Making Sense of The New 20% Business Income Deduction
The Tax Act and Jobs Act (TAJA) went into effect on January 1, 2018, but did NOT affect your 2017 tax return which was due in April of 2018. In almost every case, your 2017 return is covered by the old rules. One of the most complex areas of the TAJA is the 20% business income deduction.
If you want to operate a business, there are five main choices for doing so:
1. C corporation
2. Sole proprietorship
3. S corporation
5. Limited Liability Company (single member or multiple member)
Owners of a "C corporation" are subject to double taxation. When income is earned by the corporation, it is first taxed at the business level, at a top tax rate of 35% under current law. Then, when the corporation distributes the income to the shareholder, the shareholder pays tax on the dividend, at a top rate of 23.8%. Thus, from a federal tax perspective, owners of a C corporation pay a combined total rate on the income earned by the business of 50.47% (35% + (65% * 23.8%)).
Of course, you don't have to operate as a C corporation. Instead, you can operate a business as a sole proprietorship. Or as an S corporation. Or as a partnership. And what do these three business types have in common? They all offer a single level of taxation: when income is earned at the business level, it is generally not taxed at that level; rather, the income of the business is ultimately taxed once, at the individual level.
How does the 20% business income deduction affect these pass through entities?
20% Deduction of Qualified Income from Flow-Through Entities a Boon for Business! Under the new tax law the 20% deduction should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship (“pass-through deduction”). Permissible as a deduction will be 20% of your qualified business income (“QBI”) from a partnership, S corporation, or sole proprietorship. The deduction is taken “below the line,” meaning it reduces your taxable income but not your adjusted gross income.
Qualified business income” is defined as the net amount of income, gain, deductions, and losses with respect to your trade or business. The business must be conducted within the U.S. to qualify for purposes of this definition and the deduction. Specified investment-related items are not included within the definition of QBI, such as capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). Further, 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 pass-through deduction is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% 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.
There are limitations:
For pass-through entities, other than sole proprietorships, the deduction cannot exceed the greater of:
50% of the W-2 wages with respect to the qualified trade or business (“W-2 wage limit”), or
the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.”
“Qualified property” is defined as meaning tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.
For a partnership or S corporation, each partner or shareholder is treated as having W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages of the entity for the tax year. A partner’s or shareholder’s allocable share of W-2 wages is determined in the same way as the partner’s or shareholder’s allocable share of wage expenses. For an S corporation, an allocable share is the shareholder’s pro rata share of an item. However, the W-2 wage limit begins phasing out in the case of a taxpayer with taxable income exceeding $315,000 for married individuals filing jointly ($157,500 for other individuals). The application of the W-2 wage limit is phased in for individuals with taxable income exceeding these thresholds, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals).
Specified Service Businesses:
There are certain rules designed to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction. For single taxpayers with taxable income above $157,500 ($315,000 is the threshold for joint filers), an exclusion from QBI begins to be phased in for income of “specified service” trades or businesses. For 2021, the limits rise to $164,900 for single filers and $329,800 for joint filers.
Specified service trades or businesses are those:
involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services; orwhere the principal asset is the reputation or skill of one or more employees or owners.
For single filers, if your taxable income is $50,000 above the $157,500 phase-in threshold (which would be $207,500), all of the net income from the specified service trade or business is excluded from QBI. The full exclusion trigger for joint filers is $100,000 above the $315,000 phase-in threshold (i.e. $415,000).
If your taxable income is between the phase-in threshold and the full exclusion from QBI threshold—meaning between $157,500 and $207,500 for single filers, and between $315,000 and $415,000 for joint-filers—you would exclude only a percentage of income. The applicable percentage is derived from a fraction; the numerator being the excess of taxable income over the phase-in threshold, and the denominator being the full exclusion threshold. For example, if you are a single filer and your taxable income is $167,500 (which is $10,000 above the $157,500 single filer phase-in threshold), only 20% of the specified service income would be excluded from QBI ($10,000 divided by $50,000).
The complexities surrounding this new deduction can be daunting, especially if your taxable income exceeds the thresholds discussed above. Please contact your finance or accounting professional to discuss your individual facts and the mechanics of the deduction as applied to your specific situation.