Tax Deductions for Business Owners
One of the best provisions of the tax reform act is the 20% deduction granted to owners of pass-through entities. Any non-corporate taxpayer can take up to a 20% deduction for qualified business income ("QBI") that business owners receive from their pass-through entities. QBI is limited to income effectively earned by a trade or business, excluding investment income, and in the case of a partnership, guaranteed payments or other payment for services rendered by a partner.
Pass-through entities include the following: S corporations, LLCs, partnerships and sole proprietorships. Not all pass-through entities are treated the same under the new tax law. Certain business owners, called "specified service business" will have their deductions limited or excluded based upon their overall taxable income. These owners are those in the fields of law, accounting, financial advising, health, consulting, athletics, where the principal asset of such trade or business is the talent of its owner. There is a specific exception for architects and engineers.
The income thresholds, for specified service businesses to take the 20% deduction are as follows: a) for business owners who are married and filing joint returns the phaseout begins at $315,000 and is eliminated at $415,000; b) for business owners who are unmarried the phaseout begins at $157,500 and is eliminated at $207,500. The limitation on the 20% deduction will be based on the combined taxable income of jointly-filed tax return. For example, if a husband has $175,000 of income from his legal business that is an LLC and his wife has $260,000 of W-2 income, then their combined income of $435,000 exceeds the limit of $415,000 applicable to jointly-filed tax returns. In this instance, the Husband could file his return as married filing separately and take the 20% deduction.
Fortunately, for engineers and architects they are not treated the same as lawyers, accountants and financial advisors. These business owners are still allowed a tax deduction when their income exceeds the limits, but the deduction becomes the lesser of the following:
- 20% of Business Income; or
- The greater of: a) 50% of W-2 wages; b) 25% of wages plus 2.5% of the cost of depreciable assets in the business.
Obviously, an engineering or architectural firm can invest in depreciable assets and convert contractors to W-2 employees to generate more QBI (Qualified Business Income) deduction. for partners and shareholders of an S corporation, the deductible amount is determined at the partner or shareholder level. Wages paid to W-2 employees are apportioned to them based on their allocable shares of wages expenses, and qualified property is apportioned to them based on their allocable shares of depreciation.
Partners and LLC members should be aware that guaranteed payments will not be considered as income qualified for the 20% deduction. The partnership agreement can be amended to eliminate guaranteed payments, but that might necessitate a change to the ownership stakes, so that the partner can recover the amount of the guaranteed payment.
An option for business owners to consider, who have excess profits that eliminate their deduction, is to convert to an S Corporation and take enough of a salary to reduce net business income to an amount qualifying to the 20% business deduction. Another option is to form non-grantor trusts to move taxable income so that it is separately earned within the income thresholds.
Tax reform was premised on simplicity, but the pass-through deduction introduces new complexities to the system. Taxpayers need to plan accordingly.
Gene M. Bowman, Tax Attorney