Pass-Through Entities: Can You Benefit From This New Tax Break?
The Tax Cuts and Jobs Act (TCJA), which was signed into law late last year, contains many provisions benefiting auto dealerships. These include a low flat corporate tax rate and changes to how assets are depreciated.
In addition, there is a valuable new deduction for dealerships that are structured as pass-through entities. Even some accounting experts, however, acknowledge that this new tax break is complex. Let’s look at some of its ins and outs.
Leveling the playing field
The permanent change of the corporate tax rate from as much as 35% to a flat 21% will benefit most businesses that are structured as C corporations, but not those structured as pass-through entities. These are businesses in which net taxable income flows through to the owners’ personal returns, where it’s taxed at their individual rates. S corporations, partnerships, sole proprietorships and, generally, limited liability companies (LLCs) are examples of pass-through entities.
The TCJA does reduce individual rates, too, but by a much smaller amount: The top rate drops from 39.6% to 37%. (See “New tax rates for owners of pass-through entities” for the rest of the 2018 rates.)
To help level the playing field — temporarily — Congress created a new qualified business income (QBI) deduction for pass-through entities. For tax years 2018 through 2025, noncorporate business owners can generally deduct up to 20% of QBI, subject to some limits and restrictions. Individuals, estates and trusts that own interests in pass-through business entities will generally qualify.
QBI is generally defined as the net amount of income, gain, deductions and losses generated by a business, excluding investment income such as capital gains, dividends and interest. It also doesn’t include reasonable compensation paid to an owner for services rendered to the business or any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the partnership or LLC. QBI is figured separately for each business activity, instead of on a per-taxpayer basis.
With the individual rate cuts and this new deduction, the TCJA effectively lowers the top tax rate for pass-through entities by a full 10 percentage points — from 39.6% before tax reform to 29.6% now.
Devil’s in the details
Congress included some detailed rules in the legislation to limit the cost of the deduction (in terms of lost government revenue) and curb potential abuses. Specifically, your dealership may need to pass a “wage and capital limit” test. Your deduction may be reduced or eliminated if it exceeds the greater of:
• 50% of W-2 wages paid by the dealership, or
• The sum of 25% of W-2 wages paid by the dealership plus 2.5% of the unadjusted basis of all qualified business property.
Qualified business property is tangible, depreciable property 1) that’s held or available for use by your dealership at the close of the tax year, 2) that’s used at any point during the taxable year in the production of QBI, and 3) for which the depreciable period hasn’t ended before the close of the taxable year.
The wage and capital limit is phased in starting at an income threshold of $157,500 for single filers and $315,000 for married couples filing jointly. It fully applies once income reaches $207,500 for single filers or $415,000 for joint filers.
The QBI deduction isn’t allowed in calculating the owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction — though you don’t have to itemize to claim it.
Finally, note that the QBI deduction can’t exceed your dealership’s taxable income for the year. If the net amount of your QBI is a loss, you can carry this amount forward to the following year.
Expert advice needed
The new QBI deduction could be a valuable tax break for dealerships structured as pass-through entities. As you can see, though, the details are complex. Therefore, you should speak with your tax advisor about how your dealership might benefit from this provision.
New tax rates for owners of pass-through entities
In addition to creating a new deduction for owners of pass-through entities (see main article), the new tax law generally lowered the individual tax rates that apply to pass-through income. If your dealership is structured as a pass-through entity, your income will be taxed in 2018 as follows:
Tax rate Filing status and income level
Single Married filing jointly
10% $0-$9,525 $0-$19,050
12% $9,526-$38,700 $19,051-$77,400
22% $38,701-$82,500 $77,401-$165,000
24% $82,501-$157,500 $165,001-$315,000
32% $157,501-$200,000 $315,001-$400,000
35% $200,001-$500,000 $400,001-$600,000
37% Over $500,000 Over $600,000