In light of the temporary doubling of the federal estate, gift and generation-skipping transfer tax exemptions and the resulting inapplicability of the federal estate, gift and GST tax to 998 out of every 1,000 Americans, income tax planning considerations will now in many instances eclipse estate tax planning considerations.
While there were several changes to the income tax—including the reduction in the top corporate tax rate to 21 percent, the reduction in individual income tax rates, including a new top marginal income tax rate of 37 percent and the imposition of a $10,000 cap on the deduction for state and local income, sales and property taxes—the most controversial income tax topic may be the new 20 percent pass-through deduction.
The Pass-Through, What Now?
The 2017 Tax Reform Act allows individuals (and trusts and estates) to deduct 20 percent of qualified business income from partnerships, S corporations and sole proprietorships (the “pass-through deduction”). The term “qualified business income” means the net amount of items of income, gain, deduction and loss with respect to any qualified trade or business of the taxpayer, determined in a manner analogous to that used to determine if income is effectively connected with the conduct of a trade or business within the United States. The deduction (which can’t exceed the taxpayer’s taxable income) is computed by adding together the income and losses from all of the taxpayer’s qualified businesses, and the deduction is available even to taxpayers who take a standard deduction.
If there’s a net loss with respect to all qualified business income for a particular year, such loss is carried over into the next year, to be used to reduce the pass-through income deductions in the next year. For an individual in the top marginal tax bracket of 37 percent, this deduction would yield an effective federal tax rate of approximately 29.6 percent on qualified business income. As described below, however, there are numerous limitations on this deduction based on the taxpayer’s income.
Certain types of income are specifically excluded from being treated as qualified business income. Capital gains or losses, dividends, interest (unless properly allocable to a trade or business) and certain other types of income are all excluded. In addition, reasonable compensation payments, any guaranteed payments for services or any payments for services to partners not acting in their capacity as partners (to the extent described in future regulations) aren’t included in qualified business income. One can expect that these limitations will create additional incentives to try to reclassify employees as self-employed independent contractors, to reclassify guaranteed payments as profits interests and to minimize the amount of reasonable compensation payments.
Specified Service Businesses
A limitation on the pass-through deduction is imposed on income derived from certain specified service businesses, which include businesses that perform services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing with securities, partnership interests, or commodities and any trade or business in which the principal asset is the reputation or skill of one or more of its employees or owners. The new tax law specifically exempts engineering and architecture firms from this limitation.
The pass-through deduction for owners of these personal service businesses begins to be phased out when the owner’s taxable income (from all sources and not just from the personal service business) exceeds $157,500 ($315,000 for married taxpayers who file jointly) and is completely eliminated when the taxable income reaches $207,500 ($415,000 for married taxpayers who file jointly).
W-2 Wages and Capital
The second limitation on the pass-through deduction is based on the W-2 wages and capital of a qualified trade or business. In general, the pass-through deduction with respect to income from a qualified trade or business can’t exceed 50 percent of the W-2 wages paid with respect to that trade or business. In addition, there’s a second test based on a combination of W-2 wages and capital invested, which is designed to benefit capital intensive businesses that don’t pay significant amounts of wages, which may include real estate investments. Under the Act, the limitation is the greater of:
- 50 percent of the W-2 wages paid with respect to the qualified trade or business; or
- The sum of 25 percent of the W-2 wages paid with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.
For example, assume that a married taxpayer with income exceeding $600,000 has a 15 percent interest in a partnership that conducts a real estate business. The partnership buys a piece of commercial real estate for $10 million and places it in service in 2018. The partnership has no employees in 2018 and earns $500,000 of qualified business income in 2018, with $75,000 (15 percent of $500,000) of such income allocated to the taxpayer. The W-2 wage limitation on the taxpayer in 2018 is the allocable share (15 percent) of the greater of 50 percent of W-2 wages ($0) or the sum of 25 percent of W-2 wages ($0) plus 2.5 percent of the unadjusted basis of the real estate immediately after its acquisition ($250,000).
Applying the limitation analysis, the amount of the W-2 wage and capital limitation on the taxpayer’s deduction is $37,500 (15 percent of $250,000). In contrast, the allocable share of the qualified business income is $75,000, and the amount of the 20 percent pass-through deduction is $15,000 (20 percent of $75,000).
Because the limitation ($37,500) is greater than the deduction ($15,000), the full $15,000 is deductible from the taxpayer’s income. As a result, the taxpayer will report only $60,000 of income from this partnership, which will be subject to tax at a 37 percent rate, which results in an effective rate of 29.6 percent. If, however, this business is also a specified service business, then the entire deduction would be disallowed because the taxpayer’s income exceeds the threshold of $415,000.
The definition of “qualified property” becomes very important for this purpose. Qualified property means tangible property that’s subject to allowance for depreciation under IRC Section 167, (1) which is held by, and available for use in, the qualified trade or business at the close of the taxable year, (2) which is used at any point during the taxable year in the production of qualified business income and (3) the depreciation period for which hasn’t ended before the close of the taxable year. For this purpose, the depreciation period is measured from the date the taxpayer placed the property into service and is the longer of 10 years or the depreciation period under IRC Section 168 (without regard to Section 168(g)).
There are many unanswered questions in the legislative text, which will need to be resolved by Treasury Regulations, including the application of the limitation for a short taxable year, when the taxpayer acquires or disposes of the business during the year, to acquisitions of property from related parties, sale-leaseback or other transactions with potential to manipulate the basis of the property and to property acquired in like-kind exchanges or involuntary conversions.
The limitation based on W-2 wages and capital doesn’t apply to owners with taxable income (from all sources and not just from the business) that doesn’t exceed $157,500 ($315,000 for married taxpayers who file jointly). This limitation is phased in for taxpayers with taxable incomes between $157,500 and $207,500 (between $315,000 and $415,000 for married taxpayers who file jointly), and the limitation applies fully for taxpayers with taxable incomes exceeding $207,500 ($415,000 for married taxpayers who file jointly).
It’s important to bear in mind that just because the limitation applies doesn’t mean that the deduction will be limited, because the limitation amount may be greater than 20 percent of the qualified business income.
Even though the upheaval it causes in the short term will likely be considerable, remember that the pass-through deduction isn’t permanent and is scheduled to expire after Dec. 31, 2025.