Many small business owners choose not to incorporate in a way that would require them to pay business taxes. Instead, they choose business structures that allow them to pass income through the corporation and file it on their personal taxes.At Cook Martin Poulson, we work with small businesses every day and one of the things we assist them with is understanding pass-through business income and how to account for it on their taxes. With that in mind, here's what you need to know about the pass-through deduction and how it works.
What is the Pass-Through Deduction?
The Tax Cuts and Jobs Act (TCJA) that was passed in 2017 included some tax advantages for small business owners. One of the most significant was the addition of the pass-through tax deduction. Like many of the business tax changes included in the bill, the pass-through deduction is designed to encourage entrepreneurship by minimizing the tax burden for owners of small companies.
The deduction for owners of any pass-through entity who meets the qualifications allows them to pass business profits or losses through to their individual income, where they must file taxes. The primary benefit, which we'll review in more detail later, is that you can use it to significantly reduce your taxable income.
The original law enacted the pass-through benefits through 2025, but there was an option to extend it through 2026. That means that you may be able to qualify for a significant deduction on your 2021 taxes when you file them.
What Are the Benefits of a Pass-Through Deduction?
There are three significant benefits to pass-through taxation, and they explain why 95% of small businesses in the United States choose a qualifying pass-through business structure.
Pass-Through Taxation Helps Business Owners Avoid Double Taxation
C corporations must pay business taxes and then, the owners must also pay individual income taxes. In other words, there are two layers of taxation resulting in a much higher tax burden than with a different organizational structure where income is passed through to the owners.
With a pass-through structure, there are no business income taxes to be paid at the entity level. Instead, the profits and losses from the business are passed through the business itself and to the owners, who must then report the income when they file their individual income tax return. This is a huge benefit since it saves business owners such as yourself from having to pay a high corporate tax rate. The deduction can be particularly beneficial to people who must pay the self-employment tax even though it doesn’t reduce your Medicare or Social Security taxes.
Pass-Through Organizations Have More Flexibility
The second key benefit of pass-through taxation is that companies that pass income through to the owners have far more flexibility in terms of structure than C corporations. What we mean by that is that if your company has outgrown its existing structure -- for example, if you originally organized as a sole proprietorship but now believe that an LLC would better suit your needs -- making the change is easy from a tax perspective.
A sole proprietorship or partnership can file paperwork to switch to an LLC, and an LLC can choose to be taxed like an S corporation or like a C corporation. You can choose the structure that's right for your business and still take advantage of pass-through taxation.
Pass-Through Businesses Can Claim the Qualified Business Income Deduction
During the debate about the TCJA, some small business owners claimed that the reduction in the corporate tax rate from 35% to 21% favored large businesses. The result was that legislators added a new small business tax break to the legislation.
The Qualified Business Income Deduction allows pass-through organizations to deduct up to 20% of their qualified business income to reduce their tax burden. The process for calculating this deduction can be complex, so we advise that you work with a qualified tax accountant.
How to Qualify for the 20 Percent Pass-Through Deduction
Business owners who qualify for the pass-through deduction may take up to a 20% deduction of their net business income when they file their federal income tax returns as an individual. Whatever their share of income from the business is, they may be able to reduce their individual tax burden. Here are the three qualifications you must meet to take the pass-through deduction.
You Must Have a Pass-Through Business
The first qualification is that your business must be a pass-through entity. Here are the business types that qualify:
- Sole Proprietorships - Entities where a single person owns all the business assets.
- Limited Liability Companies (LLCs)
- Limited Liability Partnerships (LLPs)
- S Corporations - Must choose pass-through taxation instead of corporate taxation.
If your business is one of these types, then you have met the first requirement to take the deduction.
You Must Have Qualified Business Income
Qualified Business Income is defined as the net profit your business earns in a year. You can calculate this amount by subtracting your business deductions from your business income.
Qualified Business Income includes rental income (provided the rental activity is business-related), as well as income from REITs, qualified cooperatives, and publicly-traded partnerships. It does not include interest income, dividend income, short-term or long-term capital gains, and losses, wages paid to S corporation shareholders, or any business income that you earned outside of the United States.
You Must Have Taxable Income
Finally, you must have taxable income to qualify for the pass-through deduction. Pass-through owners must have total taxable income to take the deduction. Your total taxable income is the sum of all income you earn from business, jobs, and investments, less your standard tax deduction. As a reminder, the standard deduction is $12,550 for individuals and $25,100 for joint filers for 2021.
