Special US tax rate for pass-through income
Individuals have to pay US income taxes on only roughly 80% of the income they receive from partnerships, S corporations and other pass-through entities.
The actual percentage is complicated to calculate.
The tax law has “guardrails” to prevent investment managers, lawyers, doctors, and other professionals from qualifying.
The Internal Revenue Service filled in a lot of the detail in proposed regulations in August.
It estimated the average time individuals will need to figure out how much of a tax break they qualify for each year on pass-through income will vary from 30 minutes to 20 hours.
Partnership and S corporation income is reported on schedule E of individual tax returns in the US. Partners and S corporation shareholders will be allowed to deduct a percentage of that income, thus paying tax only on what remains.
The deduction is 20% of such partnership and S corporation income.
However, it may be less.
First, the deduction cannot exceed 50% of the partner’s or shareholder’s share of the wages paid by the business to employees as reported on W-2 forms sent to the IRS. If greater, the partner or shareholder can use as his or her cap 25% of wages plus 2.5% of the depreciable basis in property being used in the business.
This wage cap only applies in years when the partner or shareholder earns more than $415,000 (on a joint return, or $207,500 if single). For individuals with income in a “phase-in range” of between $315,000 and $415,000 (on joint returns, or $157,500 to $207,500 if single), the 20% deduction he or she can claim is subject to an alternate adjustment.
Second, regardless of income level, the deduction cannot be more than 20% of the ordinary income the partner or shareholder reported for the year from all sources.
Third, no deduction at all may be claimed on income that individuals earning more than $415,000 a year (on joint returns, or $207,500 if single) receive from law, accounting, brokerage and consulting firms, medical practices and other businesses where the principal asset is the “reputation or skill of 1 or more of its employees.” The deduction is also not available to investment management firms, traders and dealers in securities, partnership interests or commodities. The IRS calls any service-type business that falls in these categories an “SSTB” for specified service trade or business.
Anyone with an income in the phase-in range of between $315,000 and $415,000 a year (on a joint return, or between $157,500 and $207,500 if single) can claim some deduction on income from SSTBs, but not the full amount.
An individual trying to figure out how much pass-through income can be deducted should start with his or her taxable income from all sources for the year.
If it is below $315,000 (for a joint return, or $157,500 if single), then the calculation of the deduction is fairly straightforward.
The deduction is 20% of the income from pass-through businesses, but there are complicated rules for what can be counted as such income. For example, no deduction can be claimed on capital gains and dividends received by a partnership and then passed through to a partner. No deduction can be claimed on employee wages or on amounts that a partner is paid by a partnership in his or her capacity as a partner for services. There are special rules for investments in master limited partnerships and real estate investment trusts.
The deduction for each separate “trade or business” conducted through a partnership, S corporation or other pass-through entity must be calculated separately.
The IRS has not decided whether disregarded entities — single-owner LLCs that do not exist for tax purposes — should be ignored in deciding the number of separate businesses.
Businesses can be combined. It is up to the individual which businesses to combine. This is less meaningful for individuals with incomes below the phase-in range, but for others, it may help with the wage cap to combine businesses as this may lead to a higher overall deduction.
Businesses can only be combined if the same group of people owns at least 50% of each business being combined. None of the businesses being combined can be an SSTB. The businesses must be linked by having at least two of three features in common: the businesses must provide the same products or services or offer items that are customarily offered together, they must share facilities or central office staff like accounting, human resources or legal staff, or they must be operated in coordination with one another such as occurs when there are supply chain dependencies.
Once the decision is made to combine two or more businesses, then those businesses must be reported together in all future years absent a change in facts or circumstances.
The bottom end of the phase-in range is adjusted annually by the “chained” consumer price index. Use of the chained CPI will lead to smaller inflation adjustments because it takes into account that consumers substitute cheaper products as the cost of their regular baskets of goods increases. The figure $315,000 for a joint return and $157,500 if single are the 2018 figures. The inflation adjustments will start in 2019.
The top end of the phase-in range is $100,000 higher than the bottom end (for joint returns, and $50,000 if single).
Individuals with taxable incomes in or above the phase-in range must jump through more hoops to get any deduction.
