The New Tax Law [TCJA] Gives a Gift to Business Owners
Would you prefer to legally pay taxes on 80% of your profit or 100% of your profit? If you answered 80% [as I believe everyone did] then you are referring to new internal revenue code section 199A, also known as “pass-through entities. The Congress gave this to small business [non-“C” corporations] as a gift when they dropped the corporate [“C”] rate to 21%.
Essentially, if you otherwise qualify, you get to deduct 20% of your “qualified business income” [QBI] [Essentially your profit].
As with so many laws, there a lot of traps for the unwary and this article will go into the general principals of the new law, but don’t try this at home, instead discuss how you can qualify with your tax professional.
Taken at its simplest, if a business owner made a profit of $100,000 he or she would only pay taxes on $80,000.
But now the complications begin to set in and here are some of the most basic.
For the first time in American tax history, it makes a difference what you do for a living. Under this new law if your earnings are exactly the same as your neighbor you may pay more or less depending on whether or not you are in a “specified trade or business”. You are in a specified trade or business if you are in: “health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investing management, trading, dealing in certain assets, or any trade or business where the principal asset is the reputation or skill of one or more of its employees”. This group of people lose all of their 199A benefits if their profit exceeds the “magic numbers” [my term].
The “magic numbers” are $157,500 for a single person and $315,000 for a couple filing jointly. Singles get another $50,000 for a partial deduction and marrieds filing jointly get another $100,000 for a partial deduction.
For example, say a married orthopedic surgeon earns a profit of $1,000,000-no 199A deduction for her at all unless she consults her tax attorney for a way around this restriction. There is a good way around by her setting up an “S” corporation to sell the “replacement parts”, for example the artificial knees and hips” because that is NOT a specified trade or business and less strict limitations, which we will explain below, apply. For the purpose of this example let’s assume that the “S” corporation meets all the other 199A tests and the fair market value of the sales is $700,000 and therefore the surgeon only earns $300,000 from her medical work. She now has a 199A deduction, where she had none before, simply because she allocated part of her business out of her medical practice and into an “S” corporation.
For any business that is not a “specified business” the person exceeding the “magic numbers” gets a deduction of the lesser of the 20% of “QBI” [profit], or the greater of:
50% of the w-2 wages, or25% of the w-2 wages and [essentially] 2.5% of the original cost of depreciable assets.
Since I have had to resort to numbers I will make it more clear by way of simple examples.
Bob is a sole proprietor and makes a profit of $1,000,000 and doesn’t have any depreciable assets. No 199A deduction for Bob because he fails to meet the limitations. Bob can’t have w-2 wages because he is a sole proprietor, he must be an entity to pay w-2 wages. Bob pays tax on the full $1,000,000 profit.Sally has the identical facts to Bob above but she converted from a sole proprietorship to an “S” corporation and pays herself a wage of $400,000 out of her million dollar profit.
Sally’s gets a $200,000 199A deduction because she meets the limitations”.
The lesser of 20% of the “QBI” is $200,000 or 50% of the w-2 wages of $400,000 is $200,000.
Because of Sally’s simple tax planning of converting her sole proprietorship to an “S” corporation Sally enjoys a GIFT of a $200,000 tax deduction where she would have none, like Bob above, if she had stayed a sole proprietor.
This article barely scratches the surface, as there are many, many more planning opportunities that are beyond the scope of this article, speak to your tax professional for guidance.