By Vincenzo Villamena, CPA
The Tax Cuts and Jobs Act created a new 20% deduction for pass-through income. At first glance this sounds like a great tax saving for single-member LLCs and sole proprietors. Even shareholders and partners of S corporations and partnerships may qualify for the 20% pass-through deduction.
However, the rules and requirements for this deduction are very complex. Many businesses won’t qualify for the new deduction. And if they qualify, the actual calculation is complicated.
Furthermore, many expats and digital nomads might not the able to use it. The deduction can only be applied to U.S. domestic qualified business income, meaning it must be connected to a U.S. business or trade. More on that later.
The IRS recently published its final guidance on this complex new deduction, just in time for the new tax season. We reviewed its implications and share here with you what you should know about this new deduction for pass-through businesses.
What is the new 20% pass-through deduction?
The 20% pass-through deduction was introduced in Section 199A of the new tax law. It is considered one of the most complex and controversial provisions of the tax law. While it gives a nice tax break to some businesses, it excludes a wide range of other businesses.
Greatly simplified, under Section 199A an individual business owner may qualify for a deduction equal to 20% of the taxpayer’s qualified business income (QBI). Some trusts and estates may also qualify for this deduction. QBI includes only income from business activity conducted in the United States.
If your taxable income exceeds $207,000 ($415,000 for married filing jointly) and is earned in a “specified service trade or business” you cannot take the deduction. We examine below what “specified service trade or business” means.
If your business is in that same income category but is eligible for the deduction, the deduction amount can be limited by other factors.
As you can see, both the requirements to qualify for the deduction and the deduction calculation itself are convoluted. (So much for simplifying our tax code …)
Furthermore, this provision expires after 2026. Like most other provisions for individual taxpayers, Section 199A is only effective for tax years 2018 through 2026.
Additional Section 199A deductions
In addition to the 20% pass-through deduction, Section 199A also offers much simpler deductions for 20% of the taxpayer’s qualified REIT dividends and publicly traded partnership (PTP) income for the year.
Those two deductions are distinct and computed separately. After they are added together, they are subject to an overall limitation.
Let’s break it down.
Who can take the 20% pass-through deduction
First of all, a business must be a “Section 162 trade or business” to have income eligible for the 20% deduction. It is not well defined though what a Section 162 trade or business is. In general, it must be active, profit seeking, and performed with regularity and continuity.
For most businesses this is easy to establish. When it comes to rental real estate however, the lines between investment and trade or business are blurrier. We will publish a separate post about the pass-through deduction and rentals later.
Secondly, only business income that is connected to a U.S. business or trade qualifies, meaning income from doing business in the U.S. By having U.S. based employees, offices, and customers, and operating a U.S. company, you would qualify as U.S. trade or business. Whether selling on Amazon or producing widgets in a factory, as long as the income comes from doing business in the U.S, one would qualify as USBT.
And lastly, the tax law excludes two groups from taking the 20% pass-through deduction:
- Employees in a qualified business cannot take the pass-through deduction against their salary.
- Business owners of a “specified service trade or business” (SSTB), basically a list of disqualified business fields, cannot take the deduction, depending on their taxable income.
This means that a shareholder of an S Corp with qualified U.S. business income (QBI) from a non-disqualified service, cannot take the deduction against his salary. However, the shareholder’s share of QBI reported on schedule K-1 would qualify for the deduction.
Special considerations for expats and digital nomads
It used to be easy to determine if a business was a U.S. business or trade, e.g. by having a sales office or a factory in the U.S.
With the new era of digital nomads, and working online from anywhere however, the lines are not well defined. If you have employees, make regular trips to the U.S. or have dependent agents located in the U.S. that handle your business transactions, you might still qualify for this 20% deduction for your business while also qualifying for the Foreign Earned Income Exclusion.
Qualification limits above certain income levels
Access to the deduction also depends on the level of taxable income. Above the income thresholds, additional requirements apply.
Taxable income of less than $157,500 ($315,000 for married filing jointly) qualifies
This is the simplest case. With taxable income below that threshold, all the factors that make Section 199A complex, don’t apply yet. To compute the deduction, you can take 20% of the qualified business income, and add the other section 199A deductions, 20% of qualified REIT dividends and PTP income. Then you apply the overall limit based on taxable income.
