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Pass-through taxation has been one of the stalwarts of tax policy that is used by just about anyone with self-employment income, either individually or through a limited legal entity such as a limited liability company or limited liability partnership. Pass-through taxation allows these individuals to “pass through” their business earnings and declare them on their personal income tax thus saving the time and expense of filing a separate business return. The Tax Cuts and Jobs Act (TCJA) made some significant changes to pass-through taxation starting on January 1, 2018 and here’s what you need to know:
1) The good news. In addition to preserving pass-through taxation for all who earn income through a trade as a sole proprietor or a pass-through entity, the TCJA will allow those who pass-through their income to deduct up to 20% of that income. So, for an individual earning income through a pass-through entity that is otherwise qualified, that individual can deduct up 20% of their business income through their personal tax returns. This income has a fancy new name: Qualified Business Income (QUI) and is defined as active or passive (as in you do not have to work for it) income derived from a business or trade minus regular deductions. QBI, however, does not include salaries of partners or owners of a business that they earn working for the business.
Only owners of pass-through entities whose taxable income prior to this change is $157,500 or below for individuals and $315,000 for married joint filers are even eligible to qualify for the entire 20% deduction. If the taxable income before the deduction is above these amounts, and the entity through which the income is being passed is not a “specified services business,” then the 20% deduction is not applicable and the only deduction that will be available will be based on wages paid by the entity and capital investments.
2) The bad news. After the 20% deduction, all of the QBI that is leftover will be taxed at the owner’s individual income tax rate. This is bad news because corporate entities such as C-corps have had their income tax cut dramatically from 35% to 21%, while the personal income tax rate for taxation of QBI will be maxed out at 29.6%. Not surprisingly, this has prompted a number of partnerships and LLCs to begin to investigate whether it is worth converting to a C-corp to reap the taxation benefits of the 8.4%difference.
3) The in-between news. While the 21% flat tax rate on corporations is permanent, the 20% deduction of QBI for individuals with pass-through taxation is not. The QBI deduction is currently in place for eight years only, or until the end of 2025. This would seem to weigh the scale heavily in favor of jumping the pass-through taxation entity ship in favor of raising the C-corp flag. Even without the deduction, pass-through entities may have an advantage, for example, over corporations that pay out dividends as earnings. In this case, the pass-through entity could have a 7% lower tax rate.
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While the TCJA has changed pass-through taxation, it may not affect you negatively. The best way to find this out, however, is to contact the attorneys at Weisberg Kainen Mark who can help evaluate your tax liability and evaluate whether or not your entity should consider incorporating to avoid pass-through taxation all together. Contact us today to get started.
Weisberg Kainen Mark, PL
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