When sweeping tax reform passed in December, 2017 small business owners rejoiced over a new tax deduction aimed specifically at small businesses with pass-through income. This tax deduction is referred to as the Qualified Business Deduction (QBD) and it will apply to taxpayers with business income from pass-through entities. Unsurprisingly, this tax deduction is not as straight-forward as some would expect. Ironing through the details for tax planning purposes has been difficult and professionals continue to look for guidance from updated IRS regulations.
Below is a brief summary on what the Qualified Business Income deduction is.
With consideration to Qualified Business Income (QBI), business owners will receive a potential deduction of:
The lessor of 20% of their qualified business income or 20% of their taxable income when below applicable income thresholds. The income thresholds start at $157,500 (taxable income) for single filers and $315,000 for joint filers.
Example – John has $150,000 of qualified business income in 2018. After deductions, John’s taxable income is $100,000. The deduction will be = 20% of $100,000, totaling $20,000.
Business owners whose taxable income exceeds the above thresholds will be categorized into two groups, “specified service” businesses and everything else. Specified service businesses include professionals like doctors, lawyers, CPAs, financial advisors and any other business which the principal asset is the skill or reputation of the professional.
Specified service businesses receive the least favorable treatment. If non-joint fillers exceed $50,000 more than the taxable income threshold (totaling $207,500) and joint-filers exceed $100,000 more than their threshold (totaling $415,000), they will not be eligible for this deduction at all. If their taxable income lies somewhere in this threshold they will receive a partial deduction.
Business owners who derive income from non-specified services may still be able to take a qualified business deduction if they exceed the upper income limits mentioned above. Instead of using the 20% rule, the amount of their deduction will be the greater of 50% of W-2 wages paid by the business generating the qualified business income, or 25% of W-2 wages plus 2.5% of the unadjusted basis of depreciable property owned by that business.
Example – John files single and his taxable income is $250,000. Because John’s own’s a retail business that doesn’t fall under the specified service rules, John can still take a deduction even though his income is above the threshold maximum of $207,500. John will take 50% of his W-2 wages, which were $70,000, resulting in a $35,000 deduction. If John’s business falls under the specified service rules, his deduction would be $0 in this scenario.
Tax Planning Considerations
The tax planning implications of this new tax law are significant. If you receive qualified business income you will want to consider how some of the following tax planning strategies may apply to you.
Consider strategies aimed at reducing income. For example, someone close to the income threshold may want to defer more money in a 401k or IRA. Reducing taxable income below the income threshold will do more than just reduce your income at your marginal tax rate, it will increase your qualified business deduction, significantly increasing your marginal tax savings. Some calculations have shown that the marginal tax savings on reducing income in these scenarios can reach as high as 50%!
Business strategies should also be evaluated and can include evaluating your compensation structure and entity selection. In some cases employees may want to switch to being paid as independent contractors, and in other cases independent contractors may want to be switched to being employees. It’s also possible that an S Corp business should be converted to an LLC or C Corp, depending on the owners compensation structure.
These examples are just the tip of the iceberg. What’s important to understand is that proper tax planning in this area can save almost twice as much in taxes than in the past. If you or someone you know need tax planning in this area contact your CPA as soon as possible or call us at 480-818-8300 for a consultation.