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Pass Thru Deduction Explained

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  • Avatar grp2c 
    Participant
    Status: Physician
    Posts: 21
    Joined: 08/13/2017

    For those who think the 50% w2 calculations applies to businesses under the taxable income limit see pages 25-26 exemption from the limit that excludes 2B which is w2 calculations.

    Click to expand…

    docnews,

    the w2 calculation exemption is looking like it will create interesting scenarios.

    Consider a married sole proprietor physician that has no employees, pays no w2 wages, and has no business property, his deduction will be the LESSER OF:

    • 20% of of the taxpayer’s “qualified business income” (QBI) or
    • THE GREATER OF:
      • 50% of the W-2 wages with respect to the business, or
      • 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property.

    Say the physician has exactly $315,000 of taxable income, then the w2 calculations would not apply and his deduction would be 20% of his “qualified business income”. It’s unclear to me if qualified business income is net schedule C or net schedule C minus deductions (SE tax, health insurance premiums, retirement contributions, etc).

    However, if he makes $315,001, now the deduction is subject to the w2 limitation.  So 50% of $0 in w2 wages is $0 and 25% of $0 w2 + 2.5% of $0 of property = $0.  The deduction would be the lesser of 20% of QBI vs. the greater of $0 or $0.  So the deduction is $0.

    Hence, his aftertax income would be significantly more by making $315,000 instead of $315,001.

     

    Per spiritrider’s post in one of my previous posts

    “I think qualified business income will possibly be the following:

    1. For S-Corps and partnerships: qualified business income = Maybe Form 1040 Line 7 (Wages) attributable to the S-Corp Form 1040 Line 17 (K1) – Line 25 (HSA deduction) and Line 29 (SE Health Insurance deduction) if run through the S-Corp.
    2. For sole proprietorships: qualified business income = Form 1040 Line 12 (Business Income) – Line 27 (1/2 SE tax) – Line 28 (SE deductible retirement plan contributions) – possibly Line 29 (SE Health Insurance deduction).

    Some of this will be subject to the IRS’ interpretation of 199A(c)(3)(ii).”

     

    #93778 Reply
    Avatar docnews 
    Participant
    Status: Physician
    Posts: 412
    Joined: 01/09/2016

    For those who think the 50% w2 calculations applies to businesses under the taxable income limit see pages 25-26 exemption from the limit that excludes 2B which is w2 calculations.

    Click to expand…

    docnews,

    the w2 calculation exemption is looking like it will create interesting scenarios.

    Consider a married sole proprietor physician that has no employees, pays no w2 wages, and has no business property, his deduction will be the LESSER OF:

    • 20% of of the taxpayer’s “qualified business income” (QBI) or
    • THE GREATER OF:
      • 50% of the W-2 wages with respect to the business, or
      • 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property.

    Say the physician has exactly $315,000 of taxable income, then the w2 calculations would not apply and his deduction would be 20% of his “qualified business income”. It’s unclear to me if qualified business income is net schedule C or net schedule C minus deductions (SE tax, health insurance premiums, retirement contributions, etc).

    However, if he makes $315,001, now the deduction is subject to the w2 limitation.  So 50% of $0 in w2 wages is $0 and 25% of $0 w2 + 2.5% of $0 of property = $0.  The deduction would be the lesser of 20% of QBI vs. the greater of $0 or $0.  So the deduction is $0.

    Hence, his aftertax income would be significantly more by making $315,000 instead of $315,001.

     

    Per spiritrider’s post in one of my previous posts

    “I think qualified business income will possibly be the following:

    1. For S-Corps and partnerships: qualified business income = Maybe Form 1040 Line 7 (Wages) attributable to the S-Corp Form 1040 Line 17 (K1) – Line 25 (HSA deduction) and Line 29 (SE Health Insurance deduction) if run through the S-Corp.
    2. For sole proprietorships: qualified business income = Form 1040 Line 12 (Business Income) – Line 27 (1/2 SE tax) – Line 28 (SE deductible retirement plan contributions) – possibly Line 29 (SE Health Insurance deduction).

