The Tax Cuts and Jobs Act passed in December offers businesses multiple opportunities to save on taxes. A big help for many small businesses comes from the new Section 199A deduction, which applies to any small business that’s not taxed as a C corporation. That is, it applies to sole proprietors, S corporations, partnerships and real estate activities that qualify as a trade or business. You’ll want to be sure your tax preparer is well versed in the new changes.
The biggest winners will be individuals with taxable income under $157,500 and couples filing jointly with taxable income under $315,000. Taxpayers in this category get a deduction of 20% of their Qualified Business Income (QBI). Unfortunately, this deduction does not reduce the amount of self-employment tax liability.
QBI, as defined in the new law, is net ordinary income earned by a sole proprietorship, S corporation or partnership. It does not include W-2 wages or investment-type income such as interest, dividends or capital gains passed through on a Schedule K-1. It also does not include the wages paid to an S corporation shareholder.
Taxpayers whose taxable income falls under the threshold amounts get the full 20% deduction, regardless of what type of business they have.
When taxable income is above those thresholds, limitations kick in and the calculation becomes more complex. Now the 20% deduction is limited to 50% of the allocated share of W-2 wages paid by the small business. For capital-intensive businesses, the limit is 25% of the allocated share of W-2 wages plus 2.5% of the allocated share of the unadjusted basis of tangible depreciable property owned by the business.
The W-2 limitation itself is phased in based on how far over the threshold taxable income is. It applies fully when taxable income reaches $415,000 for joint filers and $207,500 for singles. For example, if taxable income is $20,000 over the threshold, this is 20% of the $100,000 phase out interval, so 20% of the W-2 limitation will apply.
Unfortunately, for small businesses that are in a “specified trade or business,” once taxable income reaches $415,000 for joint filers or $207,500 for singles, the Section 199A deduction is completely gone. These “specified trades or businesses” include health, law, accounting, actuarial services, performing arts, consulting, athletics, financial services, and brokerage services. Architecture and engineering firms are specifically excluded from this group.
Let’s look at a few simple scenarios to see how this works.
Sole proprietor with income under the threshold level:
Tina is a sole proprietor whose income from her Schedule C is $200,000. Her husband, Pete, is a schoolteacher and earns $60,000. Their taxable income is well under the threshold for their filing status, so they get to deduct 20% of $200,000 or $40,000.
S corporation with income under the threshold level:
The same scenario as above, but Tina is an S corporation and pays herself a salary of $80,000, so her QBI is $120,000. Twenty percent of her QBI is $24,000.
Sole proprietor with income over the threshold level:
Now let’s say Tina makes $700,000 and has no employees. Because Tina and Pete’s taxable income will be over the threshold, the 20% deduction is limited to 50% of W-2 wages from her business, or $0. They get no deduction.
S corporation with income over the threshold level:
Tina still makes $700,000 but pays herself a salary of $125,000. Her QBI is $575,000. Twenty percent of that is $115,000, which is greater than 20% of W-2 wages ($62,500), so they get a deduction of $62,500.
However, if Tina is an attorney, they won’t receive any deduction because their taxable income is over $415,000.
With these simple examples, we see that S corporation shareholders whose income falls under the threshold may have an incentive to decrease their salaries and thus maximize their Section 199A deduction. However, if compensation is not what the IRS deems “reasonable,” there is a risk that the IRS will catch this, and recalculate both wages and the Section 199A deduction to the taxpayer’s detriment.
We also see that the amount of the deduction varies, depending on the structure of the business and whether this business falls into the category of a “specified trade or business.” Capitalizing on these differences will provide many opportunities to save on taxes.
Do you have questions about the new tax law and how it may affect your small business tax planning strategy? Do you want an analysis of how the new Section 199A deduction will impact your bottom line? Contact us at 561-277-3195 and we’ll help you evaluate your options!