How Do I Qualify for the New Business Income Deduction?
President Trump signed into law the new tax reform on December 22, 2017. One of the biggest changes under the new reform is the up to 20% tax deduction of qualified business income for flow-through business entities subject to limitations. This deduction, starting January 1, 2018, will allow the business owners that qualify to save thousands on their taxes. However, with the corporate rate reduced from 35% to 21%, certain qualifying business owners will need to review whether they should change to a C-corp. Depending on business owners’ filing status, total taxable income, and business entity, the amount of savings could differ significantly. Continue reading to determine how you can qualify for the new business income deduction.
What Flow-Through Entities are Eligible for the Business Income Deduction?
- Do LLCs (Limited Liability Companies) qualify for the Small Business Income Tax Deduction? Yes and No. When you set up the business, if you elected to be treated as a corporation, then no. However, if you elected to be treated as a partnership or disregarded separate entity, then yes, you could qualify depending on the other limitations. If you do not remember which election you chose with the IRS or want to change your election, contact the professionals at Gudorf Tax Group for assistance.
- Do S-Corps qualify for the business income tax deduction? Yes. Different limitations apply to S-Corps, because they are required to make reasonable compensation payments reported as wages on W-2s. If your business is filed as an S-Corp, you may qualify for the up to 20% business income deduction. Depending on the taxable income of the business owners, it may be best to change your business entity to an LLC, Partnership, or C-Corp. However, you would want to take into consideration losing the self-employment tax benefit of the S-Corp verses the gain in the business income deduction from the considered new business entity to determine if it is worth the effort to change.
- Do partnerships qualify for the business income tax deduction? Yes. Specific limitations apply to partnerships, because they must make guaranteed payments (not reported as wages on W-2s). If your business is filed as a partnership, you may qualify for up to 20% deduction. If one partner has a high income earning spouse and the other does not, this may put the partners in a unique position where one qualifies for the 20% deduction, and the other partner does not. Partnerships with business income over the threshold will need to evaluate taxable income, partner payments, and business property to determine whether they should change their business entity.
- Do sole proprietorships qualify? Rental property reported on Schedule E? Yes and yes.
How Does the IRS Define a Qualified Trade or Business?
The IRS defines a qualified trade or business as any trade or business other than a “specified service trade or business or the trade or business of performing services as an employee.” Except for engineering and architecture fields, specified trade and business means providing professional services in the fields of accounting, law, health, actuarial sciences, performing arts, consulting, athletics, financial services, or brokerage services.
How Does the IRS Define Qualified Business Income?
Qualified business income is the business income minus any investment income. Generally speaking, this is the income the business was intended to produce with business expenses, interest, dividends, and capital gains for the sale of business assets subtracted.
Qualified business income does not consist of reasonable compensation reported on W-2s as wages by S-Corps or guaranteed payments made to partners by partnerships for services rendered for the business.
What are the Limitations on the Business Income Deduction?
The 20% business income deduction is reduced and/or eliminated for business owners whose taxable income is above $157,000 for single / married filing separately / head-of-household filers or $315,000 combined income for both spouses, if married filing jointly. The limitation does not apply if taxable income is below the income amounts stated above, and the limitation is phased in if taxable income is above those amounts. Once the taxable income of single filers reaches above $207,000 and married filing jointly filers above $415,000, the limitation applies completely.
The limitation requires taxpayers to limit the deduction to the lesser of either:
- 20% of the qualified business income; or
- the greater of 50% of the total of W-2 wages paid or 25% of the total of W-2 wages paid plus 2.5% unadjusted basis of business assets.
Stated another way, the deduction is limited to 25% of the total of W-2 wages plus 2.5% of business assets, if that amount is greater than 50% of the total W-2 wages paid by the business but lesser than 20% of the qualified business income.
