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.
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.
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.
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:
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:
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).
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:
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.
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.
