Under the new tax law, the Tax Cuts and Jobs Act, the most significant new tax deduction taking effect in 2018 impacting most of our business owners will be the so-called “20 percent deduction.” This 20 percent deduction should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. While it certainly is a worthwhile deduction, it is a very complex computation with little guidance so far from the Internal Revenue Service as to the rules related to the law.
WHAT INCOME IS ELIGIBLE FOR THE 20 PERCENT DEDUCTION?
The deduction is generally equal to 20 percent of your “qualified business income” (QBI) from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to all of your combines trade or businesses. This income is sometimes referred to as “pass-through” income. The business must be conducted within the US to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). Also, QBI does not include reasonable compensation received from an S corporation or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces taxable income but not adjusted gross income. It it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20 percent of the excess of your taxable income over net capital gain. Significantly, if QBI is less than zero, it is treated as a loss from a qualified business in the following year. Therefore, losses in years after 2017 can negatively affect your 20 percent deduction in future years.
SPECIFIED SERVICE BUSINESSES MAY LOSE OUT!
Business income from some specific services industries may not be eligible for the 20 percent deduction. Specified service trades or businesses are trades or businesses that perform services in the fields of health, law, consulting, athletics, performing arts, financial or brokerage services, or those trades or businesses in which the principal asset is the reputation or skill of one or more employees or owners. Architects and engineering service firms are not included as a specified service business.
These rules involve “thresholds,” i.e. taxable income of over $157,500 ($315,000 for joint filers). If you are a single taxpayer and your taxable income is at least $50,000 above the threshold, i.e., it is at least $207,500 ($157,500 + $50,000), all of the net income from a specified service trade or business is excluded from QBI, so no 20 percent deduction would be allowed. Joint filers would use an amount $100,000 above the $315,000 threshold, or $415,000. For taxable incomes that are between the threshold amounts and the $207,500/$415,000 amounts, the exclusion from QBI of income from specified service trades or businesses is phased in.
NOT A SPECIFIED SERVICE BUSINESS, STILL MORE LIMITATIONS
Additionally, for taxpayers with taxable incomes more than the above thresholds, there is a limitation on the amount of the deduction that is based either on wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $207,500 ($415,000 for joint filers), your deduction for QBI cannot exceed the greater of (1) 50% of your allowable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate).
Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
Obviously, the complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the thresholds discussed above. Also, since this is a VERY new law, the IRS has not had time to write rules and regulations detailing how it will be interpreted, adding to the law's complexity. However, we at Glass Jacobson have been following the changes to the tax laws since Congress began discussing them. Our extensive reading and analysis will allow insightful application of the law to position our business clients in the best possible tax situation in light of the new law.
If you wish us to work through the mechanics of the deduction with particular attention to the impact it can have on your specific situation, do not hesitate to contact us during the year. We look forward to maximizing this deduction so that your 2018 and future years’ taxes are minimized as we assist in building wealth for you!
What additional questions do you have about the tax law or this deduction? Please ask away by leaving a comment below!
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