If your business is a sole proprietorship, partnership, limited liability company, or S corporation—all pass-through entities—you report your share of business net income or loss on your personal federal tax return. Being a pass-through owner has its rewards…and punishments.
Reward for profitability
If your business is profitable, you may be able to claim the qualified business income (QBI) deduction. This is up to 20% of your share of net income from the business. This is not a business deduction; it’s a personal one that has the effect of reducing the tax rate on this business income. The Tax Foundation says that the QBI deduction reduces marginal tax rates on QBI income by 2 to 7 percentage points, depending on the owner’s income. The QBI deduction isn’t permanent in the tax law and is scheduled to expire at the end of 2025 unless Congress extends it.
Punishment for being too profitable. The QBI deduction becomes highly complex and is subject to various limitations when your taxable income exceeds a threshold amount based on filing status. The threshold amount is adjusted annually for inflation. For 2022, the threshold amounts are $340,100 for joint filers and $170,010 for other filers. The QBI deduction is then limited to a formula, which is the lesser of (1) 20% of QBI, or (2) the greater of (a) 50% of total W-2 wages paid by the business to employees, or (b) 25% of W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of depreciable tangible property owned by the business.
Those in specified services trades or businesses (SSTBs), such as doctors, lawyers, and accountants, have an additional limit on the amount of QBI that can be taken into account in figuring the QBI deduction. If taxable income exceeds the same threshold amounts above, then the deduction phases out over the first $100,000 for joint filers and $50,000 for other filers. This means that for 2022, those in SSTBs, no QBI deduction may be claimed once taxable income reaches $440,100 for joint filers and $220,050 for other filers.
Punishment for being a silent partner. If you invest in a business but don’t participate in day-to-day activities, your share of the profits may be subject to a 3.8% net investment income (NII) tax. This is in addition to the regular income tax you pay on this income.
Punishment for losses
Having business losses are punishment enough, but tax rules can add insult to injury. If your business isn’t profitable, net losses passed through to you may be deductible on your personal return, which effectively reduces the tax you pay on other income, such as wages and interest income. This could be viewed as a reward. But if your losses are too great, there’s a limit on noncorporate taxpayers’ (i.e., pass-through owners’) excess business losses that are currently deductible. Excess business losses are the amount by which the total deductions attributable to all of your trades or businesses exceed your total gross income and gains attributable to those trades or businesses plus a threshold amount adjusted for cost of living. For 2022, the threshold amounts are $540,000 for joint filers and $270,000 for all other filers.
The excess business losses limitation was supposed to expire at the end of 2025. As a revenue raiser, the American Rescue Plan Act of 2021 extended the limitation through 2026 and now the Inflation Reduction Act of 2022 extends it for two additional years—through 2028.
The excess business losses, which can’t be currently deducted, aren’t lost for tax purposes forever. The amount that can’t be deducted currently becomes part of your net operating loss (NOL). The NOL may be used in future years to offset 80% of taxable income in those years until it’s used up. In the past, NOLs could be carried back to offset taxable income in prior years and create an immediate tax refund (cash that could be helpful for an unprofitable business). The carryback ended in 2020, other than for farming businesses.
The tax rules for handling profits and losses on a pass-through owner’s personal income tax return are complex. Be sure to work with a CPA or other tax adviser to determine which rules apply to your situation and whether there are strategies you can use to improve your tax results.