The recently enacted Tax Cuts and Jobs Act creates a new deduction for individuals and trusts that own pass-through entities such as partnerships, LLCs, and S corporations. As a general rule, the deduction is equal to 20 percent of income from each trade or business, including trades or businesses of pass-through entities. The deduction cannot exceed the greater of:
- 50 percent of wages paid by the trade or business
- 25 percent of wages paid by the trade or business plus 2.5 percent of the original tax cost of certain depreciable assets (the capital limitation)
The deduction is generally not available for specified service businesses. Specified service businesses generally include personal service businesses such as those practicing accounting, law, consulting, or medicine, with the exception of some architects and engineers.
The calculation of the pass-through entity deduction and related wage and capital limitation is done for each trade or business. If an individual taxpayer owns interests in two pass-through entities and each pass-through entity is in a qualified trade or business, the individual will have little difficulty computing the pass-through entity deduction. However, if the individual has elected to group the activities under Section 469, the calculation of the pass-through entity deduction could take on additional complexity.
Consider the following example. An individual owns an interest in two pass-through entities (PTEs), PTE 1 and PTE 2. PTE 1 operates a retail clothing business. The individual does not actively participate in PTE 1’s retail business. PTE 1 pays significant wages. PTE 2 manufactures clothing that is sold to PTE 1. The individual actively participates in PTE 2. Additionally, PTE 2 uses contract manufacturers, has no depreciable assets, and pays a nominal amount of wages. The individual appropriately grouped the trade or business activity of PTE 1 and PTE 2 as a single activity for purposes of Section 469.
In 2018 the taxpayer receives the following K-1s:
|PTE 1||$(1 million)|
|PTE 2||$11 million|
Because of the Section 469 grouping, the taxpayer will report one activity with $10 million of profit. The taxpayer may think it is entitled to a $2 million pass-through entity deduction with taxable income of $8 million. However, absent any guidance from the IRS, this is not the case. The Section 469 regulations clearly limit the applicability of the grouping election to the Section 469 passive loss rules. Because the grouping rules don’t apply to the pass-through entity deduction, each K-1 activity must be evaluated separately.
PTE 1 has a $1 million loss, so a pass-through entity deduction is not available. Because PTE 2 has no wages or depreciable assets, the individual will not be entitled to a pass-through entity deduction even though PTE 2’s K-1 reflects $11 million of income. As a result, the individual will have $10 million of income from PTE 1 and PTE 2 with no pass-through entity deduction.
A similar outcome could occur if a pass-through entity has two trades or businesses and the pass-through entity has appropriately grouped the two trades or businesses as one activity. In this case, the pass-through entity likely would be required to report the profits and related wage and capital limitation of each trade or businesses separately even though the K-1 would show only the combined income.
It remains to be seen if the IRS will provide relief from this complexity. Until such guidance is issued, individuals and trusts eligible for the pass-through entity deduction should be prepared to compute the deduction without considering grouping under Section 469.