    Some of this will be subject to the IRS’ interpretation of 199A(c)(3)(ii).”

     

    Click to expand…

    So the phaseout would apply so taxable income 315000 and 315001 would have the same tax since the IRS rounds to whole dollars.

    As for what is business income anything on the 1040 will probably not count. It will be in a sense “net profit” calculated entirely on the schedule c or k1  (minus all business deductions).

    #93794 Reply
    Avatar Caligas 
    Participant
    Status: Physician
    Posts: 68
    Joined: 12/19/2017

    Wait grp2c, are you saying earning more could cost you money? Great tax policy!

    #93843 Reply
    Avatar docnews 
    Participant
    Status: Physician
    Posts: 412
    Joined: 01/09/2016

    Wait grp2c, are you saying earning more could cost you money? Great tax policy!

    Click to expand…

    He was saying that but he forgot about the phaseout. See my effective marginal rates in the article. It never costs you more than you earn but during the phaseout you get to keep less of it.

    #93844 Reply
    Liked by Caligas
    Avatar Caligas 
    Participant
    Status: Physician
    Posts: 68
    Joined: 12/19/2017

    That makes more sense. A high marginal rate is one thing, over 100% is another.

    #93881 Reply
    Avatar grp2c 
    Participant
    Status: Physician
    Posts: 21
    Joined: 08/13/2017

    (2) deduction is LESSER OF:

    (A) 20% of of the taxpayer’s “qualified business income” (QBI) or

    (B) THE GREATER OF:

    • 50% of the W-2 wages with respect to the business, or
    • 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property.

     

    docnews,

    you’re correct, reading further in the law, 3(B) the phase-in limit for certain taxpayers, it states that if the taxable income exceeds the threshold but not more than $50k ($100k MFJ) and 2(B) is less than 2(A) then (2) should be determined without regard to 2(B).

    So the w-2 calculations are basically ignored for taxpayers with taxable incomes that below the threshold and throughout the phase-in.

    Incredibly confusing, seems like this could have been worded much better.

     

    Crossing my fingers that the QBI will be solely based on schedule on C and not the 1040 as a sole proprietor.  If so, having large contributions to a defined benefit plan could get my taxable income below the threshold but then the 20% deduction would not be calculated including those contributions.

    #93885 Reply
    Liked by docnews
    Avatar beagler 
    Participant
    Status: Physician
    Posts: 273
    Joined: 07/08/2017

    New Forbes article. Maybe congress screwed up meant something different re w2 and QBI. Otherwise I hope it doesn’t force me to recharacterize my single member LLC from scorp to disregarded entity sole proprietorship to get the full deduction.

    The New ‘Qualified Business Income Deduction’ Varies Based On Your Business Type – Or Does It?

    http://www.forbes.com/sites/anthonynitti/2018/01/04/the-new-qualified-business-income-deduction-varies-based-on-your-business-type-or-does-it/#31be6ef12076

    Solo Internist, Midwest

    #95770 Reply
    Liked by docnews
    Avatar Re3iRtH 
    Participant
    Status: Physician
    Posts: 145
    Joined: 09/23/2017

    So super impatient nerd who couldn’t wait for someone in the media to actually explain these details. Preface: this my amatuer read. Looking for Kitces to chime in. If you scroll through the bill this is part 2 with key stuff on this exception to exception on page 35.

    So the service industries are excluded except if your TAXABLE income is less than $315k (half if single) and phases out over next $100k ($50k if single).

    TAXABLE is the key word. This is not your net profit from schedule c. It specifies that this deduction does not help you reach this deduction income limit which doublely confirms to me that all other deductions do! Charitable giving, 401k, HSA, mortgage interest, self employment tax deduction definitely drop me personally below this limit. I suspect most IC physicians could/do drop their taxable income at least $100k from their gross income.

    I also see no language that makes sole proprietorships are excluded from this exception.

