The Tax Cuts and Jobs Act that was signed into law in December has left CPAs and tax attorneys scrambling to understand exactly what it means for taxpayers.
We at Earney & Company are working diligently to understand the impact for our clients. There are far too many changes to cover in one post, but we will try to cover the changes over a series of posts to help our clients and the community understand the changing landscape.
One of the major changes for business owners is related to the taxation of pass through entities and a new deduction related to that income. Pass through entities consist of S Corporations and partnerships and refer to entities where the income/loss “passes through” to the owner and the tax implications are calculated on the personal return.
This is in contrast to C Corporations, which pay tax at the entity level. Pass through entities pay no tax at the entity level and instead the owners pay tax on their individual returns. The new tax law created a deduction for pass through income in an effort to provide these business owners with lower taxes, since they will not get the benefit of the lower corporate rate.
The deduction is 20 percent of your “qualified business income (QBI)” from a partnership, S corporation or sole proprietorship, defined as the net amount of items of income, gain, deduction and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. However, it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20 percent of the excess of your taxable income over net capital gain. If QBI is less than zero, it is treated as a loss from a qualified business in the following year.
Rules are in place (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
Here’s how the phase-in works – If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, viz., $415,000.) If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. So, for example, if taxable income is $167,500 ($10,000 above $157,500), only 20 percent of the specified service income would be excluded from QBI ($10,000/$50,000). For joint filers, the same operation would apply using the $315,000 threshold, and a $100,000 phase-out range.
Additionally, for taxpayers with taxable income more than the thresholds mentioned above, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element.
Here’s how it works – If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50 percent of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25 percent of such wages plus 2.5 percent of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20 percent of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000.
And if your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via the fraction discussed in the preceding paragraph. (For joint filers, the same operations would apply using the $315,000 threshold, and a $100,000 phase-out range.)
This new law has a lot of areas to plan around and this deduction is certainly one of them. It is important to understand how this change will affect you and whether those effects could trigger a change in structure, etc.
We are glad to discuss the impacts of the new tax bill with you and welcome the planning opportunities that this new law has given us.