Tax reform Q&A Thread 1 - Pass-through and 20% deduction

[Michael Plaks]

Colleagues and friends, 

The original GOP reform thread started by @Brandon Hall is well over 200 posts by now. This is one of the follow-up threads specifically for discussion of pass-through entities (Sch C / Sch E sole proprietorships, LLCs, partnerships, S-corps) that will enjoy a 20% deduction under the tax reform. PLEASE POST OTHER QUESTIONS IN THE OTHER TAX REFORM THREADS.

As of today, we have a consensus on several points.

1. All forms of doing business (aka business entities) EXCEPT C-corporations and trusts will be treated the same way, as pass-through entities:

• no entity / sole proprietorship / single-member LLC using Schedule C for non-rental business
• no entity / sole proprietorship / single-member LLC using Schedule E for rental business
• partnerships and LLCs filing as partnerships
• S-corporations and LLCs filing as S-corporations
  

2. All of them are eligible for a 20% deduction from their net profit - i.e. after all deductions. 

Example 1: Susan the wholesaler makes $150k in assignment fees - gross profit. She deducts $50k marketing, driving, and whatnot - resulting in $100k net profit. 20% of that amount - or $20,000 - is Susan's new "freebie" deduction.

Example 2: Brad the apartment guy collects $300k rent from his property. He deducts $150k for property taxes, mortgage interest and insurance (they are not limited in the reform!) He deducts another $50k for maintenance, repairs and depreciation. Brad is left with $100k net rental income. He also gets a 20% freebie deduction equal to $20,000.

Note: if your business or rental properties show a net loss - there is no 20% deduction. 20% of zero is zero, sorry.

3. This deduction is "under the line" - meaning it is NOT subtracted from the AGI. 

4. This deduction is per business. If you have multiple businesses - each one calculates its own deduction. They will eventually add up on your tax return.

5. This deduction is not limited as long as your total taxable income (including W2s and everything else) is under the threshold:

• $315,000 for a jointly filing couple
• $157,500 for everybody else

6. Once you cross the threshold, your 20% deduction becomes limited. You can choose between two ways to figure the limitation, whichever is best.

• 50% of all W2 salaries paid by the business - or -
• 25% of all W2 salaries plus 2.5% of initial basis of all depreciable business assets

Example 1: ABC Flip-Flopping, a one-owner S-corp, generated $650k in income (after deductions) and paid $150k in salaries, resulting in $500k net income. The 20% deduction would be $100k. However, it is limited by 50% of the $150k salaries, or $75k. Only $75,000 is deductible. The company has no assets, so it cannot benefit from the alternative limit.

Example 2: XYZ Slumlords, an LLC-partnership, owns an apartment complex that they purchased for $2.5 mil. It generates $500k net income (after all expenses and depreciation) and pays no salaries. 20% deduction would be $100k. Since there're no salaries - we have to use 2.5% of depreciable basis. Let's say that $0.5 mil was allocated to land - which leaves $2 mil depreciable basis. 2.5% of $2 mil is $50k - which is our limit. Only $50,000 is deductible.

7. If you're a "service business" AND over the threshold mentioned in #5 above - then your 20% deduction gets phased out and completely disappears at:

• $415,000 for a jointly filing couple
• $207,500 for everybody else

The definition of service business is "where the principal asset of the business is the reputation or skill of 1 or more of its employees" - which is not totally clear. It looks like Realtors and brokers are considered service businesses.

There're lots of questions left, and nobody has all the answers. We all expect more rules from the IRS that will change the game. Meanwhile - let's debate it here. As long as it's on topic, please. There are other threads for other tax reform topics.