Tax Tip Tuesday 9: Pass-Through Deduction 1

The new tax code has a significant change when reporting pass-through business income.  Sole Proprietor, LLC’s, Sub-S Corps, and Partnerships are considered pass-through entities and are the source of pass-through business income.  Though these entities may file a separate return, Schedule C in the case of a Sole Proprietor, the income generated flows through and is taxed on the personal return of the owner or partners as ordinary income.

Beginning in 2018 qualified income from pass-through entities can be reduced 20% before it flows through to your personal income tax return.  To determine qualified income, certain compensation expenses and investment income may not be eliminated in the calculation. Qualified business income of $60,000 would be reduced by $12,000, 20% and only $48,000 would flow through to your personal return and be taxed as ordinary income.

There are phaseout income limits that apply to personal service business owners, such as lawyers, doctors, and consultants.  The threshold for the phase-out begins at $157,500 single filers and $315,000 for business owners that file a joint return. The deduction is reduced pro-rata under the phase-out rule and no deduction is allowed when income reaches $207,500 for single filers and $415,000 for joint filers.

If you file an individual personal tax return and you are losing the employee business expenses deduction you may qualify as an independent contractor.  As such, you can still request that federal income taxes be withheld and submitted on your behalf. Social security and Medicare cannot be withheld because these are employee taxes that are matched by the employer.  As an independent contractor, you may now use your unreimbursed expenses to reduce your income. You may also make contributions to a retirement plan, deduct home office expenses, and deduct other business-related expenses, to reduce gross income.  As long as net qualified business income does not exceed the limits mentioned above, the entire 20% write off is available when passing income through to your personal tax return.

As you can see this deduction can be somewhat involved.  It is expected the IRS will soon issue guidance for pass-through entities, especially regarding wages.  As various guideline unfold, we will highlight strategies for maximizing deductions.

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