When Congress passed the 2017 Tax Cuts and Jobs Act, the discussion centered on how the new pass-through income deduction would help small businesses. But business owners aren’t the only ones who stand to benefit from the new tax law.
In 2014 (the latest year for which numbers are available), nearly 40 million taxpayers claimed pass-through income—and many of them don’t fit the idea of small-business owners who run a shop or office and have a handful of employees. In fact, fewer than half of the individual taxpayers who claimed pass-through income conducted traditional business activities, according to the Department of the Treasury.
Though they may not be classic small-business owners, many of these taxpayers claim income through such business structures as sole proprietorships, limited liability companies, partnerships, or S corporations. Under the new tax law, taxpayers who file under one of these categories, which encompass a wide range of earners, can deduct 20 percent of their qualified business income from their personal income taxes. Translation? Some pass-through entities will be taxed on only 80 percent of their pass-through income. For many taxpayers, especially those who bring in rental income from investment properties, this will be huge.
The independent contractors, freelancers, and self-employed people who make up a growing share of the gig economy may claim pass-through income even if they work for themselves and don’t have any employees. For example, an IT specialist who works for a company on a contract basis and operates as a sole proprietor generates pass-through income, as does a self-employed graphic designer who files taxes as a limited liability company.
Real estate investors can also claim the pass-through deduction for income from their rental properties. The new tax law allows them to claim a certain portion of their depreciable assets as a deduction as well.
Congress has put some limits on how much pass-through income high earners working in what are termed “professional services” are able to deduct. For the purposes of the new tax law, this category includes those in the accounting, athletics, performing arts, consulting, health, and financial services fields, as well as “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” (Architects and engineers, however, are exempt from the income limits.)
In practical terms, this provision means that high-earning professionals, such as partners in large law or accounting firms, likely won’t be able to deduct their pass-through income while those operating in smaller firms and earning lower incomes may be able to.
For 2018, married couples earning less than $315,000 or singles earning less than $157,500 qualify for the full 20 percent deduction, while couples earning more than $415,000 or singles earning more than $207,500 do not qualify. (Married couples earning between $315,000 and $415,000 and singles earning between $157,500 and $207,500 will see their deduction phased out in proportion to their income; consult the IRS for specifics.)
High earners in other fields are also subject to limits on how much of their income they can deduct: either 50 percent of their total wages paid or 25 percent of their wages paid plus 2.5 percent of depreciable property assets, whichever is higher.
While an earlier version of the tax bill excluded trusts from the new tax rules, the final version allows businesses owned through trusts or estates to take the same deduction as individuals.
It’s hard to tell how these changes will play out in the economy. The growing number of gig workers who don’t have access to traditional workplace retirement plans need to create and fund their own retirement plans. The new law means that many of these taxpayers will have lower tax payments, leaving them more funds to contribute to retirement accounts.
Should you have any questions regarding pass-through income deductions, contact the Pacific Life Retirement Strategies Group at (800) 722-2333, ext. 3939, or send an email to RSG@PacificLife.com.
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