By now you have all heard of this new 20% deduction for business income for non C-Corporation businesses. I refer to it this way instead of the 20% deduction for flow-thru business income because I want to make sure you all understand, this deduction is also available for those of you who are sole proprietors and individual owners of rental real estate, and not just for partnership and S-Corp income. You also receive this possible deduction if you receive income from a REIT, publicly traded partnership or qualified cooperatives.
When can you as a business owner qualify for this new 20 percent tax deduction with almost no complications? To qualify for the 20 percent with almost no complications, you need two things: First, you need qualified business income from one of the sources above to which you can apply the 20 percent. Second, to avoid complications, you need “defined taxable income” at or below the threshold amounts of:
• $315,000 or less if married filing a joint return, or
• $157,500 or less if filing as a single taxpayer.
Example: You are single and operate your business as a proprietorship. It produces $150,000 of qualified business income. Your other income and deductions result in defined taxable income of $153,000. You qualify for a deduction of $30,000 ($150,000 x 20 percent).
In the above example, if your defined taxable income was $100,000 instead of $153,000, your deduction would be $20,000 ($100,000 x 20%). In other words, your deduction is the lower of 20% of qualified business income or 20% of defined taxable income.
If you operate your business as a partnership or S corporation and you have the qualified business income and defined taxable income numbers above, you qualify for the same $30,000 deduction. The same is true if your income comes from a rental property, real estate investment trust, or limited partnership.
Other general rules to be aware of are that this deduction does not reduce adjusted gross income but is a deduction from taxable income. It also does not reduce self- employment income. For those of you who are partners or owners of an S Corp, you should realize this deduction is calculated at your individual tax return level and not at the entity level.
If your business is a specified service trade or business (doctors, lawyers, accountants, actors, athletes, traders, etc.), it is in the out-of-favor group and you benefit only when you are in or below the phase-out range. In other words, if you are below the threshold limits above, even though you are in the out-of-favor group, you still qualify for the full deduction. Above these thresholds, there is a $100,000 for married filing joint and $50,000 for filing as single phase-out such that if you reach $415,000 or $207,500 of income, there will be no deduction available.
If your qualified business is not in the out-of-favor group, in other words, not included in the description from complication #1, and your income is above $415,000 for married filing joint or $207,500 for a single filer, your deduction is now limited to the lesser of 20% of qualified business income or your choice of 50% of W2 wages or 25% of W2 wages and 2.5% of qualified tangible property (with again an overall limitation of 20% of taxable income).
So now, in addition to understanding what qualified business income is, you have to determine if it is best to use the 50% of wages calculation or the 25% of wages and 2.5% of tangible property calculation. Qualified tangible property is defined as depreciable property. The wage calculation is pretty straightforward, but what if you are a sole proprietor with no employees and your income is above $415,000? You have to calculate the 2.5% of qualified tangible property. This is defined as depreciable property at its unadjusted basis (purchase price before depreciation) for 10 years or its depreciable life, whichever is longer. So for your 5 and 7 year depreciable property, you can use the original purchase price in your calculation for 10 years from date of purchase. If it is 39 year commercial real estate, you can use the original purchase price for 39 years from the date of purchase.
If your qualified income is between $315,000 and $415,000 for married filing joint and $157,500 and $207,500 for single, then your 20% deduction is limited by a partial phase-in of the W2 wage limitation for the in-favor group and a partial phase-out of the deduction if you are in the out-of-favor group.
As you can see and as I have mentioned in my prior memos, this is not tax simplification, especially if you qualify for this 20% deduction. The above complications are just the three that I felt could be somewhat explained in a memo. There are many other potential complications and other items to consider. For instance, what if one spouse is in qualified business but the other is in a service business (out-of-favor group)?
It will require very detailed planning to take full advantage of this deduction and will require communication between you and our office. Sometimes, we may have to make choices. For instance, if you buy new equipment, and we have the ability to take Section 179 (deduct the cost all in one year), it may reduce your qualified business income to zero and you will not get any benefit of the deduction. As you probably know, taking Section 179 just accelerates a deduction you are entitled to take over a period of years so the savings is a time value of money calculation. It may be better in some instances to decline the election than to take Section 179.
Those of you who are owners of S corporations are aware that we usually try and bonus out all of your profit to eliminate Tennessee excise tax. By doing so, your flow-thru income will be greatly reduced and you will not get the benefit of this deduction. In some cases, it may make sense to leave the profits in and pay the Tennessee tax.
These are just a few examples of the complications this new deduction will add to the calculation of your projected tax liability. We are committed to working proactively with you to make sure we use the tax code to your advantage.
Each of your situations is different and will require different amounts and types of planning. As always, please reach out to one of the tax professionals here at WSW if you have any questions.
PLEASE REMEMBER, THIS DEDUCTION WILL TAKE EFFECT ON THE TAX RETURNS WE FILE FOR A DUE DATE OF APRIL 15, 2019. OUR PRIMARY FOCUS IS FILING YOUR 2017 RETURNS ACCURATELY AND ON TIME. WE WILL BE WORKING WITH ALL CLIENTS AFTER THE CURRENT DEADLINE TO BEGIN PLANNING FOR THE END OF THE YEAR. THANK YOU, AS ALWAYS, FOR YOUR TRUST IN WSW CPAS.