Patrick Kalbac – The calendar has finally turned the page. It is officially 2018. While the beginning of a new year is always accompanied by hope and fresh starts, 2018 is different. What makes it different? On January 1, 2018, the new tax plan took effect. Although opinions on the tax plan differ, those opinions cannot alter reality. American taxpayers have to comply with Trump’s new tax bill whether they like it or not.
But what does the new tax bill really do? Despite extensive media coverage, many Americans do not understand the finer aspects of the bill. Most view it the same way it has been portrayed on social media. They see it as a war between the rich vs. the poor. That the tax bill benefits the rich. That it will only add to the United States’ debt. Yet, one of the most significant aspects of the tax plan that has not been discussed nearly enough is the deduction of pass-through income.
A pass-through or flow-through entity is a legal business entity where income “flows through” to the owners. Unlike C corporations, which are subject to the corporate income tax, pass-through profits flow through to the owners and are taxed under the individual income tax. The biggest advantages being that flow-through entities are not subject to double-taxation and individuals may deduct business losses against current income from other sources. Examples of such entities include sole proprietorships, partnerships, and S corporations. Notably, these types of entities comprise more than 95% of business tax filings. In 2012, 80% of business were organized as flow-through entities. As recently as 2014, pass-through income was claimed by approximately 40 million taxpayers on their individual tax returns. The significant number of these flow-through entities demonstrate the importance of the changes to the tax plan regarding such businesses.
Under the new plan, flow-through businesses will now be taxed at a much lower rate. The tax plan entitles such entities to take a deduction equal to 20% of the “qualified business income” earned from profits. That is, owners of partnerships and flow-through entities can deduce 20% of ordinary, non-investment income tax-free. No longer is their income subject to their individual income tax, which in some cases was as high as 39.6%. In effect, the deduction will result in a marginal tax rate of 29.6% when taking into consideration of the reduction in individual income tax rates. At first glance, the new cap significantly benefits the wealthy; however, that is not the case. There are limits.
The deduction automatically applies to individuals whose income is less than $157,500 and married couples whose income is less than $317,000. Once that threshold amount is exceeded, the limitations set in. Most notably, “service firms” would not be able to deduct the 20%. A list which includes businesses that provide services in the fields of health, law, accounting, consulting, or financial services. It is important to note that traditional services providers like engineers and architects are not included under the disqualified businesses. Second, post-threshold, the deduction is limited to the lesser amount between 20% of qualified business income OR the greater of 50% of W-2 wages paid by business or 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property. What these do is to limit people trying to significantly benefit from the deduction and essentially level the playing field. But, due to a lack of precedent regarding what constitutes a “service firm” it remains to be seen who will actually be able to benefit from the deduction.