Tax Topics—Deductions for Pass-Through Entities

By Michael Repka, Esq. (LL.M.—Taxation, NYU School of Law ‘01)

On December 22, President Trump signed the Tax Cuts and Jobs Act (the “Act”) into law. This sweeping legislation dramatically lowered corporate tax rates, encouraged multi-national companies to bring money back to the United States, generally lowered individual income tax burdens, reduced mortgage interest deductibility, and, perhaps most significantly for people in California, eliminated all but $10,000 of state income and real property tax deductibility. Additionally, the Act created a new deduction for income from pass-through entities. On December 26, we published an article addressing these changes which was featured in many local newspapers, Gentry Magazine, and it is available on our website.

Since enacted, there have been a tremendous number of questions and substantial concern about the likely impact of the new law, which hits homeowners in California particularly hard. Nowhere was this concern more evident than at my last tax seminar which we held on January 6. Normally my tax seminars attract between 80 and 100 people with some attendees as interested in the delicious crab cakes at the Palo Alto Hills Country Club, as they are in hearing about various tax structuring ideas. However, this latest seminar attracted over 850 people—and we didn’t even serve the crab cakes! In fact, we had to split the seminar into two shows, with the second being a standing-room-only show at the JCC’s theater in Palo Alto. There is no doubt that local home owners are concerned about the potential impact on home prices and interested in possible ways to save taxes.

20 Percent Deduction for Pass-Through Entities

With regard to the positive changes, many real estate investors were interested in the new rules codified as Sec. 199A of the internal Revenue Code which provides for a 20 percent deduction for income from a pass-through entity. The number-one question was whether landlords should form an LLC or an S-Corporation to hold their investment properties. Although the Treasury Department has not promulgated any new regulations clarifying this issue, it appears that landlords will not need to form a new entity to take advantage of this deduction. In other words, real estate investment income reported on Schedule E (Form 1040) should qualify.

Over the years there has been much debate as to whether owning investment qualifies as a “Trade or Business,” but the IRS has acquiesced to an old case from the 1940’s, which held that even owning one residential rental property qualifies as a trade or business. Hazard v. Commissioner, 7 T.C. 372 (1946).

However, it should be noted that the new rules under Section 199A contain a maze of limitations and restrictions that serve to reduce the applicability of the deduction. While taxpayers that are “fortunate” enough to earn less than $315,000 as a couple (Inc. income from most sources) should be able to take full advantage of the 20 percent deduction on qualified business income. Taxpayers that make more than this amount will see the deduction phased out, with a full phase-out achieved at $415,000, unless the taxpayer qualifies for either the wage or the wage and capital exception to the phase out.

Wage or Wage and Capital Exception to the Phase Out

Some lucky taxpayers may be able to take a deduction even if their taxable income is in excess of $157,500 ($315,000 if married filing jointly), if the business pays enough wages to employees or if they have sufficient capital invested in the business. This increase to the phase is calculated as follows:

50 percent of the wages paid by the entity, or 25 percent of the wages paid by the business plus 2.5 percent of the unadjusted basis of qualified property used in the business. It is widely speculated that the latter rule, which provides relief for capital intensive businesses, was crafted to help real estate investors. Additionally, some businesses may want to reconsider the amount paid as W-2 wages to owners of the company. As if these rules are not complicated enough, there are additional restrictions on income from service-based businesses that rely upon the individual’s professional skill, such as lawyers, doctors, musicians, and professional athletes, among many others. So, what does all this mean? It means that taxpayers with income from small businesses or real estate holdings should make an appointment with their tax professional to ensure compliance with the new rules and to make sure they are taking advantage of all deductions to which they are entitled.