When you launch your own business, you’re immediately connected to each and every aspect of your business’s success, shortcomings, and operating procedures. But in addition to your management responsibilities, your personal and business finances may be considered one and the same under the eyes of the IRS. This is known as a pass-through entity. Pass-through entities are a type of business formation that directly connects a business owner’s finances to their business’s financial affairs, primarily in regards to taxes.
With the exception of corporations, most businesses in the U.S. are defined as pass-through entities. In the most basic sense, this characterization means that business owners file taxes for their business on their personal tax returns (not separately), meaning that they’re inherently responsible for any tax responsibilities involving their business. This liability ranges from tax collections and audits to filing and completing annual tax payments in compliance with business tax standards.
If this sounds like a lot of responsibility, you’re absolutely right. File your business taxes incorrectly, and you can expect Uncle Sam to be waiting at your doorstep to right your wrongs. And if you underpay sales taxes for your storefront location, you can expect the tax bill to end up right back in your mailbox.
Thankfully, the recent addition of the pass-through deduction in 2018, also known as the qualified business income (QBI) deduction, helps take some of the weight off business owners’ shoulders by limiting their taxable income—and therefore, reducing their overall tax liability. If you’re looking for ways to save money on your taxes with small business deductions, learning whether or not you qualify for the pass-through deduction is a great place to start.
If you’re in search of quick answers regarding pass-through entities and deductions, use the links below to skip ahead, or read all the way through to learn everything you need to know to take advantage of this tax-saving incentive.
- Pass-Through Deduction: Overview
- What is a Pass-Through Business?
- Qualifying for Pass-Through Tax Deduction
- How to Claim the Pass-Through Deduction
- Final Notes
Pass-Through Deduction: Overview
Before you can determine whether or not you qualify for a pass-through deduction, it’s important to establish a baseline knowledge of what this tax incentive is and how it impacts small business owners and self-employed taxpayers in general.
The pass-through deduction or QBI deduction was put into effect as a result of the Tax Cuts and Jobs Act of 2017, which was signed into order by President Trump. The deduction was designed to help business owners save money on taxes and, theoretically, boost business growth and inspire entrepreneurship.
As all deductions work, when applied, the QBI deduction subtracts a certain amount of an individual (business’s) taxable income, which in turn, reduces the amount of taxes they owe on their annual tax return. If you’re familiar with maximizing your small business budget, this should sound like a pretty valuable opportunity to save some cash. And it is! Of course, there are some restrictions on the deduction that limit eligibility to a few select groups, so it doesn’t end up being a free for all for taxpaying businesses.
The TCJA says that the following groups may be eligible to claim the pass-through deduction:
- Sole proprietors
- S corporations
- Certain trusts or estates
Keep in mind, there are additional restrictions such as income level and business type that may disqualify certain businesses from claiming the pass-through deduction. We’ll discuss how to qualify for the pass-through deduction a little later on in this post.
So, what exactly does the pass-through deduction mean?
According to the Tax Cuts and Jobs Act, eligible businesses can deduct up to 20% of their qualified business income on their annual income tax return as of January 1, 2018. If you’re wondering how to calculate the QBI deduction, you can click here to skip ahead.
What is a Pass-Through Business?
Before you get too excited about the prospect of saving money on your small business taxes, let’s ensure that you’re eligible to claim the pass-through tax deduction in the first place. In order to do that, we’ll first need to take a look at how the IRS defines a pass-through entity.
As we discussed before, the IRS says pass-through businesses must fall within one of the following business formation categories: sole proprietorship, partnership, or S corporation. But in addition, your income and business type must meet the IRS’ guidelines in order to be eligible for the QBI deduction.
Qualifying for Pass-Through Tax Deduction
In order to claim the IRS pass-through deduction, your income must meet the following criteria:
- If you’re filing single, your income must be below $157,500
- If you’re married filing jointly, your income must be below $315,000
If your income exceeds these levels, the IRS can grant or deny your claim based on the type of business you own. If you’re a doctor, veterinarian, financial advisor, or lawyer, for example, the IRS may not allow you to claim the deduction because these professions are considered specialized services trades or businesses (SSTB).
How is the pass-through deduction calculated?
Now that you know what qualifies businesses to take the pass-through deduction, let’s take a look at how to calculate the pass-through tax deduction.
1. Calculate your taxable income
2. Determine how much of your taxable income is considered qualified business income
The following are not considered qualified business income:
- Amounts paid for services that are your reasonable compensation
- Guaranteed payments to a taxpayer for services performed
- Amounts paid to a taxpayer that’s acting outside of their capacity as a partner for services
- Qualified REIT dividends
- Qualified cooperative dividends
- Income from foreign pass-through entities
- Qualified PTP income
3. 20% X QBI = The value of the pass-through deduction
In order to get a better understanding of how the QBI deduction works, let’s take a look at a fictional example.
Susie runs a flower shop as a sole proprietor. She makes $80,000 per year, so she knows she qualifies for the QBI deduction. Of her $80,000 income, Susie figures that $60,000 is considered qualified business income. To calculate how much she’ll save with the deduction, she multiplies her QBI ($60,000) by 20% to equal $12,000, which can be subtracted from her taxable income to reduce her overall tax liability.
How to Claim the Pass-Through Deduction
Let’s review. In order to claim the pass-through deduction, your business must:
- Be considered a pass-through entity
- Have an income less than $157,500 if filing single or less than $315,000 if filing jointly
- Or, if your business exceeds the income threshold, it must not be considered an SSTB
If your business income fits into the approved ranges, you can claim the QBI deduction on the standard income tax return, Form 1040. If your income exceeds the limit, you will need to complete IRS Publication 535.
What if I don’t qualify for the pass-through deduction?
If your business does not qualify for the pass-through deduction, don’t fret, because there are many other ways to save on your small business taxes as a pass-through business. Let’s review a few alternatives to the pass-through deduction.
The standard deduction is a type of tax incentive offered by both federal and state tax agencies. This deduction allows taxpayers to subtract a set amount from their taxable income based on annual income.
Itemized deductions are a list of tax incentives with assigned values that determine how much each deduction is worth. Itemized deductions are typically related to government-supported measures like integrating clean energy options, like installing solar panels at your business or donating to a local charity organization. When you add up each deduction that you qualify for, the result is the amount you can subtract from your taxable income.
Note: If you choose to itemize your deductions, you must have supporting documents, such as receipts, to prove that you qualify for the deductions that you claim.
You can only choose one method to claim deductions when you’re filing your taxes: standard or itemized. For some taxpayers, the standard deduction provides the most value because they don’t qualify for many of the itemized options, or the ones they do qualify for don’t equate to the same amount of savings. Not sure whether you should itemize or claim the standard deduction? Read our post, “Should I Use the Standard Deduction or Itemize my Taxes?”.
The pass-through tax deduction is a simple way business owners can save on their annual tax dues, but in order to qualify, you must meet the IRS’ criteria outlined above. If you’re unable to claim the pass-through deduction, don’t throw in the towel just yet. There are plenty of other ways you can save on your small business taxes. Take a look at our list of tax deductions for independent contractors for more ways to reduce your tax bill.
Looking for personalized tax help? Contact our team of tax professionals for assistance with business tax preparation services today!