A Key Provision of the Tax Reform Act: New 20% Deduction for Small Business Owners

The Tax Cuts and Jobs Act was signed into law on Dec. 22, 2017. One of the key measures provides a 20 percent deduction beginning in tax year 2018 on pass-through income from sole proprietors, limited liability companies, partnerships and S corporations.

The 20 percent deduction applies to Qualified Business Income (QBI), which includes the net amount of income, gains, deductions and losses associated with a trade or business, but not investment-related items, such as capital gains or losses, dividends and interest income. The new deduction is taken below the line, which means it reduces taxable income not adjusted gross income.

Two Limitations on High-Income Earners

The Act sets limits on how much people with high incomes can deduct:

1. Professional service industries. The new rules deter high-income taxpayers from trying to convert wages or other compensation from personal services into income that qualifies for the deduction. For people in the professional service industries, such as health, law, consulting, athletics and financial, the 20 percent deduction would begin to be phased out for those who earn more than $315,000 (for couples) and $157,500 (for singles). The deduction is fully phased out when income reaches $415,000 (for couples) and $207,500 (for singles).
2. All industries. For high-earners in all industries, the new Act uses another calculation to limit the deduction. The limit would be set to whichever is higher: 50 percent of total wages paid or 25 percent of wages plus 2.5 percent of the cost of tangible depreciable property. This means pass-through entities that pay a large amount of employee wages or are in capital-intensive industries can take more of the deduction.

Tax Savings and Planning Opportunities

Small business owners may consider doing some scenario planning to optimize the 20 percent deduction. Here are some tax planning opportunities:

• Because of the phase-outs and threshold amounts, married taxpayers may want to compare married filing jointly versus married filing separately to see which status yields the higher benefit.
• Generally, it’s advantageous to reduce W-2 wages to minimize self-employment taxes. However, increasing W-2 salaries to a certain level may be necessary to optimize the 20 percent deduction. Thus, converting a 1099 contractor to a W-2 employee could be beneficial.
• Small businesses qualifying for the 20 percent tax deduction could see their effective marginal tax rate reduced to 29.6 percent. Under the new law, the top income tax rate for C corporations is reduced to 21 percent. C corporations are taxed twice (once on the income and then on the returns to investors), so it may not make sense to convert an S corporation to a C corporation.

Case Studies

Some examples may help clarify this complex law and the impact it may have on your small business clients.

Example 1. Courtney is single and operates a solo accounting practice. Courtney is self-employed and doesn’t have any employees. In 2018, Courtney’s practice nets $100,000 in qualified business income, which is below the threshold for service businesses. Assuming Courtney’s taxable income does not top $157,500 and is above $100,000 for 2018, her qualified business income deduction is $20,000 (20% x $100,000) for 2018.

Example 2. David owns a retail business in a partnership structure, where he has one part-time employee. He is married and files jointly. In 2018, his taxable income is $420,000, and his share of net income from the business is $130,000. The W-2 wages for his part-time employee are $24,000. David is not in a service business, so he isn’t subject to the service business limitation. His deduction for 2018 would be $26,000 (20% x $130,000), yet he is subject to the wage limitation. Instead, his deduction is limited to $12,000 (50% x 24,000).

Editor’s note: Parts of this article were originally published in SmallBizDaily.