    The 20% deduction is also applied to taxable income, not net profits (as long as that is less than your net profits which should be the case unless you have other bigger sources of income other than your business). In a sense any of my deductions (especially optional ones like charity) effect is reduced by 20% once I reach the $315k number.

    Big note: AMT does apply here which means many IC physicians will likely hit it but I still have to run those numbers.

    Click to expand…

    Do I need to put my properties in LLCs in order to qualify for the 20% pass-through exemption? Lets say I earn $150K of taxable income (W-2), and $15K of net income from real estate, after expenses.

    #95777 Reply
    Avatar Re3iRtH 
    Participant
    Status: Physician
    Posts: 145
    Joined: 09/23/2017

    Sorry I ignored scorp applicable stuff because it didn’t apply to me. Here’s my interpretation:

    The deduction is whichever is less

    50% of scorp w2

    OR

    20% of all business income (w2 + dividends)

     

    So the sweet spot is 40% income to 60% dividend IF you can justify such a low income.

     

    Example: $200k in business income (20% = $40k)

    So $80k in income (50% = $40k) and $160k in dividends.

    Sweet spot = both rules equal same $40k deduction

     

    To me this plenty generous and stops scorp abusers.

     

    Click to expand…

    Although, the way you write this is confusing. Most people don’t think of W-2 income as “business income”. Businesses are sole-proprietorships, LLCs, S-Corps, and C-Corps. A employee is payed using a W-2. The hospital or military pays one with a W-2. This isn’t “business income”.

    #95781 Reply
    Avatar irb123 
    Participant
    Status: Physician
    Posts: 1
    Joined: 01/08/2018

    The actual bill has language that gives examples of just your situation White Coat Investor. The non service entity pass through will get all the favorable deductions, but since that income causes you to go over $315k (phases out at 415k), your service entity will not get any deduction. I’m not an accountant but I wonder is it possible you can have your service related income pass through your non-service corporation? If not you will get some deductions but not for the doctor stuff.

    #95812 Reply
    Avatar docnews 
    Participant
    Status: Physician
    Posts: 412
    Joined: 01/09/2016

    Sorry I ignored scorp applicable stuff because it didn’t apply to me. Here’s my interpretation:

    The deduction is whichever is less

    50% of scorp w2

    OR

    20% of all business income (w2 + dividends)

     

    So the sweet spot is 40% income to 60% dividend IF you can justify such a low income.

     

    Example: $200k in business income (20% = $40k)

    So $80k in income (50% = $40k) and $160k in dividends.

    Sweet spot = both rules equal same $40k deduction

     

    To me this plenty generous and stops scorp abusers.

     

    Click to expand…

    Although, the way you write this is confusing. Most people don’t think of W-2 income as “business income”. Businesses are sole-proprietorships, LLCs, S-Corps, and C-Corps. A employee is payed using a W-2. The hospital or military pays one with a W-2. This isn’t “business income”.

    Click to expand…

    Should I have said “your income from your business”? If it’s your business that is paying you the wages it’s still income to you coming from your business. But of course wages from another business is not your business income.

    #95835 Reply
    Avatar docnews 
    Participant
    Status: Physician
    Posts: 412
    Joined: 01/09/2016

    So super impatient nerd who couldn’t wait for someone in the media to actually explain these details. Preface: this my amatuer read. Looking for Kitces to chime in. If you scroll through the bill this is part 2 with key stuff on this exception to exception on page 35.

    So the service industries are excluded except if your TAXABLE income is less than $315k (half if single) and phases out over next $100k ($50k if single).

    TAXABLE is the key word. This is not your net profit from schedule c. It specifies that this deduction does not help you reach this deduction income limit which doublely confirms to me that all other deductions do! Charitable giving, 401k, HSA, mortgage interest, self employment tax deduction definitely drop me personally below this limit. I suspect most IC physicians could/do drop their taxable income at least $100k from their gross income.

    I also see no language that makes sole proprietorships are excluded from this exception.

    The 20% deduction is also applied to taxable income, not net profits (as long as that is less than your net profits which should be the case unless you have other bigger sources of income other than your business). In a sense any of my deductions (especially optional ones like charity) effect is reduced by 20% once I reach the $315k number.

