Currently, owners of partnerships, S corporations, and sole proprietorships – as “pass-through” entities – pay tax at the individual rates, with the highest rate at 39.6 percent. The highest rate is reduced to 37 percent under the Tax Cuts and Jobs Act. The Act also allows a temporary deduction in an amount equal to 20 percent of qualified income of pass-through entities, subject to a number of limitations and qualifications. Conversely, the Tax Cuts and Jobs Act limits the deduction for excess business losses from pass-through entities.
Pass-through Income Deduction
Noncorporate taxpayers may deduct up to 20 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship (Code Sec. 199A deduction). A similar deduction is allowed for specified agricultural or horticultural cooperatives. A limitation based on wages paid, or on wages paid plus a capital element, is phased in for taxpayers with taxable income above a threshold amount. The deduction is not allowed for certain service trades or businesses, but this disallowance is phased in for lower income taxpayers. The deduction applies to tax years from 2018 through 2025.
Caution. The Tax Cuts and Jobs Act provides rules that would prevent pass-through owners—particularly service providers such as accountants, doctors, lawyers, etc.—from converting their compensation income taxed at higher rates into profits taxed at the lower rate.
For individual taxpayers, the Code Sec. 199A deduction is not allowed in determining adjusted gross income. Further, it is not an itemized deduction, but it is available to individuals who itemize deductions and to those who claim the standard deduction. However, the deduction amount cannot be more than the taxpayer’s taxable income (reduced by net capital gain) for the tax year.
The Code Sec. 199A deduction is similar to the domestic production activities deduction under Code Sec. 199, in that both allow taxpayers to deduct a portion of their “taxable income” if it is less than a portion of their relevant business income. Also, neither deduction can be claimed if the taxpayer has no relevant business income. It is anticipated that the IRS will provide a new worksheet or form for calculating the Code Sec. 199A deduction, similar to Form 8903, Domestic Production Activities Deduction.
Limit on Excess Business Losses for Noncorporate Taxpayers
Under the Tax Cuts and Jobs Act, excess business losses of noncorporate taxpayers are not allowed for tax years beginning after December 31, 2017, and before January 1, 2026. Any excess business loss that is disallowed is treated as part of the taxpayer’s net operating loss (NOL) carryover to the following tax year.
Noncorporate taxpayers must apply this rule for excess business losses after applying the passive activity loss rules. For partnerships and S corporations, the limit on excess business losses is applied at the partner or shareholder level.
Comment: For losses arising in tax years beginning after December 31, 2017, an NOL may generally only reduce 80 percent of taxable income in a carryback or carryforward tax year.
An “excess business loss” is the excess, if any, of
(1) the taxpayer’s aggregate deductions for the tax year from the taxpayer’s trades or businesses, determined without regard to whether or not such deductions are disallowed for such tax year under the excess business loss limitation; over
(2) the sum of
(a) the taxpayer’s aggregate gross income or gain for the tax year from such trades or businesses, plus
(b) $250,000, adjusted for inflation (200 percent of the $250,000 amount in the case of a joint return).
The $250,000 amount is adjusted for inflation for tax years beginning after December 31, 2018.
Example: For 2018, Ned Brown has $1,000,000 of gross income and $1,400,000 of deductions from a retail business that is not a passive activity. His excess business loss is $150,000 ($1,400,000 − ($1,000,000 + $250,000)). Brown must treat his excess business loss of $150,000 as an NOL carryover to 2019.
The result of this provision is that an individual taxpayer is limited to offsetting a maximum of $250,000 of business loss against other income for the tax year. In the example, if Ned Brown reported wages of $400,000 (and no other income) in 2018, his adjusted gross income would be $150,000. Under present law, all of the $400,000 of losses can be used to offset wage income to arrive at adjusted gross income of $0.