Copyright © 2017 by Robert M. Kramer
Most professionals and business owners conduct their business using pass-thru entities such as “S” corporations, partnerships, and LLCs taxable as partnerships or “S” corporations. Items of income, deduction, gain, loss, etc. are passed-thru to the owners to be taxed at the owner level. There is no entity level income tax to pay.
Under the 2017 Tax Act, newly created Section 199A of the Internal Revenue Code will accelerate this trend. Many people will meet with their tax advisors to redo their organizational structure to take advantage of the Qualified Business Income deduction or the “QBI” deduction.
Discover how Arthur and Diane, a fictional married couple who file jointly, might prepare for these changes to the Internal Revenue Code. Arthur is a 50 percent shareholder in an S corporation that sells widgets. His share of the trade or business income shown on his S Corporation K-1 is $200,000. He also receives W-2 compensation income from his S Corporation. Diane is an employee at an unrelated business. Their taxable income for 2018 is $315,000, before the QBI deduction. They have no capital gains.
The below examples are oversimplified to illustrate the basics and not make this overcomplicated.
Example 1: Married filing jointly with taxable income of $315,000 or less. The QBI deduction is equal to:
(a) 20 percent of the allocable trade or business pass-thru income; and
(b) 20 percent of personal taxable income less capital gains.
In our example,
(a) 20 percent of S Corporation K-1 income of $200,000, or $40,000; and
(b) 20 percent of the taxable income of $315,000, or $63,000.
Arthur and Diane receive a QBI deduction of $40,000, which reduces their taxable income by this amount.
Example 2: Arthur and Diane have taxable income of $415,000 although the S Corporation K-1 income is still $200,000. The increase in personal taxable income is attributable to higher compensation and investment income. They still do not have any capital gains. In this example, we will assume that Arthur’s allocable share of W-2 income from the S Corporation is $110,000 and Arthur’s allocable share of the property used in the S Corporation is $100,000.
The formula is the same as in Example 1, except a new component is added. This new component is phased in starting when personal taxable income is above $315,000 and applies fully at $415,000.
The QBI deduction is the lesser of (a), (b) and (c), where
(a) is 20 percent of the allocable trade or business pass-thru income;
(b) is 20 percent of personal taxable income less capital gains; and
(c) is the greater of:
(A) 50 percent of Owner’s allocable share of W-2 compensation paid by the pass-thru entity; and
(B) 25 percent of Owner’s allocable share of W-2 compensation paid by the pass-thru entity plus the Owner’s allocable share of 2.5 percent of the original cost of property used in the pass-thru trade or business (subject to modifications.)
In this example, the QBI deduction for Arthur and Diane is the lesser of (a), (b), and (c), where
(a) is 20 percent of the S Corporation K-1 income of $200,000, or $40,000;
(b) is 20 percent of taxable income of $415,000, or $83,000; and
(c) is the greater of (A) and (B), where (A) is 50 percent of Arthur’s allocable share of the W-2 compensation of $110,000, or $55,000 and (B) is 25 percent of Arthur’s allocable share of the W-2 compensation of $110,000, or $27,500, plus 2.5 percent of Arthur’s allocable share of the property used in the S Corporation of $100,000, or $2,500, which equals $30,000. Thus (c) is $55,000.
The QBI deduction is the lesser of $40,000, $83,000 and $55,000, which is $40,000.
Another complication. Certain specified service business owners, such as doctors, lawyers, and CPAs, are not permitted to receive a QBI deduction attributable to their practice trade or business, if their personal taxable income if filing jointly is $415,000 or above. There is a phase-out of the QBI deduction for such practice income starting when personal taxable income exceeds $315,000. If Arthur were a doctor, his QBI deduction would be zero rather than $40,000 because his personal taxable income was $415,000.
This does not mean that such individuals are not eligible for the QBI deduction, it just means there is no QBI deduction available from that trade or business, above certain thresholds. The effect of this is that tax advisors will be busy restructuring their client’s practices and business interests, in order to qualify for the QBI deduction.
For example, a medical practice is really two businesses in one: the practice of medicine and a management business (e.g., accounting functions, managing employees, ordering supplies, etc.) Some practice income may be able to be allocated to a new pass-thru entity that will qualify the owners for a QBI deduction. In other cases, W-2 income may be adjusted to maximize the QBI deduction.
The conversation about taxes and pass-through businesses under the new tax law has begun and we look forward to addressing planning opportunities in upcoming articles.