    Big note: AMT does apply here which means many IC physicians will likely hit it but I still have to run those numbers.

    Click to expand…

    Do I need to put my properties in LLCs in order to qualify for the 20% pass-through exemption? Lets say I earn $150K of taxable income (W-2), and $15K of net income from real estate, after expenses.

    Click to expand…

    No. LLC means NOTHING to the IRS. Some people put real estate in an LLC to reduce renter liability but it means nothing to your taxes. The $15k should be on a schedule c as a sole proprietorship that needs no set-up.

    #95837 Reply
    Avatar docnews 
    Participant
    Status: Physician
    Posts: 412
    Joined: 01/09/2016

    New Forbes article. Maybe congress screwed up meant something different re w2 and QBI. Otherwise I hope it doesn’t force me to recharacterize my single member LLC from scorp to disregarded entity sole proprietorship to get the full deduction.

    The New ‘Qualified Business Income Deduction’ Varies Based On Your Business Type – Or Does It?

    http://www.forbes.com/sites/anthonynitti/2018/01/04/the-new-qualified-business-income-deduction-varies-based-on-your-business-type-or-does-it/#31be6ef12076

    Click to expand…

    Very interesting article. I have been in the minority from the beginning going with his alternate interpretations. I think the IRS will clarify. I still don’t think changing business structure will help anyone. Why would Congress want thousands of businesses to restructure? Thankfully I am below the taxable income limit so most of the confusion does not apply to me (like most docs whose gross is less than a half mil).

    #95840 Reply
    Avatar grp2c 
    Participant
    Status: Physician
    Posts: 21
    Joined: 08/13/2017

    beagler,

    Thank you for the forbes article.  This article highlights my frustration with changing advantages for s-corps vs sole prop. as income increases if owner wages reduce QBI for s-corps as the literal reading of the law implies.

     

    In regards to the phase out, I have yet to completely figure it out, but I believe for service related sole props with $0 w2 wages it’s actually an exponential phase out from the threshold to threshold + 50/100k.

    First, there is the exception for specified service related businesses based on taxpayer’s income (page 34 (3)) which proportionally reduces the QBI calculation by the amount taxable income exceeds the threshold up to the threshold + 50/100k (applicable %).  Then there’s the same proportional reduction of the excess benefit taking into account the w2 limitations (3)(B) (page 26).

     

    My interpretation:

    page 25-27

    (2) Determination of the the deductible amount:
    LESSER OF:
    (A) 20% of the “qualified business income” (QBI) or
    (B) THE GREATER OF the w-2 calculations:
    (i) 50% of the W-2 wages with respect to the business, or
    (ii) 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property.

    (3) Modifications to the limit:
    (A) Exception from the limit: If taxable income does not exceed threshold, 2 is determined without regard to 2B,
    (B) Phase-in limit:
    (i) (I) if your taxable income is b/w threshold and threshold + 50k/100k and
    (II) 2B is less than 2A then 2 is determined without regard to 2B and by reducing 2A by clause (ii),
    (ii) Amount of the reduction:
    (I) the amount taxable income exceeds threshold divided by (II) 50k or 100k times the excess amount
    (iii) excess amount = 2A – 2B

    page 34

    (d)(3) Exception for specified service businesses
    (A) if TI less than threshold + 50/100k then
    (i) service business treated as qualified business, but
    (ii) only applicable % of income, gain, deduction/loss, w2, and unadjusted basis used to calculate QBI
    (B) Applicable % = (i) amount TI exceeds threshold divided by (ii) 50/100k

     

    #95919 Reply
    Avatar pulmdoc 
    Participant
    Status: Physician
    Posts: 434
    Joined: 09/19/2016

    I think the Forbes article is wishful thinking. Yes, it makes more sense for different types of pass thru entities to be treated identically, but that’s not what the text of the law says. It’s a screwup, but one we’ll live with and plan around until the bill sunsets or is amended or repealed.

    #95924 Reply

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