Note: This piece was originally meant to be included in my Year-end Business Tax Planning post, but I broke it out separately due to the length and complexity of the subject.
One of the biggest changes for 2018 is the new qualified business income deduction. If you are a sole proprietor, a partner in a partnership, a member in an LLC taxed as a partnership, or a shareholder in an S corporation — i.e. a passthrough entity owner — you may be entitled to a deduction for qualified business income for tax years beginning after December 31, 2017, and before January 1, 2026. Trusts and estates are also eligible for this deduction.
While there are important restrictions to taking this deduction, the amount of the deduction is generally 20 percent of qualifying business income from a qualified trade or business. A qualified trade or business means any trade or business other than (1) a specified service trade or business, or (2) the trade or business of being an employee. A “specified service trade or business” is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.
However, there is a special rule which allows you to take this deduction even if you have a specified service trade or business. Under that rule, the provision disqualifying such businesses from being considered a qualified trade or business for purposes of the qualified business income deduction does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the restriction is phased in over a range of $50,000 in taxable income ($100,000 for joint filers). Thus, if your income falls within the range, you are allowed a partial deduction. Once the end of the range is reached, the deduction is completely disallowed.
For purposes of the deduction, items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States. In calculating the deduction, qualified business income means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer.
Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, or any guaranteed payment (or other payment) to a partner in a partnership for services rendered with respect to the trade or business. Qualified items do not include specified investment-related income, deductions, or losses, such as capital gains and losses, dividends and dividend equivalents, interest income other than that which is properly allocable to a trade or business, and similar items.
If the net amount of qualified business income from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business to the next tax year (and reduces the qualified business income for that year).
W-2 Wage Limitation
The deductible amount for each qualified trade or business is the lesser of: (1) 20 percent of the taxpayer’s qualified business income with respect to the trade or business; or (2) the greater of: (a) 50 percent of the W-2 wages with respect to the trade or business, or (b) the sum of 25 percent of the W-2 wages with respect to the trade or business and 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property (generally all depreciable property still within its depreciable period at the end of the tax year).
The W-2 wage limitation does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the W-2 limitation is phased in over a range of $50,000 in taxable income ($100,000 for joint filers).
In the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level. Each partner in a partnership takes into account the partner’s allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the tax year equal to the partner’s allocable share of W-2 wages of the partnership. Similarly, each shareholder in an S corporation takes into account the shareholder’s pro rata share of each qualified item and W-2 wages.
The deduction for qualified business income is subject to some overriding limitations relating to taxable income, net capital gains, and other items which are beyond the scope of this letter and will not affect the amount of the deduction in most situations.
Changes in Accounting Method Rules
The new tax law has also expanded the number of businesses eligible to use the cash method of accounting as long as the business satisfies a gross receipts test. This test allows businesses with annual average gross receipts that do not exceed $25 million for the three prior tax-year period to use the cash method. A similar gross receipts threshold provides an exemption from the following accounting requirements/methods: (1) uniform capitalization rules; (2) the requirement to keep inventories; and (3) the requirement to use the percentage-of-completion method for certain long-term contracts (thus allowing the use of the more favorable completed-contract method, or any other permissible exempt contract method).
As you can see, there is much more to this deduction than a simple, 20% cut off the top of your passthrough income. However, like everything else in the tax law, with proper planning, you can maximize your available deduction to get you the largest reduction in tax liability.