The new tax law's provision on pass-through entities could provide substantial tax savings to both financial advisers and clients this year.
However, the rules are complex enough to make even an accountant's head spin. Here's a breakdown of the rules to help advisers understand the law's impact.
What is a pass-through?
The Republican tax bill, which President Donald J. Trump signed into law Dec. 22, created a new section in the tax code — Section 199A — that provides a 20% tax break to some pass-through business entities.
These businesses pass their income through to their owners' tax returns, and is taxed at the owner's individual rate. Types of pass-throughs include sole proprietorships, partnerships, S corporations, limited liability companies and limited liability partnerships.
Roughly 92% of private businesses in the U.S. are structured as pass-throughs.
How does the tax break work?
The law provides a 20% "exclusion" to a pass-through's "qualified business income, which is considered any domestic income related to that business, said Jamie Hopkins, associate professor of taxation at The American College of Financial Services.
Here's an example: A business with $100,000 of net income would exclude 20% of that income from taxation. So, the business owner would only pay tax on $80,000.
• Individuals can get the tax break whether they itemize on their tax returns or take the standard deduction.
• The tax break is based on ownership interest. An individual who owns 25% of a partnership can only gets the exclusion on 25% of its net business income.
• The calculation is done on an entity-by-entity basis. An individual with two different rental properties held in LLCs must calculate the exclusions separately — their income can't be combined.
These rules are in effect for the 2018 tax year, but are scheduled to sunset after 2025. In other words, the provision will disappear in 2026, barring future action by Congress.
There are several limitations that apply to the tax break. And this is where things get thorny.
The first question to ask is: What is my taxable income?
Individuals with taxable income less than $157,500, and married couples (filing jointly) with income less than $315,000, get the full 20% exclusion. Limitations on eligibility kick in above those thresholds.
For one, there's a $50,000 phase-out for individuals and $100,000 for couples. So, those with taxable income exceeding $207,500 (and $415,000 for couples) may not get the full, or any, tax break. The tax break is diluted for those falling within the phase-out range.
Important note: These income thresholds represent an individual's/couple's overall taxable income, not just business income.
For example, a business owner earns $100,000 in net pass-through income. The owner's spouse also earns $400,000 in income as an employee of another company. Because the couple's $500,000 in taxable income exceeds the $415,000 phase-out limit, the couple may be ineligible for the 20% tax break, dependent on some other limitations (listed below).
In short, taxable income may determine eligibility, but the tax break is applied to business income.
The next question to ask is: Am I a service business?
Owners of specific service businesses — those in which the primary asset is the reputation or expertise of its employees or owners — are not eligible for the tax break above the income phase-out limits.
Service businesses include those in fields like health, law, consulting, athletics, financial services and brokerage services. It excludes engineering and architecture services, and other things like real estate and rental properties.
So, an unmarried owner of an investment advisory firm with $100,000 in taxable income gets the 20% exclusion. One with $300,000 in income — exceeding the $207,500 phase-out — does not.
Non-service firms can still get the exclusion, but the amount of the exclusion may be less than 20%, dependent on yet more limits.
Their exemption is the lesser of two things:
• 20% of business income, or
• The greater of: (a) 50% of wages the business pays to employees, or (b) 25% of wages plus 2.5% of the cost of depreciable assets in the business, like a building.
Tim Steffen, director of advanced planning in the Private Wealth Management group at Robert W. Baird & Co., provided a few basic examples to demonstrate the effect of these rules.
Example 1: The unmarried owner of a non-service pass-through has $100,000 in business income, and has total taxable income of $125,000. Because the individual's income is below the phase-out range, he qualifies for the full 20% exclusion, meaning $20,000 of business income is excluded from taxation.
Example 2: The same business owner now has total taxable income of $300,000 (which exceeds the phase-out income limit). The business pays $15,000 in wages but has no depreciable assets. The owner will exclude from tax the lesser of:
• $20,000 (20% of business income); or
• The greater of: $7,500 (50% of wages), or $3,750 (25% of wages [$3,750]+ 2.5% of assets [$0])
The owner would exclude $7,500 of pass-through income from tax, much less than in Example 1.
Example 3: Same scenario as Example 2, but the owner also purchased a building, associated with the business, for $500,000. The owner will exclude the lesser of:
• $20,000 (20% of business income); or
• The greater of: $7,500 (50% of wages), or $16,250 (25% of wages [$3,750]+ 2.5% of $500,000 [$12,500])
The owner's exclusion would be $16,250, greater than in Example 2.
The non-service-firm examples won't apply to advisory firms themselves. But, they could be valuable for some advisers' non-service-business-owner clients.
"That's where advisers will end up working with a lot of clients to see if they should add more people to payroll [or] re-leverage debt obligations to increase their QBI (qualified business income) deduction," Mr. Hopkins of the American College said. "Those are some areas where they can add thousands of dollars in value."