Eric Day, Esq.
Tax Breaks for Flow-Through Entities
Most of us business owners have taken a look at the new Tax Cuts and Jobs Act and thought to ourselves, “How will this affect me?” Then, as I’m sure all you business owners did, you googled the 429 page text, pulled up a chair and dove right in. Those of you that were able to complete your morning task, congratulations. The remaining individuals that were somehow pulled from a monotonous comma, let me help you understand what will likely affect you most.
When operating an active business, there are parameters that each one of us must navigate through to determine which entity will suit us best. There’s always the C-Corporation, which as of January 1, has a maximum rate of 21%. This is great news for you business owners operating as such, but you still might have concerns about distributing from the C-Corporation and double-taxation. You see, when a C-Corporation distributes income from the Corporation to the shareholders, it creates a dividend to the shareholder. The issue is, the dividend is not deductible to the Corporation, but the dividend income is taxable to the individual shareholder. As you can see, this means two taxpayers are paying taxes on the same income. But the rate is SO good!
That being said, what benefits are afforded all other entities that flow through to the Individual members? These are referred to as flow-through entities, of which the most common are: 1) Partnership; 2) S-Corporation; 3) Disregarded Entity or Sole Proprietorship and 4) a Trust. Flow-through entities are great because the income, loss and deductions of the entity flow-through to the individual members. What this means is that there is no tax liability at the entity level, but the tax liability is covered at the Individual member level. Each member will pay taxes on their allocable share of Income, Loss and Deduction by filing the information on their 1040. Because the Individual members pay the taxes on their allocable share, this also means that they will not be taxed on the distributions they take from the entity (for the most part). This helps the individual members avoid the double-taxation that burdens the C Corporation.
Even still, you may want to consider the C Corporation because although the Individual tax rates have reduced as well, they still max out at 37%, which is no comparison to a maximum 21% Corporate rate. It seems like Congress wanted all businesses to operate in the form of a C Corporation, right? Not so fast, while Corporations were shouting joyous hosannas for the significant rate decrease Congress afforded them, Congress passed Section 199A of the Tax Cuts and Jobs Act to alleviate those operating a Pass-through entity.
Qualified Business Income Deduction
Before we dive in to the intricacies of the law, the basic concept of the new Qualified Business Income Deduction is as follows:
For all entities other than a corporation, there shall be allowed a deduction for any taxable year an amount equal to the sum of the lesser of:
20% of your Qualified Business Income; or
The greater of:
50% of the W-2 wages paid by the qualified trade or business, OR
The sum of 25% of the wages, plus 2.5% of the unadjusted basis of all qualified property immediately after it’s acquisition.
Qualified Business Income
In order for us to determine the amount of our deduction, we must first look at what constitutes Qualified Business Income. Under the new law, Qualified Business Income is “. . . . the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” Many of you are thinking to yourselves, that is about as clear as the words coming from an enraged Donald Duck. But before we start serving buck-shot Roasted Duck, let’s take a closer look at what this means.
Qualified items of income, gain, deduction and loss are items of income, gain, deduction and loss that are effectively connected with the conduct of a trade or business within the U.S., and are included or ALLOWED in determining taxable income for the year. This is not to include items of capital gain or loss, dividend, interest (unless allocable to a trade or business), foreign currency transactions, notional principal contracts, or annuities not related to a trade or business. Further, Qualified Business Income is NOT to include any wage or guaranteed payment that the shareholder or partner might pay themselves from the Qualified Trade or Business.
For all you Lawyers, Doctors and Consultants out there, pay close attention to this next part. A Qualified Trade or Business is any trade or business OTHER THAN: 1) A specified service trade or business, or 2) an employee. So imbedded in the code, is the fact that you service providers are not considered a trade or business for purposes of this section. But don’t start looking for commodities that you could instantly start selling to support your service trade because you will still be able to take advantage of the 20% deduction if your taxable income is below the taxable income limitation. We will talk about the taxable income limitation and the phase-in of the W-2 limitation below.
What are the Taxable Income Limitations?
As with many deductions within the tax code, there are limitations on the amount of the deduction that will apply to those of you with flow-through entities. Under the provisions of section 199A(b)(3), Congress placed limits on the amount of the deduction that tie directly to the individual’s taxable income. It is important to note that the limitation is not based on the Business Income, but the taxpayer’s overall TAXABLE INCOME. The limits to the deduction begin when the taxpayer’s taxable income reaches $315,000 for joint filers and $157,500 for all other filers. In fact, up until you reach that taxable income limitation, you can ignore the W-2 wage limitation and simply take the 20% of QBI option when calculating the deduction.
