New Pass-through Tax Rules Benefit Small Business
Joseph A. Lux, C.P.A., PLLC
January 1, 2019
This year most small business owners can look forward to the possibility of enjoying a substantial tax savings on their 2018 tax returns. Such businesses will be able to take advantage of the new 20% tax deduction for “qualified business income” (QBI). A new line has been added to federal form 1040 just for this deduction. That’s a big deal! Generally, a 20% deduction = and 20% reduction of related income taxes.
Example: In 2018, Carol earned $100,000 QBI from her qualified business. Carol's Qualified Business Income Deduction (QBID) for 2018 is $20,000. Carol will take this deduction on her 2018 personal tax return. Tax will be due on the remaining $80,000. This deduction will likely save Carol anywhere from $200 - $7,400 in taxes depending upon her tax bracket.
The deduction applies to owners of so-called “pass-through” businesses such as sole proprietorships, limited liability companies, and S corporations. The great majority of small businesses are pass-through businesses that should qualify for this deduction.
Qualified business income is the net amount of qualified items of income, gain, deduction, and loss from most any U.S. business. Only items that are included in taxable income are counted in qualified business income.
A qualified business is any business except for certain professional service businesses. Excluded professional service businesses include the fields of health, law, accounting, actuaries, performing arts, consulting, athletics, financial services, brokerage services, and investing services. However, individual taxpayers who make less than $157,000 ($315,000 for married couples) are not subject to these exceptions.
Most of you are likely wondering if this benefit is just another IRS bait and switch that will evaporate as soon as your income exceeds some ridiculously low threshold, or will be lost due to alternative minimum tax (AMT). Well, good news, for most taxpayers this is not the case. Income phase out thresholds are quite high and these thresholds do not even apply to many small businesses. Also, the qualified business income deduction is allowed for AMT. With some careful planning most small business owners will be able to benefit. Lets take a look at the restrictions:
• This deduction does not apply to wages or partnership guaranteed payments. Planning to minimize this type of compensation will likely maximize your QBID.
• This deduction is subject to a phase out for most professional service businesses like Doctors, Lawyers, and Accountants. These phase outs do not start to kick in until taxable income exceeds $157,500 for singles and $315,000 for married filers. With proper planning taxable income can be reduced so to possibly fall under these thresholds.
• The QBID for other small business owners who have taxable income in excess of the above thresholds is limited to the greater of 50% of wages or 25% of wages plus 2.5% of qualified property. This is a tricky one. Advance planning is needed so to maximize your allowable QBID.
• The QBID is limited to 20% of the business owner’s total taxable income (from all sources) if that amount is less than the QBID. Low taxable income may result in a lost QBID. Planning is needed.
• This deduction is not available for rental income that does not rise to the level of a trade or business. Confirming that your rental property does rise to the level of a trade or business is crucial.
• Your choice of business entity (sole proprietor, partnership, corporation) will impact the amount of QBI available for the deduction. A change of business entity should be considered.
• Entities with losses must be offset against entities with income before a QBID is calculated. Net losses must be carried forward to future years and applied against future QBI. Planning for business losses is a must.
• Most states have not committed to following the new federal tax rules. State tax planning must be coordinated with federal tax planning.
Small business owners should ask their CPA whether they will qualify for the new QBID and how they can maximize it. Your CPA can assist you to navigate the law and implement a strategy that will help you to maximize the tax savings from your 2018 Qualified Business Income Deduction.