New small business deduction anything but simple

Chris West
Chris West

When it comes to the new tax law, the topic on the minds of most small business owners is the 20 percent deduction for pass-through income and what should provide a substantial tax benefit to individuals with qualified business income.

Be warned: This is one of the most complex provisions of the Tax Cuts and Jobs Act. But if you can make it through some of the specifics, I’ll offer a few practical thoughts.

The deduction is 20 percent of your qualified business income (QBI) from a partnership, S corporation or sole proprietorship as defined as the net amount of income, gains, deductions and losses with respect to your trade or business. Business must be conducted within the United States to qualify. Specified investment-related items are not included, such as capital gains or losses, dividends and interest income unless the interest is properly allocable to the business. The trade or business of being an employee doesn’t qualify. Also, QBI doesn’t include reasonable compensation received from an S corporation or guaranteed payment received from a partnership for services provided to a partnership’s business.

The deduction is taken “below the line.” It reduces your taxable income, but not your adjusted gross income. The deduction is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction can’t exceed 20 percent of the excess of your taxable income over net capital gain. Rules deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.

Here’s where it gets more complex. For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services or where the principal asset is the reputation or skill of one or more employees or owners. Here’s how the phase-in works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500  plus $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold.) If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction — the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. For example, if taxable income is $167,500 ($10,000 above $157,500), only 20 percent of the specified service income would be excluded from QBI ($10,000 divided by $50,000). Joint filers would apply using the $315,000 threshold and $100,000 phase-out range.

Additionally, for taxpayers with taxable income above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element. If your taxable income is at least $50,000 above the threshold, say $207,500, your deduction for QBI can’t exceed the greater of (1) 50 percent of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25 percent of such wages plus 2.5 percent of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So, if your QBI were $100,000, leading to a deduction of $20,000 (20 percent of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000. If your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via the fraction discussed in the preceding paragraph. Joint filers would apply using the $315,000 threshold and $100,000 phase-out range.

Wow, you’ve made it this far, As promised, here are a few practical planning opportunities to discuss with your tax advisor:

Depending on the type of business entity structure, it’s important to discuss the level of compensation you pay yourself as owner. Determining “reasonable compensation” to the owner has always been important for S corporation owners and will now be even more important under the new tax law.

For businesses in the phase-out ranges — especially service businesses — it’s important to consider purchasing equipment and other business assets under the new bonus depreciation rules. Such depreciation deductions could reduce QBI below the phase-out range and allow for an increase in the 20 percent deduction.

It’s common for small business owners to have self-rental structures. In other words, the owner of the business is also the owner of the entity that owns the real estate where the business operates. Adjusting rental rates between the operating business and rental business could have significant effects on the amount of the 20 percent deduction. Of course, any rent adjustments should be made within normal market ranges.

Clearly, it’s important for pass-through business owners to talk with their trusted tax and business advisors about the new law. Given the complexity, I expect the Internal Revenue Service to come out with numerous regulations and other guidance to clarify how to apply the 20 percent deduction for pass-through businesses. Stay tuned.

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