made to a partner count the same as wages. Let’s assume that you and Jennifer both take guaranteed payments of $100,000 each. That would mean you each have an individual pass-through income of $150,000 now ($250,000 – $100,000).
In Jennifer’s case, her income is still below the threshold since the change does not impact her taxable income. However, she only has a Section 199A deduction of $30,000 now (20% * $150,000). This is because her flow-through income was reduced.
In your case, you now have an amount that will qualify for the wage limitation. Your flow through income is $150,000. Your preliminary Section 199A deduction is $30,000. Your wage limitation would be 50% of guaranteed payments (plus any wages, which are zero). The amount would be $50,000 (50% * $100,000). Since the wage limitation amount is greater than the $30,000 you now have $30,000 of reduction.
Guaranteed payments in this amount mean that Jennifer has less of an income reduction, but you have more of a reduction.
I think year-end tax planning for partnerships and the ensuing conversations have just become a lot more interesting!
The day after the coaching session, I received this comment.
“Wow, EXCELLENT coaching session! You packed a lot of “meat” into this 30-minute coaching call. I will be re-listening and re-reading the Home Study course numerous times for this topic. Thank you, Diane!”
I work really hard on the tax coaching sessions and this one on the new Tax Act for flow-through businesses was especially tough. NO ONE else is talking about it! I’m so grateful that my coaching clients “get” the importance of planning ahead for this important tax change.
I have to get a shout-out to my husband, Richard, on this particular blog. After reading it, he asked me why I kept calling it an “income reduction”. He thought it would be easier to call it a deduction. What was the difference? I’m using the phrase “income reduction” because that’s what the IRS and Congress have used. It’s the same, in that it reduces taxable income. But I think it’s better to keep the language consistent.