Much ado has been published regarding the lowering of the corporate tax rate to 21% as part of the Tax Cuts and Jobs Act (the Act) passed last December. This has caused businesses taxed as pass-throughs to consider changing tax status to take advantage of the lower corporate rate. This is not a straight-forward decision, and there are many factors to consider.
One such factor is the significant new tax deduction taking effect in 2018 under the new tax law. It should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income.
The deduction is generally equal to 20% of your “qualified business income” (QBI) from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included. The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction reduces your taxable income but not your adjusted gross income. It is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year.
Rules are in place to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
These rules involve thresholds. If your taxable income is at least $207,500, all the net income from a specified service trade or business is excluded from QBI. Specified service trades or businesses 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. Additionally, for taxpayers with taxable income more than the above thresholds, there is a limitation on the amount of the deduction that is based either on wages paid or wages paid plus a capital element. Other limitations may apply in certain circumstances.
Obviously, the complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the thresholds. If you wish to work through the mechanics of the deduction with me, with attention to the impact it can have your specific situation, please give me a call. I can also assist with a comprehensive analysis of a decision to transition your business to a new tax status including projections for income taxes paid as a corporation and individual and the other rules that may apply.