20% Deduction for Qualifying Business Income
One of the most favorable and substantial changes in the 2017 Tax Act (the “Act”) for closely held business owners is what is commonly referred to as the “pass-thru deduction.” Contrary to its common name, this deduction is not limited to pass-thru entities. This new deduction is available to sole proprietorships as well as partnerships, limited-liability companies, and S corporations. It provides a deduction of up to 20% of qualified business income. The deduction, found in new section 199A of the Internal Revenue Code when maximized, effectively lowers the top federal income tax rate on business income for owners of these businesses from 37% to 29.6%.
The following provides an overview of the mechanics of this deduction and briefly discusses planning considerations.
The deduction in general equals the lesser of (A) 20% of qualified business income with respect to a qualified trade or business, or (B) the greater of one of two ceiling amounts: (1) 50% of the W-2 wages paid with respect to a qualified trade or business, or (2) 25% of the W-2 wages paid with respect to a qualified trade or business plus 2.5% of the original basis of qualified property.
Owner Level Calculation
The calculation is done at the owner level with each owner being allocated their share of qualified business income, company wages paid, and basis in qualified property.
For most business owners the two key questions with respect to the 199A deduction are: (1) is their business a qualified trade or business, and (2) does the business have sufficient wages or basis to maximize the 20% deduction? If the answer to either of these questions is “no” the 199A deduction may be limited in part or in full.
What is a qualified trade or business?
The Internal Revenue Code in section 199A defines a qualified trade or business by basically telling us what it is not. A qualified trade or business is essentially any domestic trade or business other than a “specified trade or business.” The unlucky group of professionals bestowed the title “specified trade or business” are businesses involving the performance of services in the fields of: health; law; accounting; actuarial science; performing arts; consulting; financial services; brokerage services; financial trading or securities; or any trade or business where the principal asset is the owner’s reputation. In addition, employees cannot argue that they are in the trade or business of being an employee and qualify for the deduction.
Moderate Income Exception
There is an important exception that will prove very useful for many moderate-income business owners that are in one of the “specified trades or businesses” or do not have sufficient wages or basis in qualified property to benefit from the deduction. If the taxable income for a business owner is below $157,000 (with a phased out up to $207,000) for single filers or $315,000 (with a phased out up to $415,000) for married filing jointly filers, both the exclusion for specified trade or business and the wage or basis ceiling amount limitations do not apply. Thus, for example, a married accountant filing a joint return with total household taxable income of $300,000 (without application of the 199A deduction), $250,000 of which is from her accounting planning practice would be eligible to deduct 20% of the $250,000 or ($50,000). This is true even though accounting is a specified trade or business and regardless of whether she had any employees in her accounting practice since her income is below the married filing jointly threshold discussed above.
Individuals over the moderate income threshold that are limited by one of the ceiling amounts might consider ways to increase one of their ceilings, either by capital expenditures to increase basis in qualified property or increasing wages. If a business is able to utilize the 199A deduction, it is likely most advantageous for the business to remain taxed as a pass-thru or disregarded entity (as the case may be). However, that is not always the case. The new 199A deduction is complex and its application often depends on the specific facts and situation of a client. The business and tax attorneys at Shuttleworth would be glad to discuss with you the possible implications of this new deduction for your business.