New Opportunity for Pass-Through Income Tax Avoidance
If you are a business owner who receives “pass-through” income, the Tax Cuts and Jobs Act included a major provision that you need to be aware of and start planning for. The largest take away from the new legislation might be the reduction of the corporate tax rate from 35% to 21%. However, this does not help you if your business is set up as a Sole Proprietor, S-Corp, Partnership, or certain LLCs. So, in an effort to ensure some uniformity across the different types of taxable entities, the legislation included a new deduction for these non C-Corp business owners.
The new Section 199A deduction acts as a means to lower the amount of Qualified Business Income (QBI) that is subject to taxation. In its most basic form, the deduction reduces the amount of QBI that flows through to the taxpayer’s individual return by 20%. However, there are two major limiting factors that may reduce its benefit: how much taxable income the taxpayer has and the type of business being conducted.
The type of business being conducted falls into essentially one of two camps: a “specified service trade or business” or a “qualified trade or business.” A specified service trade or business is defined as “any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners…” A qualified trade or business is essentially everything outside of the definition of a specified service. The distinction matters, because if you fall into the specified service definition, the deductibility framework is much less favorable.
As a specified service, the full 20% deduction is allowed for taxpayers whose personal taxable income does not exceed $157,500, or $315,000 if married filing a joint return. However, once a taxpayer exceeds this level of taxable income, their deduction begins phasing out until it is completely gone for taxable incomes exceeding $207,500, or $415,000 if married filing a joint return.
If you fall under the qualified trade or business definition, you receive the same full 20% deduction if your taxable income does not exceed $157,500, or $315,000 if married filing a joint return. Where the calculation differs is for taxpayers in that phase-out income level and above. For taxpayers exceeding $207,500, or $415,000 if married filing a joint return, the deduction will be based upon the greater of 50% of the business’s W-2 wages or the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis of all qualified capital property in the business. Taxpayers within these two taxable income levels will realize a deduction somewhere between the 20% amount and the W-2 amount.
Knowing the mechanics of these two different taxation schemes allows us to take full advantage of some different planning opportunities. For example, the calculation of the deduction is done separately for every business that a taxpayer may be receiving income from. So let’s say that you are an optometrist who also happens to sell glasses. You could potentially bifurcate your business into separate entities for the optometry practice and the store selling glasses. The optometry practice income would be subject to the full specified service deduction phase-out, while the store selling glasses would receive the more favorable W-2 limitation.
Similarly, if you are a qualified trade or business and you know your personal taxable income for the year is going to exceed $207,500, or $415,000 if married filing a joint return, make sure you are paying out some W-2 wages from your business, or your deduction will end up being 50% of zero.
This calculation and the associated planning around it can be exceedingly complicated, but it has the potential to yield very powerful results. Huge numbers of businesses will be affected by it. It is important to begin working early with a financial professional who fully understands the intricacies and consequences of this new tax code.
Sources: Tax Cuts and Jobs Act, H.R. 1, 115th Cong. (2017), 26 U.S. Code §199A – Qualified Business Income, and Livingstone, Jane R. (Volume 100, Number 03, March 2018) New Deduction for Qualified Business Income of Pass-Through Entities: A First Look. Mar 2018. Retrieved from RIA Checkpoint database.
This is intended for informational purposes only and should not be construed as investment, tax or financial advice. Please consult with your investment, tax, and financial professionals regarding your specific situation.
Originally Published in The Voice, a publication by the Rockford Chamber of Commerce, June 2018