Updated December 5, 2023
The pass-through tax deduction, introduced in recent years, presents a unique opportunity for business owners and high-income individuals to reduce their tax burdens. But due to the complexity of tax laws, many of these clients may have overlooked or misunderstood the potential benefits of this deduction.
According to the Internal Revenue Service, the majority of the 14 million taxpayers who claimed the pass-through tax deduction this year – 85% to be exact – had less than $200,000 in adjusted gross income.
Meanwhile, over 58% of the taxpayers who claimed the tax break, which is a 20% deduction for those who own pass-through businesses had an adjusted gross income of less than $100,000.
Financial advisers say the trend highlighted by IRS stats isn’t surprising given the mechanics of the deduction, especially around income limitations. For one, in the first tax year, the deduction starts to phase out if a single filer’s taxable income exceeds $157,500. And for married couples filing jointly, it’s $315,000.
In this article, we delve into the nuances of the pass-through tax deduction. We explore why it is crucial for wealthy clients to ensure they are not missing out on this opportunity to optimize their tax planning.
Also known as Section 199A Qualified Business Income Deduction or QBI deduction, the pass-through tax deduction was created in 2017 via the Tax Cuts and Jobs Act.
It was meant to allow households with incomes from sole proprietorships, partnerships, and S corporations to deduct up to 20% of their pass-through business income from federal income tax. However, this deduction is subject to certain limits for taxpayers in the upper income bracket.
Owners of businesses or trades that qualify as pass-through businesses are those that can avail themselves of the pass-through tax deduction.
Owners of service businesses in the fields of health, law, consulting, athletics, financial services and brokerage services cannot have the deduction under certain conditions. Taxpayers who may not qualify for QBI deduction include:
There may be cases where owners of non-service businesses can still get the deduction above those thresholds. However, there will be some limitations around items like W-2 wages and the cost of depreciable assets in the business.
A pass-through business is one that doesn’t directly pay taxes. The term “pass-through” means that the profits or losses from operating the business are passed to the individual owners, who pay taxes on their returns. Many small businesses operate in this manner.
Businesses that fall under this category can include:
A business is a pass-through business if:
The pass-through tax deduction was designed to encourage Americans to put up small businesses and get into other entrepreneurial ventures. In simple terms, the QBI deduction treats earnings from income sources other than employers in a more favorable light.
To calculate the pass-through deduction, these two amounts are compared:
The resulting taxable income is from positive net income. To arrive at net income, take an individual’s taxable income from all sources, then apply other deductions.
The pass-through deduction is capped at 20% of a business owner’s total taxable income.
The value of the pass-through deduction is the smaller of the two calculated amounts. In practice, calculating pass-through deduction can be more complicated than just multiplying business income by 20%. This is due to rules on what qualifies as business income.
The pass-through tax deduction was part of the Tax Cuts and Jobs Act that took effect in the 2018 tax year. As with most provisions of this act, the pass-through tax deduction will end after the 2025 tax year.
Should a business have rental property, a real estate investment trust (REIT) or a publicly traded partnership, the income from these businesses is deemed qualified business income.
Qualified business income does not include:
If your clients own multiple businesses and one of them has a loss, they can subtract that amount from the other qualified businesses’ income.
Should the total qualified business income from all of your clients’ businesses be zero or less, they cannot get the pass-through benefit. However, the net loss can be deducted from any qualified business income reported in the following year.
At first glance, the pass-through tax deduction or Section 199A QBI deduction looks advantageous, but it comes with certain tax and social implications:
Owners of sole proprietorships, partnerships, and LLCs may find that their self-employment tax burden is heavier. Don’t forget, these types of organizations pay it on all of their business’s profits. This is in contrast to S Corporation owners, who only pay self-employment taxes on the wages and salaries they get paid.
Business owners may find that they fall into a higher individual tax bracket with all profits passing through to their individual income tax returns.
Depending on the circumstances, this might result in paying more tax overall than they would if they had incorporated the business.
Remember how the pass-through deduction was intended to reward Americans who start and operate businesses? On the other side of the coin, the pass-through tax deduction wasn’t designed to provide tax relief to highly-paid professionals who happen to be self-employed.
There are income limitations for taxpayers whose income is from certain "specified service" businesses. Businesses that cannot use pass-through deduction include:
For those qualified, getting the tax break isn’t always as easy as it appears. This video demonstrates how small businesses, professionals, and individuals who qualify can get the 20% tax break:
For taxpayers whose pass-through income comes from one of the specified service businesses, the deduction begins to phase out beyond a certain level of taxable income for the tax year.
Taxpayers whose incomes exceed their thresholds can potentially get some deduction, and these thresholds can be adjusted for inflation in 2020 and subsequent years. Calculating the tax deduction becomes more complex above these thresholds.
While there are ways for your clients to leverage the QBI deduction legitimately, some critics say that it’s not without flaws and controversy. Critics point out some drawbacks of the QBI deduction:
According to this 2015 study from the National Bureau of Economic Research (NBER), wealthy taxpayers are much more likely to have more pass-through businesses that afford them the benefits of Section 199A. Ordinary taxpayers who don’t have as much money simply don’t have as many pass-through businesses.
As the value of the tax deduction is the deduction amount times the individual taxpayer’s tax rate, the relative value of the deduction is much higher for affluent pass-through business owners.
For instance, a QBI deduction of $150 on $1,000 goes to someone with a modest income in the 15% tax bracket, while it’s $370 for a wealthy taxpayer in the top 37% tax bracket.
In a 2023 study also done by NBER, a group of economists from the Treasury and the Federal Reserve found no evidence of any boost in economic activity due to the QBI deduction. Since its introduction, the QBI deduction did not result in any additional investment, jobs, or higher wages for employees of pass-through businesses.
While critics maintain that Section 199A helps the wealthy game the tax system, talks about extending this tax law have yet to be brought up. As of this writing, the tax break is scheduled to last until the end of 2025. Congress has the authority to extend it past that year and beyond if it wishes.
Politics aside, the pass-through tax deduction is a rare opportunity for small business owners, especially if they can deduct the full 20% from their qualified business income. As this deduction also applies to income from REITs, real estate can become a more attractive investment for your clients.
A potential downside of this tax break is its many grey areas. The IRS even issued guidelines on the pass-through tax deduction, and it isn’t an easy read. However, this poses a good opportunity for financial advisers. If you have questions as a financial adviser about Section 199A, then what more your clients?
As a tax professional, your understanding and advice on this tax provision are what your clients will need. While Section 199A is still around, leveraging this tax deduction for them is an excellent opportunity to show that your services are worth it.
As a financial adviser, a strong grasp of tax laws gives you a competitive edge. Explore our section on taxes for news, opinion pieces, and features for tips on crafting tax-efficient strategies for your clients.
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