The Tax Cuts and Jobs Act (TCJA) made permanent and temporary changes to the tax rates for all entities and individuals. Among the permanent changes was the shift in the C corporation tax rate to a flat 21% beginning in 2018. For manufacturing entities that operate as a “pass-through” (i.e., sole proprietorship, partnership, and S corporations) their income is still passed down to the individual business owners. This means that the “tax-cut” did not cut the tax rate of pass-through entities directly. To help balance the scale, TCJA created a “qualified business income” (QBI) deduction through 2025. There are many hurdles to clear to enable you to take advantage of the QBI deduction, but if you meet all of the qualifications, you could take the full 20% deduction.
What makes a pass-through so appealing to manufacturing?
Many manufacturing entities are classified and taxed as one of the following entity types:
The main advantage of these structures versus a C corporation is avoiding double taxation. The C corporation is taxed on the money it makes when it is earned and again when a C corporation pays dividends. Pass-through entity structures allow the income to flow through to each individual owner’s tax return and be reported there. Once the income is taxed at the individual level, it is not taxed upon distribution to the individual.
How did the rates change under TCJA?
C corporations had two significant changes to their tax rates. First, the rate was changed from a tax bracket structure to a flat 21%. Second, the alternative minimum tax (AMT) for C Corporations was repealed. C Corporations are still subject to double taxation.
The income tax rate cuts are less significant and only temporary (from 2018 through 2025) for individual tax payers under the new tax law. Although the individual AMT still exists under the TCJA, the exemption amount and phase-out thresholds were increased through 2025, meaning fewer individuals will be impacted by the AMT tax.
TCJA also creates a new Qualified Business Income (QBI) Deduction which we will discuss below, that helps to offset the difference in tax rates between C Corporations and individuals owning pass-through entities.
QBI
For tax years beginning after December 31, 2017, the QBI deduction will be available to non-corporate owners of qualified businesses, including individuals, estates, and trusts. The deduction will equal 20% of QBI, subject to certain restrictions.
The QBI deduction is reported at the individual level and reduces taxable income by the amount of the deduction.
QBI is defined as the partner or shareholder’s allocated portion of taxable income, gain, deductions, and loss from a qualified business, without making AMT adjustments. QBI does not include investment-related items (such as capital gains and losses, dividends, and interest income), reasonable owners’ compensation, or guaranteed payments from a pass-through business to its owners.
The QBI deduction and applicable limitations are determined at the individual owner level. All of the information necessary to make the calculations should be reported by the business to the partner or shareholder on their respective Schedule K-1s.
How to calculate the deduction
The first thing to consider is the individual’s total taxable income. If the individual’s income is less than $157,500, or $315,000 for a married joint filer, then they can take the full 20% deduction without limits. When their income rises above those levels, the following restrictions are phased in over a $50,000 taxable income range for unmarried filers or over a $100,000 taxable income range for married joint filers.
Service business limitation. This doesn’t generally affect manufacturers unless a principal asset of the business is the reputation or skill of one or more of its employees. If the service business limitation applies, then there is no deduction allowed.
W-2 wage limitation. This limits the QBI deduction to the greater of the non-corporate owner’s share of one of the two following:
Qualified property is depreciable tangible property (including real estate) owned by a qualified business as of the tax year-end and used by the business at any point during the tax year for the production of QBI.
Taxable income limitation. Your QBI deduction can’t exceed 20% of taxable income calculated before the deduction and excluding long-term capital gains and dividends.
As always, it is crucial to reach out to a trusted advisor such as the professionals at Lane Gorman Trubitt, LLC to make sure that all the hurdles involved in this process are overcome.