The New Business Tax Break: Qualified Business Income Deduction Hot

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Introduction

The Tax Cuts and Jobs Act (TCJA) has created a tax savings opportunity for businesses. Corporate tax rates have been reduced to a maximum 21 percent, while other businesses can qualify for a 20 percent income reduction by means of the Qualified Business Income (QBI) deduction.

The QBI deduction was enacted to allow “pass-through” (non-C corporation) businesses some of the benefits of tax reduction available only to C corporations. As much as this deduction is intended to create parity, it doesn’t quite get there.

The rules are quite complex, sometimes illogical, and sometimes unclear. In fact, in many areas, taxpayers will need to wait for clarification from the IRS and possibly Congress. In spite of the uncertainties, there is still plenty to learn about the QBI deduction.

Pass-Through

At a basic level, the QBI deduction is a 20 percent reduction of income from a “pass-through” entity. A pass-through entity is essentially any business structure other than a C corporation. Thus, a pass-through entity can include:

  • A sole proprietorship
  • A partnership
  • An S corporation
  • A single member LLC
  • A multi-member LLC

In other words, the type of entity is not important. When clients ask whether they should change their sole proprietorship to an LLC or an LLC to an S Corporation, the answer is no – unless they have a non-tax reason to do so.  

Service Business

Service businesses are entitled to a very limited QBI deduction, based on income levels. If the business is a service business, the maximum deduction is limited to the lesser of 20 percent of QBI or 20 percent of total taxable income minus capital gains. This deduction 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.

In other words, service businesses only get a benefit for the QBI deduction if total income is below the stated thresholds.

A pertinent question is what qualifies as a service business? The TCJA defines service businesses as those that are in the areas of:

  • Health
  • Law
  • Accounting
  • Actuarial science
  • Performing arts
  • Consulting
  • Athletics
  • Financial services
  • Brokerage services
  • Investing and investment management
  • Trading or dealing in securities, partnership interests or commodities

Strangely, the TCJA exempts engineering and architectural businesses.

At this point, it might seem that the definition of a service business is fairly straightforward. However, the law also included “any trade or business where the principal asset of the business is the reputation or skill of an employee or owner.” This broad definition creates a very uncertain situation for many businesses. For example, is a catering business’s principal asset the reputation or skill of an employee or owner? How about a glass-blower? A writer?

Non-Service Businesses

Any business that is not a service business is considered a non-service business. For these businesses, the QBI deduction is limited to 20 percent of taxable income minus capital gains and is based on the lesser of:

  • 20 percent of QBI
  • Greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of post-2008 business assets

It should be noted that wages do not include guaranteed payments to partners or LLC members or wages to S corporation owners. Yet, in determining QBI, 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 (buildings, furniture, computers, etc.) and does not include intangible assets (licenses, patents, goodwill, etc.). For purposes of the calculation, the value is equal to the original cost reduced by the section 179 deduction. Further, the assets qualify during the useful life per IRS depreciation tables or 10 years, whichever is greater.

Planning Opportunities

The first step in planning for the QBI deduction is to determine whether or not the business is a service business. If a service business, consider the income limitations. A business owner who is close to or over the income limit should look at ways to reduce taxable income. Strategies could include:

  • Retirement plan contributions
  • Change in accounting method
  • Accelerate expenses

For non-service businesses, paying wages is critical. Thus, companies that rely on independent contractors (1099 workers) should consider hiring employees instead. If business assets are material, it might be worth replacing old assets and/or buying new assets that will be needed in the near future.

As more information is known about the QBI deduction, more planning opportunities will become clear. At this point, business owners and their advisors need to begin to take steps to maximize the benefit of the QBI deduction.

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