The number one question clients have asked us this year is “how does the new tax law affect me?” For pass-through business owners (S-Corps, Partnerships and Sole Proprietorships), our answer was “we have to wait for guidance from the IRS before we can answer that.” While guidance has finally come, it is only proposed (not final) guidance, and many issues are still unclear. However, what is clear is that there is a 20% tax deduction available to all pass-through business owners as long as the owner qualifies.
What is the 20% tax deduction?
Under the Tax Cuts and Jobs Act, Section 199A of the Internal Revenue Code provides many taxpayers with a deduction for qualified business income (QBI). In its simplest form, it is calculated by multiplying your QBI by 20%. That 20% result then becomes a deduction in computing your overall taxable income. As an example, assume you own a bagel shop that had a net profit (QBI) of $100,000. Your QBI deduction from this business would be $20,000. Instead of paying tax on the full $100,000, you are now paying tax on $80,000.
While this may seem like a promising Black Friday deal from the IRS, there are several questions that come into play that may limit or completely eliminate your 20% off coupon.
How do I qualify for the 20% QBI Deduction?
There are several significant factors under Section 199A but two in particular stand out: is your taxable income (before any QBI deductions) $315,000 (married) or $157,500 (single) or less and is your business a Specified Service Trade or Business (SSTB)? Of the two most important factors, taxable income below $315,000 (or $157,500 if single) is always the first question. The income threshold disregards and overrides any concerns over whether a business is considered an “SSTB” or not.
$315,000 (Married, $157,500 if Single)
For married filers, if your taxable income is below $315,000 before the 20% deduction, the qualification testing is essentially non-existent and you will receive at least a partial deduction. The reason you may not receive a full 20% of QBI deduction is because the overall deduction cannot exceed 20% of your taxable income after subtracting out capital gains. In many cases, one’s taxable income is LESS than his or her business income due to other outside deductions such as pension contributions, mortgage interest and even the basic standard deduction. If your business is your only income, you will definitely be limited in your deduction. While that may take some icing off of the cake, 20% off of your taxable income is still a nice prize. A common instance of where a married couple would receive the full 20% of QBI deduction would be if one person has QBI and the other earns a living as a W-2 employee.
SSTB – Specified Service Trade or Business
What is a Specified Service Trade or Business (SSTB)? Why does it matter? When does it matter?
As explained above, being considered an SSTB does not matter if your taxable income is below $315,000. If your taxable income is above $315,000 and your business is an SSTB, your deduction will begin to phase out until you reach $415,000 in taxable income, at which point you will be completely phased out. This has harsh implications on SSTB business owners who earn taxable income close to $315,000 or more. To illustrate this, imagine you are a self-employed lawyer (legal work is considered an SSTB) who earned exactly $315,000. Because you are under the threshold, your QBI deduction would be $63,000 (20% of $315,000). You are, therefore, paying tax on $252,000 ($315k – $63k). If you end up earning an additional $100,000, you will receive no deduction and will pay tax on all $415,000. Therefore, the difference between earning $415,000 and $315,000 is really $163,000 more in taxable income. The tax rate at that income level ranges from 24% to 35%. But because you are losing the QBI deduction, the $100k increase in income would add $47,570 in tax which equates to a 47.57% effective tax rate.
In order to consider whether any of the above matters or not, you will have to determine if your business is considered an SSTB. A Specified Service Trade or Business is any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners…or any business which involves the performance of services that consist of investing and investing management, trading, or dealing in securities, partnership interests, or commodities.
After reading the definition above, if it is not clear whether your business is an SSTB, you are probably extremely confused and questioning the exact nature of your business. Specifically, any business that has an inherent consulting aspect to its services is in question. The proposed guidance briefly addresses each of these categories, including the definition of consulting itself. While some questions are clearly answered, it is difficult to rely on unspecific guidance that is merely considered “proposed”.
My taxable income is above $315,000 and I am not a SSTB. Does $315,000 still matter?
If your business is not considered an SSTB, you can breathe much easier. You can qualify for the QBI deduction no matter how high your income is. Your business will need to pass certain tests, however. Similar to the rules with SSTBs, the tests are only relevant if your taxable income is above $315,000. At its most basic level, if your income is above $315k, your QBI deduction will be the lesser of 20% of QBI income or 50% of wages paid to employees or 25% of wages paid to employees plus 2.5% of the basis in your net assets. Unless you own real estate or participate in large scale manufacturing, the latter calculation will be irrelevant. Wages become an important factor if your profit is more than 2.5 times what you pay your employees. As an example, if your bagel shop earns $500,000 in net profit, your maximum QBI deduction would be $100,000 ($500k x 20%). If your total W-2 wages paid to your employees is $200,000 or less, your deduction will be limited. At $150,000, 50% of wages would be $75,000 and that would be the limit on your deduction. At $210,000, 50% of wages would be $105,000 and you would be able to take your maximum deduction of $100,000.
Making sense of taxable income, SSTB and how to proceed…
There is no blanket answer that addresses everyone. In fact, more than ever, each person’s tax picture requires a different analysis and its own unique solution. Beyond keeping your taxable income below $315,000 ($157,500 if single), other factors such as other non-QBI income and deductions come into play. The most important things to consider as you close out the year are determining whether your taxable income will exceed $315,000 and is your business an SSTB.
Please contact your Raines & Fischer partner to see how the Section 199A deduction may affect you.
This article is not considered tax advice and should not be used as a guide for tax planning. Its intent is to provide a brief and basic overview of the Section 199A deduction under the Tax Cuts and Jobs Act. Please contact your tax advisor for more information.