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KNOW HOW

Common misconceptions of the pass-through deduction

February 18, 2019
Michael Duffy

Even though the U.S. Tax Cut and Jobs Act is more than a year old, businesses are still scrambling to figure out how the so-called pass-through deduction is supposed to work. As you get ready to file your 2018 tax return, consider these top five pass-through deduction misconceptions.

1. "I'm going to get a big fat 20-percent deduction!"

The pass-through deduction can provide a deduction equal to 20 percent of a taxpayer's total qualified business income. But the deduction is taken against net income, as opposed to typical deductions reducing gross income. So, if a qualifying business generates $1 million in gross receipts but only $10,000 in net profit, its owner is eligible for a $2,000 deduction. The pass-through deduction may be further reduced if the underlying trade or business performs certain types of services, does not pay any salaries, or the owner has other losses.

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2. "The pass-through deduction is a deduction."

The pass-through deduction is computed by figuring the net business income from all qualifying trades or businesses owned by the taxpayer and then aggregating the totals. It's more helpful in understanding the possible benefit by conceptualizing it as a form of rate relief on business income. In this sense, the pass-through deduction should be viewed as something akin to the lower rate on long-term capital gains.

3. "The pass-through deduction isn't available for service trades or businesses."

It is believed the pass-through deduction is not available to reduce business income derived from performing personal services like the practice of law, medicine or accounting. But this is only half true. The specified service trades or businesses limitation applies if, and only if, the underlying taxpayer reports total net income over a certain threshold. The threshold for married-filing-jointly taxpayers is currently $315,000. So, assuming a married physician reports $250,000 in practice earnings and no other income, no limitation applies.

4. "My client is performing personal services for clients: He or she must not qualify."

Even when a taxpayer is reporting income over the income threshold, it is incorrect to say service businesses will not qualify for the pass-through deduction. The limitation only applies to specified service trades or businesses. Whether a service business is specified depends on the technical language in the law and U.S. Treasury interpretations.

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5. "The pass-through deduction treats all taxpayers equally."

What is probably least understood about the pass-through deduction is most of the limitations are computed at the individual taxpayer level. This fact makes it difficult to predict who will receive relief.

For example, assume Lawyer 1 and Lawyer 2 each own half of a successful law firm generating $200,000 in qualified business income during the year. Lawyer 2 is independently wealthy and has $500,000 of extra income from investments. Lawyer 1 is eligible for a $20,000 pass-through deduction, whereas Lawyer 2's deduction is $0.

The takeaways are clear; the pass-through deduction is complicated, and estimating the potential benefits can be challenging.

Michael Duffy is a tax and corporate attorney at Fletcher Tilton PC. On Feb. 21, he is hosting a webinar entitled "Section 199A Bootcamp," which contains greater detail along with clarity on the just-released pass-through deduction regulations. Register at www.fletchertilton.com/seiminars-events.