It's been nearly a month since President Trump signed the new tax reform bill into law and taxpayers are still trying to determine how it might affect them. In particular, figuring out how the new deduction for pass-through businesses will work has challenged taxpayers and tax preparers alike. Pass-through tax law has never been simple, but now there's a twist: Business income that passes through to an individual from a pass-through entity and income attributable to a sole proprietorship will be taxed at individual tax rates less a deduction of up to 20% (under the rules, it's possible that you could have no deduction). The rules for calculating the deduction can be complicated, depending on your situation.
A number of articles have been written about the pass-through deduction, including this one from me (as well as this one from Forbes contributor Tony Nitti and this one from Forbes contributor Peter J. Reilly).
However, as much as reading about the new law can be helpful, sometimes it helps to see it as an illustration. Rob and Joe Hassett thought the same thing - and came up with one of their own.
Rob Hassett, an attorney with Hassett Law Group in Atlanta, and Joe Hassett, a consultant with Accenture in San Francisco, used SimpleMind mind mapping software to create a flowchart to express the deduction. Their purpose was to provide a visual representation of the new rules to make them easier to understand and apply.
Here's the chart:
To see the chart in full size, click here.
And some key definitions to help you navigate the chart:
- APPLICABLE PERCENTAGE means 1 - PHASE-OUT PERCENTAGE
- EXCESS TAXABLE INCOME means TP taxable income - THRESHOLD
- NEW QBIF means APPLICABLE PERCENTAGE x QBIF
- NEW QBIF - WCF DIFFERENCE means NEW QBIF - NEW WCF
- NEW WCF means APPLICABLE PERCENTAGE x WCF
- PHASE-IN RANGE means $100k for married taxpayers filing jointly & $50k for all other taxpayers
- PHASE-OUT PERCENTAGE means EXCESS TAXABLE INCOME/PHASE-IN RANGE
- QBI means qualified business income, which means the taxpayer’s share of income from a pass-through entity
- QBIF means qualified business income factor which means 20% x QBI
- QBIF - WCF DIFFERENCE means (20% x QBI) - WAGE-CAPITAL FACTOR
- SPECIFIED SERVICE BUSINESS means, in general terms, a business with respect to which the services of one or more individuals is the main source of income, such as lawyers, doctors, accountants & consultants (architects & engineers are expressly excluded). For the full definition see page 553 of the Conference Report (downloads as a pdf).
- THRESHOLD means $315k for married taxpayers filing jointly & $157.5k for all other taxpayers
- TP means TAXPAYER
- WAGE-CAPITAL FACTOR means TP's share of the greater of 50% x W-2 Wages OR (25% x W-2 Wages) + (2.5% x Capital Investment).
Of course, Rob being a lawyer, had a few caveats, notably:
In order to determine how best to structure a business for tax purposes, it will be necessary to take into account additional factors other than just what is in the Flowchart. For example, owners of S Corporations may be able to avoid a substantial amount of Social Security and Medicare/Self-Employment taxes which can add as much as (.9235) x (15.3%) or 14.129% of income. Actions that lower your amount of Self-Employment tax may decrease your pass-through deduction. Also, with the additional change of the corporate rate to a flat rate of 21%, without knowing all the rules and crunching numbers, it is not possible to determine whether taxation as a proprietorship, partnership, S- Corporation or C-Corporation will be optimal.
Rob also notes that the flowchart is not meant to constitute legal or tax advice and is, instead, provided solely for educational and discussion purposes. Feel free to test the formulas, which were crafted to make it as easy to follow as possible - and not to incorporate every possibility - and reach out to him directly with feedback (click here for email). Changes may be required.
I would also stress that this is meant to be a visual representation to help you sort through some pretty complicated rules, and isn't meant to be a substitute for finding out more, including consulting with your tax professional.
