Many investments by buyout and venture funds are made in pass-through entities, in particular LLCs that are classified as partnerships for US federal income tax purposes. The Tax Act creates a new deduction for non-corporate taxpayers who have domestic “qualified business income” (“QBI”) from flow through entities (e.g., partnerships, S corporations or sole proprietorships) (a “Flow-Through Deduction”) engaged in qualifying trades or businesses (“QTB”). The Flow-Through Deduction applies to taxable years beginning after December 31, 2017 and before January 1, 2026. The Flow-Through Deduction is generally the lesser of: (i) 20% of the QBI for the taxable year; or (ii) the greater of: (a) 50% of the W-2 wages with respect to the QTB; or (b) 25% of the W-2 wages with respect to the QTB plus 2.5% of the unadjusted basis of qualified property.
In general, QBI is income from a US trade or business, and also includes certain dividends from REITs and cooperatives and qualified publicly traded partnership income. However, QBI does not include investment income such as capital gain, dividends, investment interest income, and commodity and foreign currency gains, and does not apply to reasonable compensation for services or guaranteed payments paid to a partner for services. Except for persons with income below a threshold, the Flow-Through Deduction also does not apply to taxpayers with pass-through income from specified service businesses including those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, or which involve investing, investment management, trading or dealing in securities, partnership interests or commodities.
This provision is very complex and there is uncertainty about the application of particular aspects of the new rule. However, it is expected that the Flow-Through Deduction should benefit US individuals and other non-corporate fund investors receiving allocations of taxable income from fund investments in pass-through entities such as LLCs.