Treasury unveils new tax rules for ‘pass-through’ companies

Small business owners may have a few more answers if they’re hoping to take advantage of a major business tax break tucked in last year’s new tax law.

The Treasury Department and Internal Revenue Service released on Wednesday long-awaited guidance on how US taxpayers can claim a 20% deduction on income for owners, partners and shareholders in so-called pass-through entities — e.g. S-corps, LLCs, partnerships and sole proprietorships.

The proposed changes are part of a sweeping $1.5 trillion tax overhaul, which provided deep tax cuts for businesses, including setting a new corporate tax rate at 21%, down from 35%.

“The pass-through deduction is an important tax cut for small and mid-size businesses, reducing their effective tax rates to their lowest level since the 1930s,” said Secretary Steven Mnuchin, in a statement. “Pass-through businesses play a critical role in our economy.”

Owners of pass-through businesses, who pay taxes on their profits at the owner’s individual tax rate, have wrestled with an additional dose of complexity about whether they qualify for the deduction.

The new guidance answers two big questions, said Nicole Kaeding, director of federal projects at the Tax Foundation.

First, it clarifies how companies that have multiple sources of income from various business lines can claim the deduction. Many larger pass-throughs were concerned they would not be able to take advantage of the full deduction without restructuring their business. Companies will now be allowed to aggregate pass-through income from multiple sources as single business income under the new guidance, Kaeding said.

Second, the guidance clarifies what businesses cannot use the deduction because they are based on the “reputation or skill” of an employer or owner. The guidance narrows the definition to specify just those individuals who receive endorsement deals, licensing income, or appearance fees, Kaeding said.

“It will probably exclude someone who is paid to be on TV or radio, but not someone who is a niche industry consultant,” she said.

The guidance also reiterates previously outlined rules about the deduction. Americans with taxable income no more than $157,500 (or $315,000 if married filing jointly) automatically qualify. Those that earn more are subject to a complex set of a rules to figure out whether they can claim it.

The law also prohibits service businesses in certain industries from taking the deduction, including health, law, accounting, actuarial sciences, athletics, consulting, financial and brokerage services and the performing arts.

The public will be allowed to comment on the new guidance before it goes into effect.