Under the new Tax Cuts and Jobs Act, pass-through business owners can claim a 20% deduction on the “qualified business income” conditional to certain criteria (Sec. 199A). Qualified business income deduction impacts Pass-Through businesses such as S-corporation, sole proprietorship or partnership which do not pay corporate tax rates. In fact, when people refer to businesses as “Small” businesses meaning S corporations or partnerships, they do not realize that nearly 95% of all American businesses are actually flow through entities. Owners of these entities pay a single tax unlike the stratified taxation of C corporations. Generally, the tax rates for these entities are lower than C corporations which is added advantage aside from simplified taxation. The resultant profits from paying lower taxes are filed as “pass-through business income” as a part of their individual income tax returns.
This depends on if the taxable income is above or below a threshold amount ($157,500 for individuals and $315,000 for married joint filers):
- When taxable income is below threshold, the deduction is simply 20% of the business income.
- When it is above threshold, limitations on the deduction apply depending on the taxable income, W-2 wages and applicable percentage.
The taxable or Qualified Business Income (QBI) specifically, varies just like W-2 wages based on the specified service, trade or business*.
*defined as any trade or business where the primary asset is skill or reputation
Calculating deductions in certain cases:
Case 1: An individual’s taxable business income is $300,000 and has a W-2 wage share of $200,000.
In this case, the deductible amount will be the lesser amount between (a) 50% of W-2 wage share and (b) 20% of business income share. In this case (a) is $100,000 and (b) is $60,000. Therefore, the amount the person can claim as deduction here is $60,000.
Case 2: An individual’s share in buying property co-owned by 4 is $3M and his annual rental income is $1M.
In this case if no W-2 wages are payed, the individual cannot claim a deduction under the former tax policy. The reforms allow the individual to claim a deductible amount that is the lesser between (a) 20% of rental income and (b) 25% of W-2 Wages + 2.5% of property purchase share. In this case (a) is $200,000 and (b) is $75,000. Therefore, the individual’s deduction in this case would be $75,000
Additional Notes: Deductions generally cannot exceed 50% of an individual’s W-2 wage share from business. Certain individuals involved in businesses rendering personal services in cases such as accountants or lawyers cannot avail the deduction if their income is above the threshold amount.
- For Specified trade and businesses, partial deductions can be availed if taxable income is between threshold amount $157,500/$315,000 and $207,500 / $415,000 – phase in range
- Taxable income takes the limelight as a major factor in determining whether a specified trade, business or others qualify for a pass through 20% deduction.
- The taxable income reported should include taxable income from ALL sources.
- Given that W-2 wages are factored in calculating the deductible, with the inclusion of the depreciation component it can act as a limiting factor.
- It may be the case for some owners that self-employment taxes are calculated on the net business income pre-deduction. This means they maybe paying higher self-employment tax than expected. The jury is still out on this point though.
- Structuring the business as an S corporation can help save on taxation.
Optimizing tax savings for businesses:
An important point for business owners to note is optimizing W-2 amounts that are paid out. Low W-2 salaries can limit the amount of deductions that can be availed under the Sec. 199A amendments. However, higher W-2 salaries may mean paying higher self-employment tax. Unless there is official clarification from the IRS regarding aspects of this amendment, it is still hard to say how small or pass through businesses can better utilize this change.
Get details on Advisory And Valuation Services, Reasonable Compensation Report for S Corporation and IRS Audit, 2018 Tax Reform – New Tax Rates for businesses, Qualified business deduction, depreciation rates and accounting methods and 2018 Tax law update for Individuals.