Understanding and Maximizing the “Pass-Thru” Deduction

The 2017 Tax Act introduced the “pass-thru” deduction (the “Deduction”), which has been understandably misinterpreted. Even the term “pass-thru” deduction is a misnomer since it applies to income for sole proprietorships (and single-member LLCs taxed as sole proprietorships) as well as S corporations and tax partnerships (such as most LLCs). Please note that these rules do not apply to 2017 tax returns, so please resist the urge to call your tax accountant during his busy season.

The Deduction may allow a taxpayer to deduct as much as 20% of his qualified business income allocated from these entities (or derived from a sole proprietorship). The initial focus is on the taxpayer’s taxable income from all sources (not just business income). For 2018, up to $157,500 (joint income up to $315,000) is Level 1; between $157,501 and $207,500 (joint income between $315,001 and $415,000) is Level 2; and above $207,500 (joint income above $415,000) is Level 3.

The Deduction applies to most business income (including most real estate income). It does not apply to wages or other compensation. For Level 3, no Deduction is available for certain service-focused businesses (such as law, accounting, healthcare, athletics, financial services, brokerage, and consulting (but not engineering or architecture)). For Level 1, the Deduction is basically allowed without limit up to 20% of the qualified business income (including from service-focused businesses). Level 2 is mind-bogglingly complicated, but basically the Deduction becomes subject to greater limitation as the taxpayer approaches Level 3.

For Level 3, again, the taxpayer receives no Deduction for income from service-focused businesses. The Deduction for other qualified business income is subject to reduction or elimination. The allowed Deduction is greater generally the more wages the business pays, the more depreciable assets the business owns, or perhaps both.

The government has given little guidance. However, given the significance of the potential Deduction, taxpayers (especially those predicting to be in Level 2 or 3) need to consult with their tax advisor as soon as possible. Understanding the rules and early planning should allow the Deduction to be maximized.