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How are Pass-through Entities affected by the Tax Cuts and Jobs Act?

October 01, 2018

How will S corps, LLCs and partnerships be treated under new tax reform guidance? While there are opportunities to benefit from new deductions, there are also new restrictions of which you should be aware.

How will pass through entities be treated under the Tax Cuts and Jobs Act? The tax rules for pass through entities including S Corporations, LLCs, partnerships and sole proprietorships have become more advantageous under the new regulations, but slightly confusing. Here’s what you should know.

New deduction for pass through business income

Tax law provides that net taxable income from pass through business entities ( sole proprietorships, partnerships, LLCs, and S corporations) is passed through to owners and taxed at the owner level at standard tax rates.

The Tax Cuts and Jobs Act, or TCJA, establishes a new deduction based on a non-corporate owner’s qualified business income, or QBI.

The deduction generally equals 20% of QBI and is available to eligible estates, trusts, and individuals.

Is the deduction subject to restrictions?

  • W-2 wage limitation- For all pass- through entities , the QBI deduction generally cannot exceed the greater of the non-corporate owner’s share of:

1.) 50% of the W-2 wages paid to employees by the qualified business during the tax year; or

2.) The sum of 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.

*Under one exception, the W2 limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500, or $315,000 for a married filing joint filer.

Did you tune into our recent webinar? If you missed it, access it here: “The Impact of Tax Reform on Businesses and Individuals” Here’s a question from a viewer on the $315k threshold:

Q: For an LLC, do the guaranteed payments to owners count as wages for the calculation above the $315k threshold?

A: First of all, QBI does not include guaranteed payments made to owners of an LLC. Thus QBI is reduced by any guaranteed payments made to owners. Secondly, guaranteed payments to owners are not considered W-2 wages for the calculation of the limitation that is applicable when the taxpayer's taxable income exceeds the $157,500, for unmarried filers, or $315,000 for married filing jointly filers.

  • Specified service business limitation- The QBI deduction for taxpayers in a specified service business is phased out if the taxpayer's taxable income exceeds $157,500 ($315,000 for jointly filed returns).Specified services include but are not limited to health, law, accounting, performing arts, consulting, athletics, financial and brokerage services.

New rules for ESBTs

A little bit of background- generally, trusts cannot be S corporation shareholders, but an exception allows electing small business trusts, or ESBTs, to be S corporation shareholders.

A change under the TCJA holds that, for 2018 and beyond, an ESBT can have nonresident aliens as beneficiaries, this was not allowed under prior law.

Technical termination rule repealed

Under prior law, a partnership was considered “terminated” for tax purposes if within a 12 month period there was a sale or exchange of 50% or more of the entity’s capital and profits interests. The TCJA repeals this rule for tax years beginning 2018 and after.

Questions on tax reform and how your business will be affected? Contact us.

For more tax reform updates, be sure to visit our Tax Reform Center- your “one stop shop” for all things Tax Cuts and Jobs Act (TCJA) related.

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