A Fresh Look at the Pass-Through Deduction

The deduction is allowed for tax years beginning after December 31, 2017 and before January 1, 2026. This pass-through deduction is for sole proprietorships, S corporation, and partnerships; C corporations are not eligible.

A Quick Refresher

The pass-through deduction—found in Section 199A of the Internal Revenue Code—allows eligible owners to deduct 20% of their qualified business income (QBI). Think of QBI as income from your primary line of business. For simplicity purposes, this means that income and expenses related to investment activities would not be included in calculating your QBI. In calculating QBI, it is essential to note that reasonable compensation paid to the shareholder from an S corporation, as well as guaranteed payments paid to a partner within a Partnership, are not considered in the QBI calculation.

There are important limits to consider:

1. Exclusion for certain service businesses. If a business is considered a “Specified service trade or business” (SSTB), the deduction is subject to the thresholds noted below. Though construction is not considered to be a SSTB, consulting income earned within the construction industry is considered to be SSTB. See Planning Ideas below for more detail.

2. Wage and capital limit. When calculating the pass-through deduction it is important to note that it is limited to the greater of:

a) 50% of the taxpayer’s share of W-2 wages

OR

b) 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property

Once the two limitations above are calculated, the deduction is subject to an overall limitation equal to 20% of the excess of the taxpayer’s taxable income, less the sum of net capital gains, before considering the deduction.

The Final Regulation

Some contractors feared that the construction industry could be considered a field under the SSTB grouping since the "catch all" wording describing an SSTB included "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees." Fortunately, the final regulations do not include construction as a field under the SSTB grouping.

Another concern was for contractors that provide consulting services, since consulting is considered a SSTB. The final regulations, however, provide a de minimis exception when an entity’s gross receipts are either:

1. Gross receipts < $25 million, and 10% or less of those gross receipts are composed of SSTB income

 OR

2. Gross receipts exceed $25 million, and 5% or less of the gross receipts are SSTB-related

The final regulations also provide aggregation as a tool to help contractors minimize the impact of the wage and capital limit. Owners are given the ability to elect to aggregate separate related businesses for Section 199A purposes, so long as they are commonly owned, are part of a larger integrated business, and meet certain other requirements. The election can be advantageous and help maximize the 20% deduction.

Planning ideas

Here are some tips for maximizing the pass-through deduction:

Bundle your charges. If your business provides consulting services to construction customers, you may invoice for the consulting services (i.e. project planning and management services) and construction activities jointly to avoid SSTB treatment.

Consider hiring. If your deduction would be reduced or eliminated because the business has insufficient wages, depreciable property, or both, consider strategies for increasing them, such as aggregating related businesses or hiring employees in place of independent contractors (keeping in mind that adding employees will increase your employment tax and benefits costs).

Aggregating businesses. Consider aggregating entities that have common control. If entities are eligible for aggregation, an entity whose deduction is being limited due to insufficient W2 wages, for example, would be able to use the excess W2 wages from other aggregated entities, to maximize the deduction allowed. It is important to note that once a taxpayer elects to aggregate entities, the election can generally not be revoked

Avoiding SSTB treatment. If neither of the de minimus rules, mentioned above, apply, steps can be taken to make sure all business gross receipts are not disqualified for the pass-through deduction. Key steps include, keeping separate books and employees for each line of business. Commingling either of the two would not reflect the distinction between the consulting services and the construction activities, which could cause SSTB treatment for all gross receipts.

Watch out for employee questions/anti-abuse rules

Even if you’re otherwise eligible for the pass-through deduction, beware of new “anti-abuse” rules. For example, an employee who converts to an independent contractor status to qualify for the deduction, but who continues to perform substantially the same services, is presumed to be an employee for Section 199A purposes, and will not be eligible for the pass through deduction for a specified period of time.

In Summary

The pass-through deduction is subject to complex limits and restrictions; it is vital to contact your CPA or accounting advisor with your specific situation to determine whether you’re eligible and to identify potential strategies for maximizing its benefits.