For example, if Maria, a married sole proprietor, makes $100,000 in qualified business income (not in a specified service business), has one employee who is paid $20,000 in wages on a W-2, and $10,000 in qualified business assets, she may qualify for up to 20% business income deduction, depending on her taxable income. If her husband makes $100,000 (after deductions), so their combined taxable income is $200,000, she would be entitled to a $20,000 deduction ($100,000 x 20%). The W-2 limitations would not be applicable because their combined taxable income is below the $315,000 phase out limit.
Under the same facts as the example above, if the husband makes $250,000, bumping their combined taxable income limit up to $350,000, the limitation of $3,500 would apply, reducing her business income deduction to $16,500, calculated as follows:
- Determine percentage amount of limitation that applies by using the following formula: taxable income minus phase in limit divided by limitation range amount ($350,000 - $315,000 / $100,000 = 35%);
- Determine the applicable limitations, either the lessor of:
- 20% of qualified business income (20% x $100,000 = $20,000); or
- the greater of 50% of W-2 wages (50% x $20,000 W-2 wages = $10,000) or 25% of W-2 wages plus 2.5% of business assets ((25% x $20,000 W-2 wages = $5,000) + (2.5% x $10,000 business assets = $250) = $5,250)), therefore, $20,000 and $10,000;
- Multiply the percentage of the phased in restriction by the difference between the applicable limitations ($20,000 - $10,000) x 35% = $3,500;
- Finally, subtract the limitation of $3,500 from $20,000 (20% of QBI), resulting in a business income deduction of $16,500.
If their taxable income had been $415,001 or more, the limitation would have applied in full, reducing her business income deduction to $10,000 (the lesser of the 20% of QBI or 50% of W-2 wages, because they were greater than 25% of W-2 wages plus 2.5% of business assets).
What is the Limitation on Business Owners Offering Specified Services?
If the taxpayer’s taxable income does not exceed $415,000 (married filing jointly filers) or $207,500 (single / married filing jointly / head-of-household filers), the exclusion does not apply. However, the limitation is phased in for business owners with taxable income above $315,000 and $157,500, respectfully. If the taxable income of the business owner exceeds the threshold, the exclusion applies in full, and the business owner is not entitled to the business income deduction.
Using the example above, if Maria worked as an attorney, a specified service, her business income deduction would be $20,000, if her combined taxable income with her husband was $200,000. However, if her combined taxable income was $350,000, her deduction would be $6,500, calculated as follows:
- Determine the percentage of includable qualified business income to calculate the limitation by using the following formula: 1 minus (taxable income minus phase in limit divided by limitation range amount) ((1 – ($350,000 - $315,000 / $100,000) = 65%);
- Multiply the percentage by the business income to determine the amount of includable qualified business income (65% x $100,000 = $65,000);
- Multiply the percentage by the W-2 wages to determine the amount of includable W-2 wages (65% x $20,000 = 13,000);
- Multiply the percentage by the business assets to determine the amount of includable business assets (65% x $10,000 = $6,500); and
- Finally, determine the applicable limitations either the lessor of:
- 20% of qualified business income (20% x $65,000 = $13,000) or
- the greater of 50% of W-2 wages (50% x $13,000 = $6,500) or 25% of W-2 wages plus 2.5% of business assets ((25% x $13,000 = $3,250) + (2.5% x $6,500 = $162.50) = $3,412.50).
If Maria and her husband have taxable income of $350,000, she gets to take the lesser deduction of either $13,000 or $6,500. Therefore, Maria qualifies for a $6,500 business income deduction.
If their combined taxable income had been $415,001 or more, the exclusion for attorneys would have applied in full, and Maria would not be entitled to the new business income deduction.
How Do You Qualify for the New Business Income Deduction?
Qualify for the most advantageous business income deduction for your individual circumstances by careful and strategic planning. Review your business entity options and determine the best one for you based on your business plan, taxable income, and business assets. The professionals at Gudorf Tax Group are available to meet with you to review your individual situation and help you determine the best entity for your business and best way to report your business income to take advantage of the new business income deduction.