Wealthy clients likely missed out on pass-through tax deduction

Nearly 85% of those who claimed the deduction had less than $200,000 in income

Aug 8, 2019 @ 1:43 pm

By Greg Iacurci

Wealthy clients of financial advisers likely missed out on the lucrative new pass-through tax deduction in the most recent tax filing season.

Of the more than 14 million taxpayers who claimed the pass-through deduction this year, the vast majority — 84.5% — had less than $200,000 in adjusted gross income, according to statistics from the Internal Revenue Service.

More than 58% of these taxpayers who claimed the tax break, a 20% deduction for individuals who own pass-through businesses such as sole proprietorships, partnerships and S-corporations, had an adjusted gross income of less than $100,000.

The 2017 tax law created the pass-through deduction, and this year's tax returns represented the first time taxpayers could claim it (for the 2018 tax year).

Taxpayers who took the pass-through deduction
Note: Data is through May 23, 2019 and represents the 2018 tax year.
Source: Internal Revenue Service

Financial advisers say the trend highlighted by IRS stats isn't wholly surprising given the mechanics of the deduction, especially around income limitations. For one, the deduction starts to phase out if a single filer's taxable income exceeds $157,500. It's $315,000 for married couples filing jointly.

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Further, owners of service businesses — which include those in fields like health, law, consulting, athletics, financial services and brokerage services — can't get the deduction at all if their taxable income exceeds $207,500 for single filers or $415,000 for couples. Owners of non-service businesses can still get the deduction above those thresholds, but with some limitations around items like W-2 wages and the cost of depreciable assets in the business.

Leon LaBrecque, an adviser at Sequoia Financial Group, said the IRS statistics align with his firm's experience — a vast majority of his married clients who claimed the deduction had less than $315,000 in taxable income.

"We only had a few bigger ones," Mr. LaBrecque said. "I was thinking I'd see a lot more people over the $315,000, and I was more surprised I didn't."

Some of the trend may be demographic in nature, Mr. LaBrecque said — there's a much larger share of pass-through businesses making modest incomes as opposed to large incomes. Further, some larger entities converted to C corporations from pass-throughs to take advantage of the 21% corporate tax rate. The tax law made this lower rate permanent, whereas the pass-through deduction is scheduled to disappear in 2026.

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Overall, nearly 11% of the 134 million tax returns filed this year took the pass-through deduction, known technically as the qualified business income deduction, according to IRS tax-return stats available through May 23.

Jamie Hopkins, director of retirement research and vice president of private client services at Carson Group, thought the percentage of people claiming the deduction would be higher, but said it will likely notch higher in the coming months and years.

For starters, many business owners file for extensions on their tax returns, which wouldn't be due until October, said Mr. Hopkins. He also thinks taxpayers and their advisers will do more proactive planning to be able to claim the pass-through deduction in the future.

For example, service-business owners could contribute more money to a 401(k) plan in order to reduce their adjusted gross income and get below the income thresholds.

"This year and into next year, I'd say we'll get more of the proactive planning," Mr. Hopkins said.

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