We sent out a summary of the 20% tax deduction yesterday and have come to realize that there was a misstatement in the example. Below is an updated example to correct this. If you have any questions, please contact us.
The Tax Cuts and Jobs Act signed into law by President Trump late in 2017 established a new deduction for owners of passthrough businesses (S-Corp, Partnership, LLC's) and Schedule C, F and Form 4835 filers. This deduction is a game changer and creates opportunity for all business owners to do some significant tax planning. The calculation at its core sounds simple, but as with most tax law there are several exceptions and hoops to jump through as a taxpayer's income rises. We are expecting the IRS to issue regulations to clarify several questions regarding some of the details of the calculation and who qualifies, but now is the time to get started planning for this new deduction.
The deduction is calculated on the business owner's individual tax return. It is not a deduction on the business' financial statements or tax return. In its simplest terms the deduction is 20% of the lesser of Taxable Income or Qualified Business Income. Taxable income is exactly what you think it is, the calculated amount on Page 2 of Form 1040. Qualified Business Income is the income or loss passed through from a S-Corporation, Partnership or LLC and the net income or loss reported on Schedule C, E, F or Form 4835. It, however, does not include income items such as interest, dividends and capital gains. Let's look at a simple example: Taxpayer A owns an S-Corporation and it generates $50,000 of income. Taxpayer A and his wife have total taxable income of $125,000. The deduction is 20% of the lesser of qualified business income or taxable income. In this case the deduction is $10,000 which is 20% of the $50,000 of income from the S-Corporation.
As taxable income increases so does the complexity of this calculation. Once taxable income reaches $157,500 for a single person or $315,000 for married couples filing joint returns, two limitations to the deduction begin to be phased
in. At these income levels, the deduction is potentially limited by the wages paid by the business and/or the cost of the fixed assets owned by the business.
The first potential limitation is the wage limitation. The limitation is 50% of wages paid to all employees, including owners. The second potential limitation is the wage and capital limitation. Here we must take 25% of wages paid to all employees, including owners, plus 2.5% of the cost of fixed assets that are still in service and being depreciated.
Let's look at an example that includes the income limits: Taxpayer B and Spouse have taxable income of $525,000. This includes income from a Partnership of $225,000. The Partnership paid total wages of $75,000 and 2.5% of its depreciable property is $5,000. Step 1 is to calculate the deduction just like we would without respect to the wage and wage and capital limitations. In that case the deduction is 20% of the lesser of taxable income or qualified business income. Therefore the deduction is tentatively $45,000 ($225,000 x 20%). However, since taxable income is over the $315,000 threshold for a married couple we must look at the wage & wage and capital limitations. So, Step 2 is to calculate 50% of wages paid, or $37,500. Step 3 requires us to calculate 25% of wages plus 2.5% of the cost of depreciable property. This calculates to $23,750 ($18,750 in wages plus $5,000 in assets). We need to compare the tentative deduction we calculated in Step 1 of $45,000 to the greater of: the wage limitation in Step 2 of $37,500 or the wage and capital limitation of $23,750 in Step 3. As the deduction is the lesser of Step 1 versus the greater of Step 2 or Step 3, we see that our deduction will be $37,500.
Specified Service Business
Income from specified service businesses is not considered Qualified Business Income and may not be eligible for the deduction. This only applies to taxpayers above the $157,500 and $315,000 thresholds discussed above. If you have a specified service business and your taxable income is below the thresholds you are eligible for the full deduction. Specified service businesses with taxable income between $157,500 and $207,500 for single taxpayers and between $315,000 and $415,000 for married taxpayers receive a partial deduction. Any taxpayers with specified service business income above $207,500 single and $415,000 married receive no deduction.
Specified service business is defined as the following: health, law, consulting, accounting, performing arts, actuarial services, athletics, financial services, brokerage services and 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. That last item is meant to be a catch all. An example that would fall into that category is a real estate agent.
As you might imagine this calculation can get complex quickly and there are several other factors that might need to be considered including a situation where there are multiple businesses, when losses occur, or situations where income falls in the middle of the phase in range for the wage and capital limitations. However, this new law does open the door to some planning ideas.
For example, owners of S-Corporations will want to take a look at the wages they pay themselves. It might be a good idea to limit the wages as much as possible to maximize qualified business income. Although you must be careful with this as S-Corporation owners must take a reasonable salary.
Owners of businesses that fall into the specified service category may want to consider spinning off a portion of their business into a new entity that wouldn't fall into that category. For example, an optometrist who sells eyeglasses may want to spin off the sale of glasses to a separate entity to create qualified business income. This could work well for business owners above the thresholds as a taxpayer below the threshold would receive the deduction anyway.
Members of an LLC taxed as a partnership may want to consider removing any provisions in their agreements regarding paying guaranteed payments. Eliminating guaranteed payments would help maximize qualified business income.
These are just a few ideas that may work for you.
Please also keep in mind that the IRS is expected to issue regulations on this deduction in the coming months. Some items we expect they will address specifically are the definition of a specified service business and if this deduction will apply to certain rental properties. These regulations could alter some of the assumptions we have made regarding the law.
Each taxpayer is unique and the complexity of this law and calculation require us to look at all of our clients on a case by case basis. We strongly encourage you to contact us as soon as possible to begin looking into how the new tax law and specifically this provision will affect your specific tax situation.