The 2017 Tax Cuts and Jobs Act added one of the largest tax benefits to small business owners in decades. The IRC section 199A Qualified Business Income deduction (QBI) allows flow-through entities to claim a deduction of up to 20% of their qualified business income. These flow-through entities include:
- Sole proprietorships
- S-corporations, and
- Certain real estate professionals
(This credit does not apply to C Corporations)
Calculating the Deduction for Taxable Income below Threshold Amounts
For unmarried taxpayers with unmodified taxable income under $157,500 and couples filing a joint return under $315,000, calculating the 20% of QBI deduction is somewhat less complex. For these folks, the deduction is the lesser of 20% of unmodified taxable income, or 20% of their qualified business income.
Guaranteed Payments and Sub S Shareholder Wages Impact the Deduction
Partnerships that pay their partners guaranteed payments, and Subchapter S corporations that pay their shareholders wages are somewhat at a disadvantage over partnerships without guaranteed payments and S-corporations without wages paid to their shareholders. There is no QBI deduction on wages and guaranteed payments.
Assume that a taxpayer has a business with $100,000 of net business income before draws or wage payments, and $100,000 of unmodified taxable income. How would the deduction look for a sole proprietor versus and 100% owned S Corporation shareholder assuming that the proprietor takes a draw of $50,000 from the business and the shareholder pays herself $50,000 in wages.
- As a sole proprietor, the deduction is 20% of $100,000 or $20,000.
- The QBI deduction for the S-Corporation would be 20% or $50,000, or $10,000, exactly half of our sole proprietor.
S-Corporations are required by the IRS to pay shareholders a reasonable compensation in the form of wages. In the S Corporation example, the corporation takes a deduction of $50,000 for the wage payment leaving net corporation income (also qualified business income) or $50,000, whereas the proprietorship gets no deduction for the $50,000 draw.
Because of this disadvantage, many sole proprietors may want to rethink the timing of incorporating their business to save Social Security tax given that the 20% deduction is on their business net income after deducting shareholder wage payments.
Impact of Higher Taxable Income Thresholds
The maximization decision becomes more complicated for taxpayers with taxable income of $207,500 for unmarried taxpayers, $415,000 for married taxpayers filing a joint return; once these taxpayers reach these threshold amounts, the QBI deduction can be limited by the greater 50% the business pays in wages or 25% of wages paid plus 2.5% of qualified assets used in the trade or business. The limitations are phased in between $157,500 and $207,500 for unmarried taxpayer, and $315,000 to $415,000 for couples filing jointly.
Phase In of the Limitations
The phase in of these limitations affect the timing of deciding when to elect S-Corporation status for a sole proprietorship, partnership, single or multiple member LLC.
Joe Handyman is a general contractor operating his business as a sole proprietorship. He is single, with net income from his business totaling $220,000, and taxable income $225,000. He has no employees and paid no wages. His QBI deduction is the lesser of 20% of his QBI, $44,000 (20% x $220,000), or 50% of the wages his company paid to employee, $0. Assuming that Joe has no qualified assets used in his business, his QBI deduction is zero because Joe did not pay any wages.
Now assume Joe’s tax advisor recommended Joe incorporate his business and have the corporation pay him reasonable compensation of $63,000. After claiming the wages as a deduction, his Qualified Business Income is $157,000 ($220,000 minus $63,000). His 20% QBI deduction is $31,400, the lesser of 20% of $157,000, $31,400, or 50% of the $63,000, $31,500.
Limitations for Specified Service Trade or Businesses (SSTBs)
Specified Service Trade or Businesses (SSTBs) do not get the benefit of the QBI deduction once their taxable income exceeds $207,500 for unmarried taxpayers, $315,000 for couples filing a joint return regardless of the amount wages paid or assets owned by the business. Examples of SSTBs include attorney, accounting, and financial service businesses, but not engineering and architectural service businesses.
Commercial and Residential Real Estate Landlords Should Consider Electing to Be Real Estate Professionals
Owners of commercial and residential rental real estate may, or may not be eligible for the deduction unless they are qualified real estate professionals. The IRS has not clarified their position on these activities. Thus, if rental owners meet the material participation requirement, they should consider making the election to receive real estate professional tax treatment for their rental activities.
Calculating the QBI deduction can be a very complex and nuanced process, particularly for taxpayers with multiple businesses and/or higher income. This blog only scratches the surface of the complexity of this deduction. Consider making an appointment with a qualified tax advisor to maximize the benefit of this new deduction. Once you have considered the best choice for your business, any changes need to be made and implemented this month. This is an opportunity that could save you thousands when you file your 2018 tax return.