If you report business income on your individual federal tax return, figuring out your 2018 taxes is about to get more complicated.
That’s because there are many unanswered questions about a major business tax break under the new tax law: A 20% deduction on business income for owners, partners and shareholders in so-called pass-through entities — e.g., S-corps, LLCs, partnerships and sole proprietorships.
Not everyone will qualify. And if they do, the deduction may apply to a smaller percentage of their income than they’d expect.
Among the many assessments tax filers will have to make, here are just five basic questions anyone with pass-through income should consider:
1. Is my pass-through a domestic trade or business?
Only pass-throughs that perform work in the United States and sell goods and services on U.S. soil can qualify.
“This [deduction] is designed to benefit U.S. businesses that work, have employees and produce in the U.S.,” said John Rooney, a director of the pass-throughs group in the Washington National Tax office of KPMG.
If you have production facilities abroad, but sell products in the United States, the deduction may apply to a portion of your income generated from your U.S. sales.
2. Is my taxable income low enough to automatically qualify me for the deduction?
If your taxable income will be no more than $157,500 (or $315,000 if married, filing jointly), you automatically qualify for the deduction.
Keep in mind, taxable income is more than your business income. It includes all income sources, such as your spouse’s earnings or your investment income.
“That makes it a lot harder for people to get under [the threshold,]” Rooney said.
If your taxable income is over these thresholds but under $207,500 ($415,000 if married), you will have to figure out how much of the deduction you may take, since it’s gradually reduced within this upper income band.
When your income tops $207,500 (or $415,000 if married), you’ll have to meet other tests to see if you qualify.
3. What field is my business in?
The law prohibits service businesses in certain industries from taking the deduction. These industries include health, law, accounting, actuarial sciences, athletics, consulting, financial and brokerage services, and the performing arts.
There may be exceptions. For example, Rooney said, based on prior rulings from the IRS a pass-through business that tests blood samples may not be considered a health services business, so may be eligible for the deduction.
4. How much of my business is based on my reputation or skill?
The deduction is disallowed for pass-through businesses that have as their “principal asset” the “reputation” or “skill” of the owners or employees.
That raises a lot of questions for tax experts.
People go into business — sometimes naming companies after themselves — because they’ve developed a reputation for being good at what they do and hiring good people.
So, what gives? Will they be disqualified? How about business owners who promote their products or services on TV?
Rooney suspects the IRS can’t let this disqualifying rule knock out too many businesses because it would undercut the purpose of the deduction.
But it’s unclear who the rule is meant to block.
5. How much does my business pay in wages and own in tangible property?
High earners whose pass-through income may be eligible for the deduction must use a complex calculation to determine how much of a break they’ll get.
Rooney sums it up this way: To get the most out of the deduction your business either needs to have a lot of employees and pay a lot of wages, or have purchased a lot of tangible, depreciable property (e.g., buildings, equipment).
For most filers, the deduction will be the lesser of:
— 20% of your share of a pass-through’s qualified business income, or
— The greater of half your share of the W-2 wages paid by the business or 25% of the W-2 wages plus 2.5% of the unadjusted basis of the business’ tangible property.
Still confused? Play it safe
The IRS hasn’t said when it will offer clarifying guidance on the pass-through deduction.
In the meantime, businesses have to make estimated tax payments throughout the year.
CPA John Lieberman of Perelson Weiner LLP recommends playing it safe while you figure out how much of the deduction you may claim. Make estimated payments that total 110% of your 2017 tax bill by the end of this year (or 100% if your adjusted gross income is less than $150,000).
That way you avoid underpayment penalties if you end up owing more when file your 2018 taxes.
He and Rooney also advise anyone with pass-through income to see a tax adviser at least once this year, and preferably one who knows the business you’re in.
Besides getting help figuring out how to apply the new deduction, there are other questions to consider. For instance, does it make sense to hire employees — instead of independent contractors — to better qualify for the deduction? Or should you convert to a corporation, which is taxed at a lower rate than a pass-through but applies other handcuffs? Neither are simple to answer.
“Planning is the No. 1 thing we’re doing for clients and doing a cost-benefit analysis,” Lieberman said.