If you do not have taxable income, you do not qualify for the deduction.
How Much is the Pass-Through Deduction Worth?
We already noted that the maximum amount allowed under the TCJA is a 20% deduction on pass-through income. It's important to note that the deduction applies only to pass-through income. If you pay yourself a salary or have income from other sources, you may not use it to calculate the deduction.
Some limitations dictate the maximum amount that the deduction can be worth and these are reviewed next. Provided your business and income fall within the threshold, you can qualify for 20% tax savings.
What Are the Limitations of the Pass-Through Deduction?
A 20% reduction in your taxable income is undeniably attractive but there are some limitations that you'll need to understand before you claim the pass-through deduction. These limitations include the following.
Let's start with what qualifies as income and what doesn't. Your profits from the business qualify, however, the following things do not:
- Reasonable compensation for employment
- Guaranteed payments (usually applies to partnerships)
- Capital gains
- Income from dividends and interest
You should be sure to subtract any income that doesn't qualify for the deduction before you calculate.
Limits on Upper Income Households
For calculating the pass-through tax deduction, an upper-income household is a household with $164,900 or more of income for a single taxpayer, and $329,800 or more for married taxpayers filing jointly. These income limits apply to taxpayers at the very top of the 24% tax bracket and in the three higher tax brackets.
These high earners are subject to additional limitations, as follows:
- They are disallowed from counting income from a list of service trades and businesses (SSTB) in their calculation. Some examples are accounting, actuarial science, health, law firms, financial services, and several others. You can find a complete list here. Make sure to determine if your service business qualifies for the deduction.
- They may not claim the deduction if their income source is a business where the "principal asset is the reputation or skill of one or more of its employees or owners."
- The wage or wage/capital limit may also apply to these households if they earn income from businesses that have paid wages or own property.
If you're a wage/service provider and your income exceeds the limits by $100,000 or more, you should know that your business income will be subject to a W-2 wage and business property limitation. Your allowable deduction is limited to the higher of:
- 50% of the W-2 employee wage income paid by the business; or
- 25% of the W-2 wage income you paid plus 2.5% of the cost of acquisition of your depreciable business property.
There is no cap on the deduction for income from a pass-through business, but high earners are limited based on the above requirements.
How is the Pass-Through Deduction Calculated?
Let's look at two examples of how the pass-through deduction is calculated for profitable businesses. The first is for a business owner who is below the income threshold specified above.
If someone owned a pass-through business and had $100,000 of qualified business income as a single filer, they would first take the standard deduction of $12,550. After that deduction, their qualified income for the pass-through deduction would be reduced to $87,450. They could claim 20% of that amount as a deduction for a total of $17,490, reducing their taxable income to $69,960.
Now let's look at an example of a married couple with income that exceeds the thresholds. They have a taxable income of $400,000 from a business they own, and they paid $125,000 in W-2 wages. They own the building where their business is located, and it has an unadjusted acquisition basis of $300,000. Their deduction would be limited to the greater of:
- 50% of the W-2 income for their employees, or $62,500; or
- 25% of the W-2 income for their employees + 2.5% of their building's $300,000 acquisition basis, or $31,250 + 7,500, for a total of 38,750
Since the first number is higher, their maximum pass-through deduction would be $62,500. Pass-through firms can use these calculations as an example of how to calculate their deduction.
How Can Taxpayers Claim the Pass-Through Deduction?
To claim the pass-through deduction, you first need to complete Form 8995 or Form 8995-A. According to the Internal Revenue Service, you should use Form 8995 if:
- You have qualified business income, qualified PTP income, or qualified REIT dividends
- Your 2021 taxable income before the deduction is less than $164,925 if filing singly and $329,800 if married and filing jointly
- You are not a patron in a "specified agricultural or horticultural cooperative".
If you do not meet the above qualifications, you should use Form 8995-A. After you have calculated your deduction, you can claim it on Line 13 of your Form 1040.
Pass-Through Deduction is a Valuable Tax Break for Business Owners
If you are a pass-through owner and your business has qualified income, you can claim the pass-through deduction to reduce the amount of tax you pay. We suggest working with one of our experienced business tax accountants to ensure that you calculate your deduction correctly and claim the maximum amount allowed.
Do you need assistance preparing and filing your pass-through business taxes?