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Tax Reform Provides New 20% Deduction

Ron Skalberg
Tax Reform Provides New 20% Deduction

The new 2018 Section 199A tax deduction, also known as the Qualified Business Income (QBI) deduction, arises from the Tax Cuts & Jobs Act of 2017.  This provision provides for a 20% deduction of QBI and is one of the most significant tax breaks in the new law; but it is also one of the most complex and subject to numerous rules, limits and restrictions, of course.  See the section below titled “How the 20% Deduction Works for a Specified Service Provider” for more details on one of the more restrictive provisions.

If you operate your business as a sole proprietorship, partnership, or S corporation (pass-through businesses), your 2018 income from these businesses can qualify for some or all of the new 20% deduction.  You also can qualify for the deduction on the income you receive from your real estate investments, publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives.

When can you as a business owner qualify for this new 20% tax deduction with almost no complications?

To qualify for the 20% 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%. Second, to avoid complications, you need “defined taxable income” 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%).

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.

Some unfriendly rules apply to what Section 199A calls a specified service trade or business, such as operating as a doctor, lawyer or accountant. But if the doctor, lawyer or accountant has defined taxable income less than the thresholds above, the income qualifies for the full 20% deduction.

In other words, if you’re a physician with the same facts as in the example above, you would qualify for the $30,000 deduction.  See the section below titled “How the 20% Deduction Works for a Specified Service Provider” for more details.

Once you’re above the thresholds and phaseouts ($50,000 single, $100,000 married filing jointly), you can qualify for the Section 199A deduction only when

  • you are not in the out-of-favor group (accountant, doctor, lawyer, etc.), and
  • your qualified business pays W-2 wages and/or has property.

Phase-out of the 20% Deduction

If your pass-through business is an in-favor business and it qualifies for tax reform’s new 20% tax deduction on qualified business income, you benefit at all times, including being above, below, or in the expanded wage and property phase-in range. 

On the other hand, 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 phaseout range.

Once your taxable income exceeds the threshold amounts above, you arrive in one of the four possible categories below:

1. Phase-in range for a non-specified service trade or business

2. Phaseout range for a specified service trade or business

3. Above the phase-in range for an in-favor non-specified service trade or business

4. Above the phaseout range for an out-of-favor specified service trade or business

How the 20% Deduction Works for a Specified Service Provider

As discussed above, the 20% tax deduction under new 2018 tax code Section 199A is a very nice tax break for business owners, except for owners with high income who also fall into the out-of-favor group. 

In general, the out-of-favor group includes lawyers, doctors, accountants, tax professionals, consultants, athletes, authors, securities traders, actors, singers, musicians, entertainers, and others. 

Getting just a little more technical, the out-of-favor “specified service trade or business” group includes any trade or business

  • involving the performance of services in the fields of health, law, consulting, athletics, financial services, and brokerage services; or
  • where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners; or 
  • that involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose, a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities (Sections 475(c)(2) and 475(e)(2), respectively).

Notably, engineers and architects who had previously been in the out-of-favor professionals group somehow escaped the group with passage of this new law.

When you are a member of the out-of-favor group, your Section 199A deduction on your out-of-favor business is zero when you have taxable income of more than 

  • $415,000 if married filing a joint return, or
  • $207,500 filing as a single taxpayer.

The Specified Service Provider provision is one of the most vexing parts of the new law and we don’t think anyone truly understands what is going on with Section 199A, what the folks who drafted it were trying to accomplish, or who was supposed to benefit, and who wasn’t. 

Preserve the Deduction with an S Corporation  

Will your business operation create the 20% tax deduction for you? 

If not, and if that is due to too much income and a lack of (a) wages and/or (b) depreciable property, a switch to the S corporation as your choice of business entity may produce the tax savings you are looking for.

As mentioned above, to qualify for the full 20% deduction on your qualified business income under new tax code Section 199A, you need defined taxable income of less than $157,500 (single) or $315,000 (married).

If your taxable income is greater than $207,500 (single) or $415,000 (married), you don’t qualify for the Section 199A deduction unless you pay W-2 wages or have property.

Example. Sam is single, not in the out-of-favor specified service trade or business group (doctors, lawyers, consultants, etc.), operates a sole proprietorship that generates $400,000 of proprietorship net income, and has taxable income of $370,000. In this condition, Sam’s 20% Section 199A tax deduction is zero.

Here’s how the S corporation helps Sam. The S corporation pays Sam a reasonable salary, let’s say that’s $100,000. With this salary, Sam pockets

1. $10,871 on his self-employment taxes, and

2. $17,500 on his newfound 20% deduction under new tax code Section 199A.

Obviously, the complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the thresholds discussed above.  We’ve received significant guidance from the IRS since the law passed and expect further guidance, clarifications and corrections to come; and your team at Beaird Harris is prepared!

See Related Blog Posts Regarding the Tax Cuts and Jobs Act:

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