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Does the new tax law impact the pass-through deduction?

There are many different business practices that can reduce tax obligations. Recent changes in the law can impact the impact of various practices. One specific question involves the impact of recent changes on the pass-through deduction.

This piece focuses specifically on the impact of the new law to businesses that use pass-through deductions. The pass-through deduction is of particular interest to sole proprietorships and S-corporations. An S-corporation is a corporation that has properly elected subchapter S status under the Internal Revenue Code.

Some business owners choose subchapter S status for their corporation to take advantage of the pass-through deduction. Unlike C corporations, taxable income of S corporations is not subject to double taxation.

How does the new law impact the pass-through deduction? The previous tax law required small businesses owners pay income tax on earnings of pass-through businesses based on their individual tax rate. The new law is different. It allows a deduction of 20 percent of qualified business income. Owners of entities eligible for this deduction can stand to see a tax reduction due to this change.

Two key points that business owners who believe they qualify for this deduction should take into account include:

  • Make sure the income is qualified. Qualified business income is generally  directly connected to the business. Investment-related income like capital gains do not qualify.
  • The IRS is watching. The Internal Revenue Service expects that those who work for an entity taking the 20% deduction receive reasonable compensation. A failure to meet this expectation can trigger an audit and potential tax penalties.

It is wise to review strategic tax planning for your business to see how these changes will play out in 2018. An attorney experienced in these matters can provide assistance, better ensuring your strategy translates to real savings.

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