It’s long been a tenet of taxation that when a group of individuals come together for a “joint venture”, the taxation of their collective business should simply be done by taxing each individual on their respective share of the business. Over the years, this has been formalized into the structure of “pass-through” business entities, from partnerships to LLCs to S corporations (and of course, the sole proprietor themselves)… all of which simply subjected the business’s income to the tax rates of their individual shareholders.
Until the Tax Cuts and Jobs Act (TCJA) of 2017, which for the first time has introduced a so-called “Qualified Business Income” (QBI) deduction for pass-through entities that will effectively permit pass-through businesses to be taxed on only 80% of their income. To some extent, the introduction of this new QBI deduction was necessary to keep pass-through business tax rates reasonably in line with corporate tax rates (which were also reduced to 21% under TCJA) when stacked on top of qualified dividend or long-term capital gains tax rates. Yet at the same time, the new QBI deduction also introduces a substantial tax planning opportunity… and some complexity, too.
The core of the qualified pass-through business income deduction is that shareholders will simply be permitted to deduct 20% of the business income against itself, which will be claimed as a below-the-line (but not itemized) deduction for tax purposes. However, to prevent abuse – especially at higher income levels – the new QBI rules do not permit the deduction for high-income “Specified Service” businesses (including lawyers, accountants, doctors, consultants, and financial advisors), and high-income individuals may also have their QBI deduction limited if they do not employ a substantial number of people relative to the size of the business (under a new “W-2 wages” limit), or invest into a substantial amount of property (under the “wages-and-property” limit).
The end result of these rules is that small businesses should have relative ease claiming at least a modest new QBI deduction, which is available even if they’re simply a sole proprietor (i.e., it’s not necessary to literally create a pass-through business entity like a partnership, LLC, or S corporation). And large highly scaled businesses may enjoy an even greater deduction. However, businesses that rely primarily on the efforts of their owners – whether overtly as Specified Service businesses, or simply those with a limited amount of employee or capital investments – may still struggle to take advantage of the new QBI rules, especially those over the new income thresholds of $157,500 for individuals, and $315,000 for married couples!