The Tax Cuts and Jobs Act (TCJA) lowered all individual tax rates, but it also added a special benefit for business owners that operate as pass-through entities (S corporations and Partnerships). Certain business owners can get an additional 7% tax rate reduction. It’s important to make sure that you qualify and that your benefit will not be limited by a number of special rules that reduce the amount of the tax benefit.
Who Qualifies for the Lower Rate?
The pass-through deduction is intended to reward businesses, and all of the business activity of a typical dealership will qualify. However, the deduction generally excludes investors and many service providers, which affects dealership owners who own real estate and dealership groups that have management companies. In many cases, real estate and management companies can qualify for the deduction, but we have to take a closer look at what each company does.
Real estate owners who earn rents from a related dealership can qualify for the deduction. The dealership and real estate owner has to have 50% common ownership. If the real estate is not related to the dealership operations or the ownership test is not met, we need to look harder at what the real estate owner does for the tenant. If the rental is structured as a triple net lease, it may be hard to argue that the rental rises to the level of a “trade or business.” But if the landlord spends more time managing the property, it can often be argued that rental is a business that qualifies for the deduction.
Management companies can provide a variety of different things to a dealership group. Costs are allocated among all stores within a group, such as software charges or personnel costs. Although some of these costs could be considered services, the law only excludes “specified services,” so many management companies can still qualify for the deduction. Taxpayers should review the invoices related to intercompany charges to confirm that all of the income of the management company qualifies for the deduction.
How Do You Make Sure You Will Benefit?
Once you have determined which of your business activities qualify for the deduction, you also need to make sure that your deduction will not be limited. The 20% deduction is only available to taxpayers who pay wages or have investments in real estate. The reason for this was to provide a tax break to businesses that provide jobs or invest capital in their property.
The new law adds two additional limitations on claiming the 20% pass-through deduction. Every business that qualifies for the deduction should calculate both of these limitations and see if either apply:
- 50% of the W-2 wages reported by the business
- 2.5% of depreciable property plus 25% of W-2 wages
If 20% of the business’s income is greater than 50% of its W-2 wages (or alternatively the sum of 2.5% of its depreciable property and 25% of its W-2 wages), the deduction will be limited.
What Should You Do Now?
All business owners should take the following actions:
- Review all your business operations to determine how much of your income qualifies.
- Prepare some calculations to see the amount of the deduction. Business income and loss are both considered in calculating the 20% deduction.
- Make sure that your deduction will not be limited by the wage or asset threshold.
Wipfli’s dealership team can help you estimate your taxable income and calculate the amount of tax savings you can expect to realize. We can also help you plan to maximize the deduction if you are not getting the benefit you should. Contact us today to learn more.