By Susan Rolfe

   South Carolinians are proud of their entrepreneurial spirit and the significant impact small businesses have on the state’s economy. Many businesses have been set up as sole proprietorships, partnerships, or S Corporations. These businesses are called “pass-through entities” because their income is not subjected to a separate tax liability but is included in the owners’ personal income tax returns. There is no additional tax when income is withdrawn by the owners.  In contrast, taxable corporations, typically known as C corporations, not only have the business’ income subjected to a corporate income tax (maximum rate of 21 percent under the new tax law) but also to a second tax (maximum rate of 20 percent) when the dividends are distributed.

Congress created a new deduction as part of its tax reform legislation, the Tax Cuts and Jobs Act (TCJA), which could make pass-through entities even more attractive to some small business owners.  For the first time, owners of certain types of pass-through businesses can potentially deduct 20 percent of their qualified business income from taxable income. Unfortunately, the rules associated with this provision have complex limitations on who can claim the deduction and the amount that qualifies.

What Businesses Can Take the Deduction?

Taxable corporations (C Corporations) cannot claim the pass-through deduction. Most partnerships, S-corporations, and sole proprietorships with income less than $315,000 for married taxpayers ($157,500 for single taxpayers) can claim the full amount regardless of the type of services or trading they provide. However, once this income level is reached, the TCJA specifically limits the deduction as income gets higher, plus phases in a limitation based on wages and depreciable property for “specified service businesses”.  These are companies that earn income from the “reputation or skill” of their owners or employees. The act provides a long list of services that fall into this category that includes health, law, accounting, consulting, and financial services. Once taxable income of $415,000 for married taxpayers is reached ($207,500 for single taxpayers), a deduction cannot be claimed for the income of specified service businesses.

For example: Stephanie, a single taxpayer, is a tax lawyer with taxable income of $150,000. Her qualified business income would qualify for the twenty percent deduction with no limitation. However, if her taxable income were $210,000, she would not get any pass-through deduction.

Not all types of services are affected by this rule. Architecture and engineering services are specifically excluded from the definition of specified service businesses. This allows them to qualify for the deduction, no matter how much they earn.

How is the Deduction Calculated?

The business owner first calculates the qualified income of the business. This is the net income of the business with a few adjustments, such as one for REIT dividends. The deduction is twenty percent of the qualified income.

For example: Hannah has a sole proprietorship with income of $160,000. Her husband, Ronald, has wages from Burton County Hospital of $150,000.  Hannah would be entitled to a pass-through deduction of $32,000 (20 percent of $160,000). If they took the standard deduction and did not itemize, their taxable income would $254,000 ($160,000 +150,000-32,000 – 24,000).

Business losses from previous years reduce the amount of business income that qualifies for the deduction. For example, Sam’s accounting practice lost $30,000 in the first year but made a profit of $50,000 in the second year. The second year’s income is reduced by the $30,000 loss before the 20 percent pass-through deduction is calculated: ($50,000-30,000) multiplied by 20 percent gives a deduction of $4,000.

Complicated limitations start to kick in once a taxpayer’s income exceeds $315,000 for married taxpayers ($157,500 for single taxpayers).  First, the deduction starts to be phased out and is eliminated once the taxable income reaches $415,000 for married taxpayers ($207,500 single). In addition, the deduction could be limited by the amount of wages (W-2 wages) paid by the business or a combination of wages plus a percent of depreciable property owned by the company. This limitation generally will prevent companies that do not pay salaries or have significant depreciable assets from claiming much of a deduction.

Conclusion

The TCJA was the most comprehensive tax reform bill passed in more than 30 years. One of the most significant provisions is the pass-through deduction for owners of sole proprietorships, partnerships, and S Corporations. Though the Act was comprehensive, it was also complex.  The pass-through deduction has the potential to offer savings to small businesses, but owners should consult tax experts to determine the exact extent of any benefit.

Susan Rolfe is a Lecturer of Accounting at Columbia College.  She holds her Masters of Accounting from the University of South Carolina and her Bachelors of Science from Southern Adventist University.