It is stunning how few people realize the significance of one provision of the new Tax Jobs and Cuts Act of 2017, which became effective earlier this year. Perhaps the reason for this is that it is conceptually complicated, but that is my problem; it should not be yours.
Under the new Tax Act, independent contractors and small business owners fared very well. Employees who do not own an interest in a business got hurt.
Independent contractors and owners of small businesses received what is known as the Qualified Income Deduction (“QID”), which could reduce their taxable income by up to 20 percent. Given the progressive rate structure, this could reduce their federal income tax by more than 20 percent.
Employees who do not own a business do not qualify for the QID. What they got instead was a prohibition on deducting expenses relating to their employment such as union dues and costs of uniforms.
The computation of the QID is both a function of your personal taxable income and the allocable share of your trade or business income. Then there are limitations for certain individuals whose personal taxable income exceeds certain amounts. In addition, all businesses are not created equal. Certain businesses, such as professional practices, including doctors, lawyers and CPAs, are subject to additional limitations. Conveniently, engineers and real estate developers are exempt from the second limitation.
The key to maximizing the QID is to maximize the amount of income that qualifies for this deduction and work around the various limitations. This could be done by the following:
1. Adjust personal taxable income either up or down to qualify for a larger deduction.
2. Spin off certain assets or businesses that are now conducted in one entity into multiple entities.
3. Increase or decrease W-2 compensation at the entity level to owners and others.
4. Increase or decrease amounts contributed to a qualified retirement plan.
5. Purchase business assets at the entity level or at the individual level.
6. Become an independent contractor.
7. Change from a “C” corporation to an “S” corporation.
8. Change from an “S” corporation to an LLC to be treated as a partnership or disregarded entity for tax purposes or vice versa.
9. Create trusts for the benefit of family members (e.g., children) to own a portion of the business entity.
The last item is often ignored, but could be the most important. In addition to increasing the QID, it could reduce the family’s overall income tax by use of multiple income tax brackets. Funds in the trusts could be used to finance the children’s education and assist them in the purchase of a home or business, at reduced tax rates.
Like all matters of this complexity, it is important not to solve one problem and create another. While many of the issues to consider are tax related, some are not. There are asset protection issues, estate planning issues, control issues, compliance costs, regulatory issues, and more. It is important to remember the adage, “First, do no harm.”
This type of work should only be done by a well-qualified, experienced attorney, with a background in the areas discussed.
The new tax laws may be complicated, but don’t let that stop you from benefitting from potentially significant tax savings in 2018.