Higher taxable income only qualifies if it is not from a specified service trade or business (SSTB)
Once the taxable income exceeds the threshold of $157,500 ($315,000 for married filing jointly), only certain businesses can take the deduction. The tax law excludes a wide range of service providers from these tax savings.
Which businesses qualify for the 20% pass-through deduction – and which don’t
Only income that is not from a specified service trade or business (SSTB) qualifies for the deduction if you are above the income threshold. The way the new tax law defines SSTB is intricate and seems arbitrary. The IRS final regulation now gave much needed clarification on services and entire fields that don’t qualify.
The regulations define consultants as “those who provide professional advice and counsel to clients to assist in achieving goals and solving problems”. This sounds like an extremely broad category. After all, many sole proprietors and single-owner businesses, such as developers, marketers, writers, tutors, and videographers, provide advice and counsel.
Luckily, the term “consultant” is further defined under personal service corporation regulations: consultants are paid only for advice and counsel. However, if you as a contractor are implementing your advice for the client and you get only paid after you implemented your advice, you are not a consultant. ( “whether the compensation for the services is contingent upon the consummation of the transaction that the services were intended to effect”.)
Let’s say you are an internet marketer and develop a Google Adwords plan for a client. If your services stop there and you get paid for advising on the plan, you are a consultant. On the other hand, if you then design and place the ads and you get paid for running the ad campaigns, you are not a consultant.
If you are a health coach and advise your clients on nutrition or exercise without providing the meals or the exercise class, you are a consultant.
Sales representatives and people who provide training and educational courses are not considered consultants and therefore not disqualified. So if your business is to develop and market online courses, you can take the 20% pass-through deduction.
But remember the caveat that qualified business income must be connected to trade or services performed in the United States, as explained above.
Traders of securities, commodities or partnership interests cannot take the deduction
Healthcare professionals who provide services directly to the patient are disqualified. This includes doctors, nurses, pharmacists, therapists, dentists, and even vets.
Owners of a health club or spa, or of a medical research or testing service qualify for the deduction. So do businesses that sell pharmaceuticals and medical devices.
Financial service providers including those providing wealth management, retirement planning or other financial planning, M&A advisory, valuations, and investment banking are disqualified. Banking however is not disqualified from taking the deduction.
Accountants, book keepers, tax preparers, enrolled agents, financial auditors and any similar accounting service provider, so basically all accounting services, are disqualified from the deduction.
Everyone providing a legal service such as lawyers, paralegals, arbitrators and mediators is disqualified. Only support services like office support or delivery qualify.
If you are creating performing art as a singer, actor, musician, director or similar professional, your income is disqualified. However, if you disseminate or broadcast recordings of art performances or operate facilities or equipment used in the performing arts, you are not disqualified.
Disqualified are those who provide investing, asset management or investment management for a fee. Real estate management however is not disqualified.
A stock broker is disqualified. However, if the brokerage service is not for securities, it’s not disqualified. So again, real estate gets the preferential treatment.
Athletes, coaches and team managers cannot take the deduction. Only those who broadcast sports events or maintain and operate sports equipment are not disqualified from taking the deduction.
Actuaries and similar professionals are disqualified. On the other hand, analysts, economists, mathematicians, and statisticians who are not engaged in analyzing or assessing the financial costs of risk or uncertainty of events are not disqualified.
In addition to the fields above, the tax law includes a catch-all category of disqualified services, which it left rather ambiguous. Luckily, the final IRS regulation defines it narrowly. Basically, any trade or business where the primary asset is the skill or reputation of its employees is disqualified under the catch-all.
That means if you are receiving any type of payment for your name recognition, trademark and anything associated with your identity, that income would be disqualified. This includes income for endorsing a product or service, or for appearing at a real-life or online event. Besides athletes or famous chefs, it also applies to motivational speakers, journalists and other professionals known for their name.
Can you take the new 20% pass-through deduction?
As you see, the rules around the pass-through deduction are complex.
For most expats and digital nomads the first step would be to determine if the income is connected to a U.S. business or trade. The simplified steps are:
- Is the income qualified business income (QBI), connected to a U.S. business or trade? Only U.S. domestic income qualifies.
- Is the qualified income below $315,000, if married filing jointly, or $157,500 for all other filing statuses? If yes, you qualify.
- Is the income from a specified service trade or business (SSTB)? Income above the threshold only qualifies if it is not from an SSTB.
In many cases the situation is more complicated. To find out if you qualify, or if there are other ways to optimize the tax situation for your business, please schedule a free tax consultation.