## How Does the New Pass-Through Deduction Work?

By now, you’ve probably read a variety of summaries about the new tax reform legislation. If you own a pass-through entity, you’ve probably wondered whether you should convert to a C Corporation (if you’re still wondering about that, check out *Should You Convert Your Business to a C Corporation?*). You may also be wondering how the new pass through deduction you keep hearing about works. That’s what we’re going to try to explain here.

Unfortunately, it’s not as easy as taking 20% off the top of your income. There are several formulas, definitions, and limits that all go into calculating this deduction. We’ll start with how the deduction is calculated, and then break down the components.

**Here’s the formula:**

Under new Code Section 199A, the deduction equals:

(1) the *lesser *of the “combined qualified business income” of the taxpayer; or an amount equal to 20% of the excess to taxable income over the sum of any net capital gain.

*PLUS*

(2) the *lesser* of 20% of qualified cooperative dividends; or taxable income less net capital gain.

There. That doesn’t look so imposing, does it? But what is “combined qualified business income”? You might be surprised to learn that it’s actually a deduction by another name. Here’s the formula:

“Combined qualified business income” equals:

(1) the *lesser* of 20% of the taxpayer’s qualified business income; or the *greater* of (a) 50% of the W-2 wages with respect to the business, or (b) 25% of the W-2 wages with respect to the business *plus* 2.5% of the unadjusted basis of all qualified property.

*PLUS*

(2) 20% of qualified REIT dividends and publicly traded partnership dividends.

Still with us? To keep this article from becoming a treatise, we’re going to ignore the items not likely to impact your typical small business: cooperative dividends, REIT dividends, and publicly traded partnership dividends. Removing those items, the pass-through deduction is equal to the *lower amount* of:

(1) 20% of your “qualified business income” (aka “QBI”) or

(2) the *greater* of (a) 50% of the W-2 wages with respect to the business, or (b) 25% of the W-2 wages with respect to the business *plus* 2.5% of the unadjusted basis of all qualified property.

Now we know that “combined qualified business income” is actually a formula partially based on “qualified business income.” So what is QBI? It is the net ordinary income after deductions earned from a pass through entity (LLCs taxed as a partnership or making an S Election, S Corporations, and sole proprietors). However, QBI does *not* include wages earned as an employee. So if you take a salary as an employee of an S Corporation, those amounts are not subject to the deduction (but amounts you receive as a distribution are). QBI also excludes short- and long-term capitals gains and losses, and dividend and interest income.

So you take your K-1, subtract out all of the exclusions mentioned in the paragraph above, and arrive at a QBI amount of $350,000. Calculating the deduction is as easy as taking 20% of QBI ($350,000 x 20% = $70,000), right? Not always. Section 199A also provides limits to the deduction in certain circumstances.

**Limitations:**

Remember all the italicized *lessers* and *greaters* in our formulas above? Those are the deduction limits. Instead of making you scroll back up, we’ll provide them again here. You can deduct 20% of your QBI, but only up to a limit equal to the *greater* of:

(a) 50% of your allocable W-2 wages with respect to the business, or

(b) 25% of your allocable W-2 wages with respect to the business *plus* 2.5% of your allocable unadjusted basis of all qualified property.

These limits exist to prevent taxpayers from recharacterizing their wages as QBI.

“W-2 wages” are payments received for services as an employee plus elective deferrals to qualified benefit plans. If you’re an S Corporation shareholder, this is determined under Sections 1366 and 1377 on a pro rata basis amongst shareholders. Partnerships are determined based on the manner in which wage expenses are allocated to partners.

“Qualified property” is any tangible property subject to depreciation used in connection with the production of QBI and not fully depreciated before the end of the applicable tax year. The big exclusion here is inventory. Importantly, the formula uses unadjusted basis, meaning you don’t reduce your basis by depreciation deductions when calculating the deduction limit.

For example, if you own 25% of a pass through entity that earns $1,000,000 in ordinary income and pays W-2 wages to employees of $250,000, the amount of W-2 wages allocable to you is $62,500 ($250,000 x 25%). If that LLC has a total unadjusted basis in its property of $100,000, your allocable share of that basis is $30,000.

Now let’s calculate your deduction. Remember, it is the *lesser *of (1) 20% of QBI or (2) the *greater* of the limits above. Running the numbers, your deduction would be equal to the *lesser* of: (1) $250,000 ($1,000,000 x 25% ownership interest) x 20% = **$50,000**; or (2) the *greater *of (a) $62,500 (W-2 wages allocable to you) x 50% = **$31,250**, or (b) $62,500 x 25% *plus* $30,000 (basis allocable to you) x 2.5% = ($15,626) + (750) = **$16,376**. Based on these numbers, you would be entitled to a deduction of $31,250.

If you’re still awake at this point, you’re probably thinking that this deduction isn’t very helpful to small businesses with few employees. For example, if you’re the sole owner of your LLC, made $100,000 in QBI last year, and paid a part time worker wages of $10,000, your deduction would be the lesser of $20,000 ($100,000 x 20%) or $5,000 ($10,000 x 50%). Fortunately, the limits have limits.

**Limits on Limits:**

Yes, that heading is plural. We already talked about two limits to the deduction amount. Now we’ll talk about two limits to the limits. The first one is easy. If you’re married and your taxable income is less than $315,000 ($157,000 if you’re unmarried), the limits do not apply. So, for example, if you made $300,000 from your S Corporation and your spouse does not work, you can disregard the W-2 wages limits and take a deduction of $60,000.

The second limit is less easy and phases in when taxable income exceeds $315,000. Above this threshold, the W-2 limits above start to come back. In determining this limit, Step 1 is determining the “excess amount.” The “excess amount” is the amount of the deduction the taxpayer would lose if the W-2 wages limit applied.

Returning to our example, if instead your spouse works and makes $65,000, your total taxable income would be $365,000. Further assume that, in addition to your $300,000 in QBI, your share of W-2 wages is $50,000 and your share of basis in qualified property is $0. If the W-2 limits were applied, the deduction would be limited to (a) 50% of $50,000 ($25,000) or (b) 25% of $50,000 *plus* 2.5% of $0 ($10,000). In other words, your deduction would only be $25,000 if the limits applied. The “Excess Amount” is the difference between if the limits did and did not apply: $60,000 - $25,000, or $35,000.

This second limit is phased in as your income grows from $315,000 to $415,000. Once you reach $415,000, the W-2 wages limits apply in full. Inside of this range, you have to do more math to determine the extent to which the unlimited deduction will be lowered by a portion of the excess amount. Section 199A gives you $100,000 to work with, and for each $1,000 earned, 1% of the excess amount is applied against the unlimited deduction amount. In our example, $365,000 is $50,000 over the lower threshold. To compute the application of the second limit, we divide the amount over the lower threshold by the permissible range: $50,000 / $100,000 = 50%. Therefore, the deduction is reduced by half the excess amount: $60,000 - $17,500 = $42,500.

**But wait, there’s more. **

Much, much more. We already said we were going to ignore cooperative dividends, REIT dividends, and dividends from publicly traded partnerships. We barely scratched the surface on allocating W-2 wages and unadjusted basis, and the rules for determining basis. Additional rules exist that limit the application of this deduction in the context of “specified service trade or businesses” (fields of health, law, accounting, etc.), and there are more limits, phase-ins, and phase-outs that apply to these businesses.

Hopefully this article gives you a slightly better understanding of how this deduction works and is applied. To understand how the deduction applies to your business specifically, contact a Foster Swift tax attorney.

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