Remember when we said that Specified Service Trades or Businesses were not considered a Qualified Trade or Business for this deduction? Well, as long as you maintain your taxable income below the taxable income limitation threshold, we get to disregard that unfortunate clause in this section. In other words, if an attorney’s taxable income is below the $315,000/$157,500 thresholds, he will get to take the 20% shave off his Service Income, just like everybody else.
So what happens when we reach taxable income of $315,000 for joint filers or $157,500 for all other filers? Once you reach that taxable income threshold, Congress has created a “phase-in” period, where you will no longer be able to disregard the W-2 limitation. In fact, the phase-in will make the W-2 limitation the standard for your business. The phase-in period will start once your income reaches $315,000/$157,500 plus $100,000/$50,000 respectively. Put plainly, once your income reaches $315,000 for joint filers or $157,500 for all others, you will have until you reach either $415,000 or $207,500, respectively, before you are required to use the W-2 Limitation fully.
For those Specified Service Trades or Businesses, when you have exhausted this phase-in region, you will lose the opportunity to take the deduction altogether. Congress felt that since the labor of the service individual is the profitable asset, they shouldn’t get a tax break for the amount of money they make that otherwise would have been paid as a wage-earning employee, who are also labor intensive.
Here is an example of how the wage limitation will work:
Dan and Patti are married and they file a joint tax return. Dan has Qualified Business Income of $200,000. His allocable share of the wages paid to employees from the business is $60,000. His wife also works and their taxable income together is equal to $300,000.
Under this example, Dan and Patti’s deduction would be $40,000 ($200,000 x .20). Because their taxable income remained below the $315,000 threshold, they were not required to account for the W-2 limitation and could simply take the 20% of QBI deduction.
All facts remain the same, except Patti is bringing in a little more now and their Taxable Income is equal to $355,000.
Assuming all other facts remain the same, Dan’s 20% of QBI deduction would still be $40,000 if we didn’t have to account for the W-2 limitation. The goal of the phase-in region is to lessen the 20% of QBI deduction until it equates to the W-2 limitation. So the first step is to determine what the excess amount of the 20% QBI deduction is over the W-2 limitation. The W-2 limitation is $30,000 ($60,000 x .5), therefore, the excess would be equal to $10,000 ($40,000 – $30,000). The next step is to determine what percentage of the phase-in amount have we used up before we are all the way phased in. Remember, we have a total of $100,000 after we pass the $315,000 Taxable Income Limitation before we are completely phased in. We are only $40,000 ($355,000 – $315,000) above the Taxable Income Limitation. Therefore, we have only used up 40% ($40,000/$100,000) of the total phase-in amount. After we have determined the ratio of complete phase-in that we have used up, we will take the same ratio of our excess deduction, $10,000, and subtract that from the 20% of QBI deduction we are allowed. Thus, we will subtract $4,000 ($10,000 x .40) from $40,000 to come up with our deduction of $36,000.
Same facts as before, but now we have Taxable Income of $415,000.
At $415,000 of taxable income we are now $100,000 ($415,000 – $315,000) above the taxable income threshold. We are allotted $100,000 of excess taxable income to allow us to phase-in to the W-2 limitation, giving us 100% ($100,000/$100,000) of used up phase-in value. If we were to take the same ratio of the excess 20% QBI deduction over the W-2 Wage Deduction, you would be left with $10,000 ($10,000 x 1). Subtract that $10,000 from the 20% of QBI deduction and you are left with $30,000, which just so happens to be the W-2 limitation. You are now phased into the W-2 limitation. That’s how it works.
Now I don’t intend for this blog to be the all-encompassing roadmap to success, but this is a start to understanding how the new tax laws will work. There are other things to consider, like the differences between an S-Corporation and a Sole Proprietorship. Since wages are a requirement of one entity, but are not included in the other, wouldn’t that affect how much deduction an individual gets to take? If my wage is not part of Qualified Business Income, I get less of a 20% deduction through the S Corporation, right? But I also don’t have to account for Self-Employment tax, which is determined before the 20% deduction is calculated, since the 20% deduction is a below the line deduction. There are many areas of the law that are still up in the air as to their treatment. That is one of the beauties of new law, there is no case law to determine the interpretation of that law. This means we are free to treat the ambiguities as we feel they should be, until told otherwise. But this all comes from risk adversity and how aggressive you want to be.
If you would like a consultation for any tax issues you might have, or just to do some tax planning, call us at Day & Nance and sit down with our tax attorneys to develop a plan for you. We can be reached at 702-309-3333 or send us an email at firstname.lastname@example.org. We look forward to helping you with your tax problems and providing you with a solution.