The 20% Pass-Through Deduction Gets Clarified: W-2 Wage and Basis Limitations Receive New Calculation Rules.

The Treasury Department and Internal Revenue Service released on Wednesday, August 1 2018, long-awaited guidance on how US taxpayers can claim a 20% deduction on income for owners, partners and shareholders in so-called pass-through entities — e.g. S-corps, LLCs, partnerships and sole proprietorships.

When the Tax Cuts and Job’s Act was signed into law on December 22, 2017 – a brand new provision was added: Section 199A. It permitted owners of sole proprietorships, S corporations, LLC’s, or partnerships to deduct up to 20% of the income earned by the business.  While the purpose of Section 199A was clear, its statutory construction and legislative text was anything but. The provision was rife with limitations, exceptions to limitations, phase-ins and phase-outs, and critical but poorly-defined terms. As a result, Section 199A created significant controversy after its enactment. The new guidance clarifies how companies that have multiple sources of income from various business lines can claim the deduction.

HOW TO CALCULATE THESE LIMITATIONS NOW:

In the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined in the same proportion to total W-2 wages as the deductions associated with those wages are allocated among the particular trades or businesses. ( Prop Reg § 1.199A-2 ) In the case of a trade or business conducted by a relevant pass through entity (RPE), a partner’s or shareholder’s allocable share of wages is determined in the same manner as the partner’s allocable share or a shareholder’s pro rata share of wage expenses. (Prop Reg § 1.199A-2(b)(4)).

In the case of Third-party payors, when determining W-2 wages, an individual or RPE may take into account any W-2 wages paid and reported another person on Forms W-2 (e.g., a professional employer organization), provided that the W-2 wages were paid to common law employees or officers of the individual or RPE for employment by the individual or RPE. In such cases, the person paying and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.

The guidance also reiterates previously outlined rules about the deduction. Americans with taxable income no more than $157,500 (or $315,000 if married filing jointly) automatically qualify. Those that earn more are subject to a complex set of a rules to figure out whether they can claim it.

For tax payers above these limits, the law also prohibits service businesses in certain industries from taking the deduction. This includes health, law, accounting, actuarial sciences, athletics, consulting, financial and brokerage services and the performing arts. To learn more about this recent part of the provision, please click here.

If you would like to discuss how these changes affect your particular situation, and any planning moves you should consider in light of them, please contact your KatzAbosch representative; or contact us by clicking here.

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