What Is the Tax “Pass Through” Rule?

Unlike corporations, which distribute profits to shareholders via dividends, pass through businesses’ profits go right to their owners, essentially “passing through” the books of the business. As a result, these funds count as individual income tax, and the owner pays taxes on them at the same rate he or she pays income tax. There are a number of different types of pass-through companies out there, including sole proprietorships, partnerships, S corporations, limited liability companies, and limited liability partnerships. All in all, the majority of businesses in the United States – or about 92 percent – are pass-through businesses.

Trump’s Tax Cuts and Job Act, which was signed into law in December 2017, has made changes to how this pass through income is taxed at the federal level, a move which has proved controversial. Republicans say that the move is a big win for small businesses, while Democrats allege that it is only going to make the wealthy even wealthier. What, exactly, are the changes, and why are they so controversial? Luckily, we’re here to break it down for you.

The Tax Cuts and Jobs Act and the “Pass-Through” Rule

Before the Tax Cuts and Jobs Acts, the owners of pass through businesses paid tax on these profits at the individual income tax rate – not the corporate tax rate. That meant many small businesses were paying tax at rates as high as 39.6 percent, the highest individual income tax bracket. Under the Tax Cuts and Jobs Act, however, qualifying pass through businesses can now deduct up to 20 percent of qualified business reduction. In other words, if a pass-through business has a net income of $100,000 the owner can exclude 20 percent of that from taxation, meaning that he or she only has to pay tax on $80,000 of the $100,000 net income.

A Benefit for Small Business Owners or a Boon for the Wealthy?

This change to the pass through rule is good news for many small business owners, and Republicans have championed the bill as a major gain for these entrepreneurs, claiming that it will help to create jobs by creating big savings for business owners. So, why the controversy?

There are a few caveats to the pass through rule. Firstly, in order to qualify, taxable income must be below $157,500 for those filing a single return or $315,000 for those who are married and filing jointly. When income exceeds these thresholds, there is a limit on who can claim the deduction and how much they can benefit from it. For example, businesspeople with services businesses, such as financial and tax advisors, doctors, and lawyers, are unlikely to be able to take advantage of the deduction if their income exceeds the threshold. However, a “capital element” in the formula used to determine eligibility beyond these formulas do present a very lucrative tax break for several categories of taxpayers, including wealthy individuals who own commercial property, much to the ire of Democrats.

A significant giveaway in the conference bill weakens the requirement for high-income owners to pay employee wages to be eligible relative to what was in the original Senate bill,” 13 tax law experts explained in analysis of the final tax bill. “This addition will expand the ability of highly paid owners in certain industries – and particularly those heavy in property but light in employees, like real estate – to qualify for the pass through deduction . . . Real estate firms with high original basis and few employees should be able to more easily access the preferential rate.”

The bottom line? Controversy on the pass through rule probably isn’t going to go away anytime soon. But this specific provision of the Tax Cuts and Jobs Act is set to expire in 2025, meaning that it will disappear in 2026 unless Congress takes action before then to extend it.

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