The first step is to determine whether the partnership or S corporation is a type of business called an SSTB on which no deduction is allowed. Individuals with taxable incomes for the year from all sources above the phase-in range get no deduction. Individuals with incomes in the phase-in range get a partial deduction. The deduction phases out as the person’s income moves across the phase-in range. Thus, for example, a person filing a joint return and earning $375,000 from all sources in 2018 qualifies for only 40% of the deduction, since such a person is $60,000 into a phase-in range of $100,000.
Businesses performing services in the following fields are considered SSTBs: law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, trading, investing and investment management, and dealing in securities, partnership interests or commodities. Electricity is a “commodity.” However, partnerships selling electricity from a power plant are not considered dealers. A dealer is someone who both buys and sells a commodity.
Congress added a catch-all category that picks up any business that relies on the “reputation or skill of 1 or more of its employees.” However, the IRS said it would only put in this category pass-through income earned from endorsing products or services, earning appearance fees or earning licensing fees from use of an individual’s name, voice or other likeness.
Real estate and insurance agents and brokers were given a pass. They are not considered engaged in SSTBs.
A pass-through business that does a mix of things can still be labelled an SSTB. A business with $25 million or less in gross receipts will not be treated as an SSTB if SSTB-type services account for less than 10% of the gross receipts. The 10% cap falls to 5% for pass-through businesses with more than $25 million in gross receipts. A Treasury lawyer said at a conference in early October that the 10% and 5% caps are a cliff. A business that is slightly over will be an SSTB, unless a way can be found to treat the SSTB-type services as earned in a separate business.
The next step is to calculate the deduction. This starts the same way as for individuals with lower incomes: it is 20% of the income from pass-through businesses, but with complicated rules for what counts as such income and with the need to calculate the deduction separately for each business, although some businesses can be combined at the option of the taxpayer.
However, the deduction from each business or combination of businesses is capped.
The cap is 50% of the W-2 wages reported by the business to employees or, if greater, 25% of the W-2 wages plus 2.5% of the basis in depreciable property.
Each partner in a partnership is allocated a share of the W-2 wages. The cap on a partner’s deduction is 50% of the wages the partner is allocated. This could be a challenge for developers of renewable energy projects that are in tax equity partnerships where the developer is a pass-through entity owned by individuals because the W-2 wages, like other tax losses, may be allocated almost entirely to the tax equity investor.
The basis in depreciable property is the original cost, ignoring any depreciation claimed. Thus, for example, if an asset cost $100 and $60 in depreciation has been claimed, absent a transfer of the asset for tax purposes, the basis used to calculate the pass-through deduction is $100.
However, the basis is no longer counted after 10 years or, if longer, the MACRS recovery period. Thus, for example, the basis in a transmission line with a voltage of 69 kV or greater that usually has an MACRS recovery period of 15 years would be counted for 15 years. A wind farm or solar project usually has an MACRS recovery period of five years. The basis to calculate the pass-through deduction is not affected by the fact that an investment tax credit was claimed on the project.
Many power projects are owned by partnerships. Any “step up” in basis that an individual receives via a section 754 election after buying a partnership interest is ignored. When a project is contributed to a tax equity partnership, the partnership keeps the same basis and continues counting down the 10 years (or longer recovery period) that the contributing partner had on whatever share of the project is considered contributed.
Renewable energy projects throw off losses for the first three or four years. If a business (or combination of businesses) has a loss for the year, then the loss must be allocated across the other pass-through businesses owned by the individual in proportion to the positive income from each such business. It will reduce his potential pass-through deduction on income from the other businesses.
The W-2 wages and depreciable basis from any business with a loss for the year are lost. They are not allocated to the other businesses.
The deduction takes effect in 2018. It ends after 2025.
Investors in master limited partnerships benefit from special rules. They can deduct not only as much as 20% of income allocated to them by the MLP, but also gain from the sale of MLP interests to the extent the gain is taxed as ordinary income.
Partnerships and S corporations will have to report to partners and shareholders the information they need to calculate their deductions. This includes whether the business is an SSTB, how much income qualifies potentially for the 20% deduction and what each partner’s share is of W-2 wages and depreciable basis.
The same pass-through deduction can be taken for calculating the alternative minimum tax.