One of the most talked-about provisions of the 2017 Tax Cuts and Jobs Act is the 20 percent deduction on pass-through income from sole proprietorships, partnerships, S corporations, and LLCs. Because so many construction-related businesses are organized as pass-through entities, many contractors have greeted this provision with understandable enthusiasm.

It is important to remember, however, that the 20 percent deduction is subject to some complex limitations. In addition, contractors must consider how some other elements of the new tax law will interact with the pass-through deduction.

Examples include the elimination of the corporate Alternative Minimum Tax (AMT), higher exemption levels for the personal AMT, and provisions that give small contractors more flexibility in choosing their accounting methods. Because of these interacting variables, owners of pass-through businesses will need to work closely with their accountants to apply the deduction properly.

A Closer Look at the Deduction
Starting in 2018, C corporations are taxed at a flat rate of 21 percent. But owners of pass-through entities are taxed on earnings at individual tax rates, which still could be as high as 37 percent under the new law. To balance out this disparity, the law allows sole proprietors, partners, and owners of pass-through entities to claim a below-the-line deduction of 20 percent of their net “qualified business income.”

The term “qualified business income” does not include wages that are paid to S-corporation shareholders and reported on their individual Forms W-2. Rather, the deduction applies only to the S-corporation profits that are reported to shareholders on Form K-1. Similarly, qualified business income also excludes guaranteed payments associated with partnerships and LLCs.

The deduction begins to phase out if the individual’s taxable income (including income from all other sources) exceeds $157,500 (or $315,000 if filing a joint return). The phaseout is calculated using several formulas that take into account the total wages paid to all employees and other factors.

What Is “Reasonable Compensation”?
While S corporation owners might be tempted to reduce their W-2 wages to create more pass-through income, they still must adhere to the IRS requirement that S corporation officers must be paid “reasonable compensation.” The IRS provides only limited guidance as to what is considered reasonable, but it has developed a list of nine specific factors that U.S. tax courts have considered in such cases. These factors are
1) The duties and responsibilities of the shareholder.
2) The time and effort the shareholder devotes to the business.
3) The shareholder’s training and experience.
4) Payments the company provides to non-shareholder employees.
5) The timing and manner in which the corporation pays bonuses.
6) The company’s dividend history.
7) What comparable businesses in the industry pay for similar services.
8) The existence of written compensation agreements.
9) Any documented formulas the company uses to determine compensation.
The more of these factors a taxpayer can demonstrate, the better the chances of convincing the IRS that officers’ salaries are reasonable.

For S corporations—and all other types of pass-through entities—there are still several unanswered questions regarding the new deduction. While tax professionals urge the IRS to provide additional guidance soon, contractors whose businesses are structured as pass-throughs should continue to monitor developments and, in the meantime, take care that the salaries they pay themselves and other active shareholders will stand up to scrutiny.