Small and medium sized businesses (SMBs) were quick to cheer the new 20% deduction on pass through income that Congress included in the new tax law. As with so many tax and legal issues, however, the devil is in the details.
The tax attorneys at the Baltimore law firm, Rosenberg Martin Greenberg LLP, note that the deduction applies generally to SMBs that pass their profits through to the SMB’s owners, who then pay taxes on those profits at their individual rate and not at a corporate tax rate. Yet the details in the law indicate that not every SMB will be able to automatically shield 20% of those profits from their owner’s personal income calculations. Our tax lawyers have identified several factors that will affect whether SMB pass through income qualifies for the deduction.
The “Reasonable Compensation” Limitation
S corporations and other pass through entities are still subject to “reasonable compensation” limitations that require them to pay salaries to owner-employees. Those pass through entities may run afoul of regulations if they attempt to convert all owner-employee compensation into pass through profits in an attempt to shield 20% of those profits from taxes. The situation is even more complex for partnerships and LLCs that are not subject to the same “reasonable compensation” restrictions as S corporations.
Taxable Income Limitations on Who Qualifies for the Deduction
An owner-employee will automatically qualify for the deduction if his or her taxable income is less than $157,500 (or $315,000 if married and file jointly). Taxable income includes a spouse’s income and income from investments and other sources, and accordingly it is usually a higher number than business income. The 20% deduction begins to phase out when taxable income exceeds $157,000. Further qualifications begin to apply when taxable income exceeds $207,500.
Business and Industry Limitations
Owners of many types of service businesses, including health, law, accounting, consulting, and entertainment firms, will not qualify for the deduction. In general, businesses that are based on the reputation or skills of their owners or employees will similarly not qualify for the deduction. Tax experts are debating certain exemptions to this limitation, but no clear guidance is yet available.
Total Wages and Tangible Asset Ownership Issues
The biggest beneficiaries of the 20% deduction will be SMBs that have a lot of employees and pay large amounts of wages, or that purchase large amounts of tangible or depreciating assets such as buildings and equipment. The tax law will require those SMBs to perform complex calculations for both tax planning and filing. For example, the amount of the deduction available to an SMB employee-owner will be the lesser of (i) 20% of the SMB’s qualified business income, or (ii) the greater of half of the employee-owner’s share of the W-2 wages paid by the SMB or 25% of the W-2 wages plus 2.5% of the unadjusted basis of the SMB’s tangible property.
Contact the Baltimore Tax Lawyers at Rosenberg Martin Greenberg Today
SMBs and other entities that anticipate planning for or using the 20% deduction on pass through income will inevitably require strong guidance from knowledgeable tax specialists on how to factor that deduction into their financial affairs. The tax attorneys at Rosenberg Martin Greenberg have studied and followed the developments on the 20% deduction and on how SMB’s and other pass through entities can derive the maximum benefit from it within the current understandings of its application. Please see our website or contact us to schedule an appointment with one of our tax attorneys who can answer your specific questions about this new tax benefit.