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How Tax Reform is a Big Win for Most Small Business Owners

by
Sherri Hastings
on
2/27/2018
How Tax Reform is a Big Win for Most Small Business Owners

One of the most notable changes created by the new tax law is the new tax benefit in the form of a deduction impacting non-C corporation business owners. When Congress decided to eliminate the graduated rate (which maxed out at 35%) that C-corporations were paying, they were mindful of making sure that all taxpayers with business income were on a level playing field. The result was a flat rate of 21% for C-corps, and a deduction equal to 20% of qualified business income (QBI) for business entities with pass-through income such as sole proprietorships, partnerships, and S-corporations.

The new rules, which also applies to pass-through income from cooperative dividends, rentals and farms, Real Estate Investment Trust (REIT) dividends and pass-through income from publicly traded partnerships, can be found in Internal Revenue Code section 199A. Though it represents a significant benefit for most non-C-Corp business owners, it is quite complicated. Let's review the details.

What is QBI?

The first thing that needs to be understood when addressing the new tax deduction is exactly what Qualified Business Income (QBI) is, what it includes and what it doesn't include. QBI includes the net of a U.S. business or trade's income, losses, gains, and deductions. When calculating a business' QBI, keep in mind that negative numbers are taken as qualified business losses in the following tax year.

QBI specifically excludes the following:

  • Annuity income not received in connection with a trade or business
  • Capital gains or losses
  • Dividends or payments in lieu of dividends
  • Gain or loss from foreign currency transactions
  • Guaranteed payments from a partnership.
  • Interest income
  • Limitation thresholds
  • Reasonable compensation from an S-corporation
  • Trade or business of being an employee
  • Wage limit

The new deduction on pass-through income can be taken whether the individual itemizes or claims the standard deduction. It is taken after the taxpayer calculates adjusted gross income and is not considered a business deduction. It has no impact on the calculation of the taxpayer's self-employment tax liability, which remains the same.

High Level of Complexity

Remember those promises about filing taxes on a postcard? That definitely does not apply to the calculation of this deduction. There is a high level of complexity, and taxpayers will need to be mindful of limitations and thresholds on its applicability based on the taxpayer's taxable income (note: where taxable income is referred in this article, it means taxable income without regard to the deduction), and the combined pass-through deductions from all entities.

Limitations and Thresholds

Though the promise of a 20% deduction on QBI seems straightforward, in reality, there are numerous limitations and rules based on the taxpayer's taxable income for the specific year for the amount that can be deducted. In some cases, these result in a reduction, while in others there are phase-outs and phase-ins.  The details are shown below:

Where taxpayers, have a taxable income, without regard the deduction, below the threshold for their filing status their deduction is calculated very simply and is 20% of their QBI Income.

Example: Jack is single and self-employed. His net profit from his Schedule C business for 2018 is $120,000. His deduction is $24,000 (.2 x $120,000).      

However, where a taxpayer's taxable income without regard the deduction exceeds threshold amounts then things become complicated.  There is also a special rule for what the tax code refers to as “specified service businesses”.  So lets first take a look a look at that special rule.

Special Rules for Specified Service Businesses

Businesses that are categorized as specified service businesses are those that operate and succeed based on their owners' and employees' specific skill or reputation. Though this category excludes architectural businesses, investment-oriented businesses and trades and engineering businesses, it includes consultants, financial services businesses, law and medical practices, accounting and actuarial science services, athletics, performing arts, and others.

For these type of businesses, the deduction begins to phases out when then the taxpayer's taxable income, without regard to the deduction exceeds the threshold amounts and is fully phased out the taxable income reaches the maximum. 

Example: Maury is a married self-employed financial planner.  His net profit from his Schedule C business for 2018 is $365,000. Since his business is a specified service business the deduction ratably phases out between $315,000 and $415,000. Since his taxable income is halfway between the threshold and the maximum his phase-out will be 50%. Thus his deduction is $31,500 (315,000 x 20% x 50%). Once his taxable income exceeds $41,000 his deduction is fully phased out and he no deduction.      

Deduction Limits for Entities Where The Taxpayer's Taxable Income is Above The Threshold. 

For businesses other than specified services businesses or where the taxpayer's taxable income is above the threshold the calculation of the business' QBI becomes considerably more complex and takes into consideration what is referred to as the “wage limitation.”   

The wage limit is the greater of

  • 50% of the W-2 wages from the business or
  • 25% of the W-2 wages from the business plus 2.5% of the unadjusted basis of the business's qualified property.

However, the wage limitation is phased in where taxpayer's taxable income is between $315,000 and $415,000 for married taxpayers filing jointly and $157,500 and $207,500 for others.  

Thus the deductible amount for a business entity where the taxpayer's taxable income is above the threshold is the greater of lesser of 20% of QBI or the wage limitation. 

Example: In a more complex calculation, consider a shareholder in an S-corporation who files jointly and who has taxable income of $500,000, which is above the maximum. This means that the calculation of the deduction needs to first determine whether the wage limitation is lower or whether 20% of the QBI is lower.  If the K-1 reports that their prorated share of the qualified business property is $75,000 and the shareholder received $300,000 as their pro rata QBI, then 20% of QBI would be $60,000 ($300,000 x .20). The wage limitation calculation compares 50% of the $100,000 in wages ($50,000) against 25% of the $100,000 in wages added to 2.5% of the $75,000 in qualified business property ($26,875) to see which is larger. Even at the higher $50,000 calculation, the wage limit deduction comes in lower than the $60,000 QBI, and thus the deduction is limited to the $50,000.

Adding it all Up

As complex as the calculations up to this point have been, they're not the end of the story. Taxpayers need to run through these calculations for every one of their business entities, then add them in another intricate calculation. Then they are combined with the sum of all of the taxpayer's cooperative dividends after limitations, their publicly traded partnership income and their REIT dividends, multiplied by 20%.  This represents the total deduction for all entities which is then limited to the taxpayer's adjusted taxable Income (taxable income less capital gains).

Though the new business deduction offers significant benefits, it also represents a tremendous amount of calculation that could easily become overwhelming. For assistance, contact an accounting professional to make sure that every aspect of this complex process has gotten the attention that it needs.

Tim Murphy, CPA writes for TaxBuzz, a tax news and advice website. Reach his office at [email protected].

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Sherri Hastings

Sherri Hastings

Tim Murphy is the managing member at Murphy & Murphy, CPA, LLC, a full-service certified public accounting firm, with emphasis on tax preparation, audits of governmental, educational, and non-profit entities, retirement planning, estate planning, business valuations, litigation support, and banking. He is a Certified Public Accountant in Maryland and Virginia. Tim is also a CERTIFIED FINANCIAL PLANNER professional, Personal Financial Specialist, Accredited Estate Planner, Certified Valuation Analyst, and Investment Adviser Representative.

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