The Tax Cuts and Jobs Act created a tax savings opportunity for businesses. Corporate tax rates have been reduced to a maximum 21%, while other businesses can qualify for a 20% income reduction by means of the qualified business income deduction. This was enacted to allow “pass-through” businesses—in this case, essentially any business structure other than a C corporation—benefits similar to the tax cut available only to C corporations.
As much as this deduction is intended to create parity, it doesn’t quite get there. The rules are complex, sometimes illogical, and at times unclear. In fact, in many areas, taxpayers will need to wait for clarification from the IRS and possibly Congress. Despite the uncertainties, there is still plenty to learn about the QBI deduction. What matters is the type of business and the amount of income, payroll, and business assets.
Service businesses are entitled to a very limited deduction, based on income levels. A pertinent question is what qualifies as a service business? Although many CPAs might look to the Internal Revenue Code’s definition of service businesses found in the personal service corporation rules, the new tax law defines service businesses differently. Specifically, the law includes the following as service businesses: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. The law also includes the performance of services that consist of investing and investment management, and trading or dealing in securities, partnership interests, or commodities. (Strangely, it exempts engineering and architectural businesses.)
This seems fairly straightforward. However, the law also includes “any trade or business where the principal asset of the business is the reputation or skill of an employee or owner.” This broader definition creates uncertainty. Is the principal asset of a catering business, for example, the reputation or skill of an employee or owner?
In any event, if the business is a service business, the maximum deduction is limited to the lesser of 20% of qualified business income or 20% of total taxable income minus capital gains. This is further limited based on the owner’s taxable income:
- Full deduction if taxable income is less than $315,000 for married couples or $157,500 for singles.
- Phased-out deduction for taxable income between $315,000 and $415,000 for married couples or between $157,500 and $207,500 for singles.
- No deduction for taxable income above $415,000 for married couples or $207,500 for singles.
For nonservice businesses, the qualified business income deduction is limited to 20% of taxable income minus capital gains and is based on the lesser of:
- 20% of qualified business income, or
- the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of post-2008 business assets.
For example, assume that Jim owns a car wash and that his total taxable income (minus capital gains) is $800,000. Assume that the car wash’s qualified business income is $500,000, wages are $300,000, and business assets are $50,000. Jim’s QBI deduction cannot be greater than $160,000 (20% of $800,000). Twenty percent of qualified business income is $100,000. Fifty percent of W-2 wages is $150,000, and 25% of W-2 wages plus 2.5% of post-2008 business assets is $76,250. Jim’s deduction is the lesser of $100,000 or $150,000; thus, the deduction is $100,000. Because this amount is less than $160,000, he can claim the entire $100,000 deduction.
Note that wages do not include guaranteed payments to partners or LLC members or wages to S corporation owners. Yet, in determining qualified business income, income must be reduced by “reasonable compensation” attributed to owners.
Post-2008 business assets include assets placed in service after 2008 that are real or tangible business property, and not intangible assets. For purposes of the calculation, the value is equal to the original cost reduced by the Section 179 deduction. The assets qualify during the life according to IRS depreciation tables or 10 years, whichever is greater.
The first step in planning for the QBI deduction is to determine whether or not the business is a service business. If it is, consider the income limitations and explore ways to reduce taxable income, such as making retirement plan contributions and accelerating expenses.
For nonservice businesses, paying wages is critical. Thus, companies that rely on independent contractors (1099 workers) should consider hiring employees. If business assets are material, it might be worth replacing old assets and buying new assets that will be needed in the near future.
As more is clarified about the QBI deduction, more planning opportunities will become clear. But business owners and their advisors can take steps now to maximize the benefit of the deduction.
This article originally appeared in the June/July 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.