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How to Calculate the Deduction for Pass-Through Business Income

With regard to the new tax law, by far the most common topic of questions from readers has been the new deduction for pass-through business income (i.e., income from sole proprietorships, partnerships, S-corporations, or LLCs taxed as any of the above).

What follows is my best attempt to explain the new deduction clearly. Unfortunately, it is complicated. So if this deduction will be relevant to your personal tax planning, I’d encourage you to meet with a tax professional, read the applicable part of the new law for yourself, and/or read articles on the topic by other sources (e.g., Steve Nelson, Michael Kitces, Kelly Phillips Erb).

One point before we get started: I’m simplifying here by assuming that you have no qualified cooperative dividends, qualified REIT dividends, or qualified publicly traded partnership income. Each of those types of income gets special treatment under this new Code section.

Basic Calculation

If your taxable income* is under a certain threshold amount, the deduction is 20% of the pass-through income from your business(es), but it cannot be greater than 20% of your taxable income excluding net capital gains.

The threshold amounts are $315,000 if you are married filling jointly or $157,500 if you are single, head of household, or married filing separately. (Of note, this is the top of the 24% tax bracket for each filing status.)

When your taxable income exceeds the threshold, two potential complications kick in:

  • A wage (or wage + property) limit, and/or
  • A phaseout for “specified service businesses.” 

Wage (or Wage + Property) Limit

If your taxable income exceeds a certain phaseout range (i.e., the threshold amount from above, plus $100,000 if married filling jointly or $50,000 if single/head of household/married filing separately), then your deduction for each business will also be limited to the greater of:

  • 50% of the W-2 wages paid by the business**, or
  • 25% of the W-2 wages paid by the business**, plus 2.5 percent of the unadjusted basis immediately after acquisition of all “qualified property” (basically, depreciable tangible property that is used by the business or held by the business and available for use).

If your taxable income is in the phaseout range, the calculation basically says, “If you were past the phaseout range, how much would the wage (or wage + property) limit reduce the amount of your deduction? Now, instead of reducing your deduction by that whole amount, we’ll multiply that reduction by a percentage that is the percentage of the way you are through the phaseout range.”

Example: You are single and you have $150,000 of pass-through income from a sole proprietorship. Your taxable income is $182,500 (i.e., halfway through the phaseout range). The business has no qualified property. The business has two part-time employees to whom it paid a total of $40,000 of W-2 wages over the course of the year.

Without regard to the limitations, your pass-through business income deduction would be $30,000 (i.e., 20% of $150,000). But your taxable income is past the threshold amount of $157,500. If you were past the phaseout range, your deduction would be limited to $20,000 (i.e., 50% of the wages paid by the business). That’s a $10,000 reduction relative to what it would be without the limitation.

But you aren’t past the phaseout range. You are halfway through it. So your deduction ($30,000) is reduced by half of that $10,000 — for a total deduction of $25,000.

Specified Service Business Phaseout

If your business is a “specified service business,” there’s another limitation that can come into play. A specified service business is:

  • Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees; or
  • Any trade or business which involves the performance of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

If your business is a specified service business, then we again calculate how far your taxable income is through the same phaseout range (i.e., the same threshold, plus either $100,000 or $50,000).

If you are past the phaseout range, you get no deduction for pass-through business income.

If you are in the phaseout range, then we calculate the deduction as normal, except we only consider a pro-rata share of all of the amounts from the business (income, gain, deduction, loss, W-2 wages from the business). So, for example, if your income is 70% of the way through the phaseout range, everything is 70% phased out, so only 30% of your income from the business would be counted for calculating the deduction.

A key point here is that this affects the amount of wages counted for applying the wage and wage+property limits! And this is where the complexity starts to get ugly.

Example: You are single and you have $150,000 of pass-through income from a sole proprietorship. Your taxable income is $170,000 (i.e., 25% of the way through the phaseout range). The business has no qualified property. The business has two part-time employees to whom it paid a total of $40,000 of W-2 wages over the course of the year. The business is a specified service business.

Because you are 25% of the way through the phaseout range, all of the amounts from the business are 25% phased out, meaning we use 75% of each of them. So instead of calculating 20% of the income from the business, we calculate 20% of 75% of the income from the business (i.e., 20% of 75% of $150,000). That gives us a deduction of $22,500 before applying the wage-related limit.

As in the prior example, to apply the wage-related limit, we calculate what the reduction to the deduction would be if you were all the way through the phaseout range, then we apply only a portion of that reduction, based on how far you are through the phaseout range.

Again, the wage limit is 50% of the wages from the business, but because of the specified service business phaseout we are now calculating 50% of 75% of the wages from the business (i.e., 50% of 75% of $40,000). That gives us a limit of $15,000. That’s what the limitation would be if you were past the phaseout range. Relative to the $22,500 deduction you’d have without the wage limit, that’s a $7,500 reduction.

But you aren’t past the phaseout range. You’re 25% of the way through it. So we calculate 25% of the $7,500 reduction, which gives us a reduction of $1,875. So we take your initial $22,500 deduction and reduce it by $1,875 for a total allowed deduction of $20,625.

Other Assorted Points of Note

The deduction for pass-through business income is not an “above the line” deduction (i.e., it does not reduce AGI). But it is also not an itemized deduction; that is, you can claim it as well as the standard deduction. In other words, it works much like personal exemptions did prior to 2018.

As far as first-glance tax planning thoughts, I’ll offer three brief points:

  • For business owners below the phaseout range, this new deduction is usually going to be a point in favor of keeping sole proprietor taxation (or partnership taxation) rather than electing S-corp taxation, as the wages that the S-corp would have to pay to owner-employees would not be pass-through business income.
  • Business owners below the phaseout range will have two different marginal tax rates for different types of income. (Normal taxable income will have a normal marginal tax rate, and pass-through business income will have a lower marginal tax rate because it results in a larger deduction.)
  • For business owners in the phaseout range, those two marginal tax rates will be higher, because each additional dollar of income (whether from the business or not) will cause partial phaseout of the deduction.

*For brevity’s sake, I’m referring to “taxable income” throughout this article. In reality, we are concerned with taxable income without regard to the deduction for pass-through business income.

**For multiple-owner pass-through businesses (i.e., partnerships, S-corps, or LLCs taxed as either of the two), “W-2 wages” only includes that one owner’s allocated share of total wages paid. For example, if the business paid $60,000 of wages and there are two partners each with 50% ownership, $30,000 would be the amount of wages each partner would use when calculating the deduction.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
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