How to Save 20 Percent or More on Federal Income TaxesMarch 9, 2018 | Category: Corporate and Taxation
How to Save 20 Percent or More on Federal Income Taxes
Copyright © 2017 by Robert M. Kramer
This is the second in a series of articles on the new Qualified Business Income (“QBI”) tax deduction. Click here for the first article, which covers the mechanics of the QBI deduction.
Today’s article focuses on case studies and planning opportunities to maximize the deduction. Because the deduction has the potential to reduce your federal income tax by 20 percent or more on your QBI, this is not something to ignore.
Here is a quick summary of the QBI. I have oversimplified some aspects for the sake of clarity.
You will need to be an independent contractor or an owner of an “S” corporation, partnership or an LLC that is engaged in a trade or business. These trade or businesses are referred to as “pass through entities.” Those who have no ownership in a trade or business are not eligible for the QBI deduction.
The personal QBI deduction is the least of (a), (b) and (c), where:
(a) is 20 percent of the individual’s allocable share of trade or business pass-through income;
(b) is 20 percent of the individual’s taxable income (less capital gains); and
(c) is applicable if taxable income (less capital gain) for a married individual filing jointly is over $315,000 with a phase-in between $315,000 and $415,000; Component (c) is the greater of (A) and (B), where
(A) is 50 percent of Owner’s allocable share of W-2 compensation paid by the pass-thru entity; and
(B) is 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-through trade or business (subject to modifications).
One more issue. Owners of professional practices (including doctors, attorneys, and CPAs) and certain others, receive no QBI deduction from such practice if their personal taxable income (less capital gains) is $415,000 or higher and a reduced QBI if their personal taxable (less capital gains) is between $315,000 and $415,000. These practices are known as a “specified service trade or business.” This rule does not apply if your taxable income is $315,000 or less.
Case Study 1
Southport Cardiology, P. A., an “S” corporation, is owned equally by 2 doctors. Each doctor receives a K-1 for $250,000 and a W-2 for $200,000. With other income and deductions, each doctor has taxable income of $415,000. Dr. Thomas is an employee who receives W-2 compensation of $250,000, but no K-1 income as he owns no stock in the practice.
Under such circumstances, he is entitled to no QBI deduction as he has no pass-through income from the practice. He and the P.A. renegotiate his arrangement so that he now makes $275,000 per year as independent contractor. Assuming that his taxable income is then $275,000, Dr. Thomas receives a QBI deduction of $55,000 (20 percent of $275,000) which reduces his taxable income to $220,000. From a health law perspective, in switching from an employer-employee relationship to that of an independent contractor relationship, the P.A. and Dr. Thomas need to carefully consider the basis for their compensation arrangement, to ensure that same does not violate the federal and Florida fraud and abuse statutes.
Case Study 2
The two shareholders in Southport Cardiology, P.A. receive no QBI deduction from this organization because of the specified service trade or business rule discussed above.
They meet with their tax attorney who recommends a defined benefit plan that allows the PA to contribute $100,000 on each of their behalves to a related trust. This results in $200,000 less in PA corporate profits and a reduction of K-1 pass-through income from $250,000 to $150,000 for each of them.
Since each of their taxable income before the QBI deduction is now $315,000, the specified service trade or business trade or business rule does not apply. Each doctor will receive a QBI deduction of $30,000 (20 percent of K-1 income of $150,000). The QBI deduction further reduces each of their taxable income from $315,000 to $285,000.
Case Study 3
Mr. Perini, a CPA, practices through a wholly-owned LLC that is treated as a disregarded entity. He is therefore treated as a sole proprietor. His personal taxable income (less capital gains) is $415,000 ($439,000 gross income from the practice, and no other income, less the $24,000 standard deduction), which makes him ineligible for a QBI deduction from this business as he practices in a specified service trade or business. Undeterred, the LLC purchases a state of the art computer system that costs $100,000. Under the 2017 Tax Act, he can deduct the full cost of the computer in the year of purchase. This $100,000 cost reduces the LLC and, in turn, his taxable income to $315,000, before the QBI deduction. He is now eligible for the full QBI deduction of 20 percent of $315,000 or $63,000, which reduces his taxable income from $315,000 to $252,000.
Case Study 4
Mr. Diaz, an attorney, received a K-1 from his wholly-owned “S” corporation of $300,000 and a W-2 for $150,000. With itemized deductions, his taxable income is $415,000. He has no capital gains. Once again, no QBI deduction is available because of the specified service trade or business rule.
His spouse forms a litigation administrative company that performs the duties of running the business aspects of the law practice- bookkeeping, personnel matters, fringe benefits selection and compliance, travel arrangements, etc. The administrative company generates $100,000 of profits, which reduces the law firm profits by the same amount. In essence, $100,000 of income has been shifted from the law firm to the administrative company. While the couple still cannot receive a QBI deduction from the law firm as their taxable income is still $415,000, they receive a QBI deduction of $20,000 (20 percent of $100,000) from the administrative company.
Case Study 5
Ms. Miller, a sole proprietor, operates a computer software company that provides her $600,000 profits per year. She has virtually no investment in the business. She produces the software herself primarily but hires independent contractors as necessary. Assume her personal taxable income (less capital gains) is $600,000.
From a QBI standpoint, Ms. Miller is not operating in the appropriate entity as there are no W-2 wages being paid to herself or anyone else. Since the wage component (c), addressed earlier, is zero, and the QBI deduction is the least of (a), (b), and (c), the QBI deduction is zero.
By operating through an “S” corporation and taking a W-2 salary of $175,000 a year, her K-1 income from the “S“ corporation would be approximately $425,000. She would now be entitled to a QBI deduction equal to the least of (a) 20 percent of her taxable income (less capital gains) of $600,000 or $120,000; (b) 20 percent of the trade or business profits of $425,000 or $85,000; and (c) 50 percent of W-2 income of $175,000 or $87,500. The QBI deduction is $85,000, which reduces her personal taxable income from $600,000 to $515,000.
Changing forms of organizational structures and relationships are fraught with complex tax, economic, asset protection and regulatory issues. Be sure to seek qualified professionals to help you.