Does Tax Reform Spell a Happy New Year for Your Business?
In the past couple weeks, much ink has been spilled over the contents and ramifications of the 2017 Tax Cuts and Jobs Act, also known as the Trump Tax Cuts, passed in a twinkling before the Christmas holiday. The bill is perhaps the most radical reform of the tax code in decades, but flew through the legislative process with relatively little debate, and even less exposition to the American people. President Trump and House Speaker Paul Ryan boasted that after they wrangled with the code, most citizens would be able to file their federal income taxes on a postcard. However, the redoubtable revenue code proved a difficult beast to slay, and taxpayers expecting a simpler process in 2018 will be disappointed.
None more so than small business owners. The bill’s abrupt passage, combined with confusion and outright misinformation in the media, leaves most business owners befuddled. One section of the bill garnering a large amount of buzz is the new 199A deduction for pass-through entities. This deduction for small businesses and the self-employed could yield sizeable tax benefits for you, but only if you know how it works and how to claim it.
The 199A deduction is only available to pass-through entities; sole proprietorships, partnerships (and LLCs taxed as partnerships), and S-corporations (likewise, LLCs taxed as S-corporations). Basically, anyone who has to file a schedule C on their income tax return, or schedule E for landlords. The deduction is equal to 20 percent of “qualified business income.” Qualified business income (QBI) is defined as the net amount of qualified items of income, gain, deduction and loss with respect to any qualified trade or business of the taxpayer. Notably, QBI does not include wages or guaranteed payments under a partnership, or short and long term capital gains. Perhaps as part of President Trump’s “America First” agenda, QBI also excludes foreign earned income.
This makes sense as the 199A deduction is largely cribbed from the old Section 199 domestic manufacturing deduction, which allowed domestic manufacturers (and eventually other businesses, like Starbucks, engaged in the “manufacturing” of lattes and other decidedly non-durable goods) a nine percent deduction. To a large extent, 199A is a codification and expansion of this deduction, and an affirmation of the reasoning behind it.
Things begin to get complicated when a taxpayer’s taxable income exceeds $157,500 for an individual, and $315,000 for a married couple filing jointly. The 199A deduction phases out proportionately until an individual’s taxable income reaches $207,500, and a married couple’s $415,000, where the deduction is no longer available. However, for those with incomes over the threshold amount, the deduction can still be available pursuant to an alternative formula.
Namely, taxpayers with incomes over the threshold amount can deduct the greater of either 50 percent of W-2 wages, or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition of real property, provided that none of these values exceed 20 percent of qualified business income.
To complicate matters further, certain service industry trades are disfavored in claiming the exemption. Doctors, lawyers, accountants, athletes, artists, and operators of the vague catchall category of “any trade or business that relies on the reputation or skill of one or more employees,” can only claim the deduction if their income falls below the $157,500/$315,000 single/married threshold. Architects and engineers are exempt from this exclusion, maybe because the legislature considered them an ancillary service necessary to the building boom the bill hopes to spur.
These rules are best explained by example. For these examples, it’s important to note that the tax brackets under the new tax bill are compressed and lowered:
- Steve, a single, self-employed IT consultant makes $100,000 a year in taxable income. Steve operates as an LLC taxed as a sole proprietorship. Steve, although he is engaged in a Specified Service Trade, can deduct $20,000 from his taxable income under Section 199A. This results in a tax savings of $4,750.
- Jerry, a successful married home builder has a banner year in 2018, earning $500,000 in taxable income. If Jerry has no W-2 wages, he can’t claim the 199A deduction. But Jerry is set up as an S corporation, and he pays himself $200,000 in W-2 wages as a salary. Jerry can claim 50 percent of that salary, $100,000, as a Section 199A deduction, resulting in taxable income of $400,000. Jerry’s tax savings are $35,000 from the deduction, but he has to pay the self-employment tax (15.3 percent) on the first $127,200 of his W-2 salary, resulting in a net savings of $15,538.40.
As you can see, for high earners there is a balancing act between setting a reasonable salary to minimize self-employment tax liability, and trying to maximize the 199A deduction on the dividends from an S corporation. Also, consider that the tax bill slashed the corporate income tax to 21 percent, making the conversion to a pass-through entity not as appealing as many early commentators opined. Ultimately, small business owners would be well advised to sit down with their accountant and legal counsel, and investigate whether any changes to their business entity, adjustments to salaries, capital improvements and other distributions should be made.
The rules regarding this deduction have yet to be ironed out, and questions regarding how to treat taxpayers owning multiple pass through entities pose some problems for tax professionals. Also, keep in mind that this deduction is slated to sunset in 2025 unless the legislature opts to extend it, as they did with the Bush tax cuts. So anything you do now, you may have to reverse in seven years. In any reorganization, there are tax and transactional cost consequences to carefully consider. So much for simple!
Brandon Dornbusch is an attorney at Bowerman, Bowden, Ford, Clulo & Luyt, PC in Traverse City. He practices in the areas of business planning and succession, trusts and estates, probate administration and litigation, elder law, real estate and civil litigation. He can be reached at (231) 941-8048 or firstname.lastname@example.org.