One of the key promises during President Trump’s campaign was to lower taxes for businesses from 35 percent to 15 percent and eliminate the corporate alternative minimum tax. The final version of the tax bill did eliminate the corporate alternative minimum tax, and lowered the tax for corporations to 21 percent in 2018. Furthermore, businesses organized as “pass-throughs” will get taxed at less than 30 percent.
Pass-through businesses are your LLCs, partnerships, S corporation, and sole proprietorships, in which the entity is not subject to income tax. Owners are taxed individually on the income, calculating tax on their share of the profits and losses. Because these business owners were at the mercy of their individual tax rates, some business owners could be taxed as much as 39.6 percent, not including the phase out of itemized deductions for high income earners.
In the finalized bill, pass-through businesses receive a 20 percent deduction for the first $315,000 of joint income. Because taxes are never simple—despite the promise to simplify the tax code—the deduction is actually the lesser of: 20 percent of the taxpayer’s “qualified business income” or the greater of: 50 percent of the W-2 wages with respect to the business, or 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property.
OK, you want this in English. Qualified business income is income less ordinary deductions that you earn from a pass-through business, such as an LLC, sole-proprietorship, S corporation, or partnership. This does not include wages you earn as an employee. Let’s say you have an LLC, and your share of the qualified business income is $500,000. Multiply that by 20 percent and you get a deduction of $100,000. Woo hoo! Not so fast. There are income limitations on this that were added to prevent abuse of the rules.
How does this work? Let’s look at the example of your LLC of which you only own 40 percent. The company produced $1.25 million in ordinary income. The company paid W-2 wages of $455,000 and holds $200,000 in property. Your allocation of the wages is $182,000 and 50 percent of that is $91,000. One more calculation: 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property—in our example, this comes to $47,500 ($45,500 + $2,000). You’ve got two numbers: $91,000 and $47,500. The greater of the two is $91,000. This is your income limitation. So, your deduction on your $500,000 qualified business income is now $91,000 versus the simple 20 percent. Mindboggling, isn’t it? And this example was highly simplified for your convenience.
Now, not every LLC is making $1.25 million. Lots of small businesses make around $125,000 a year. There is an exception for you! If your taxable income is less than $157,500 or $315,000 for married filing jointly, you should be able to ignore the W-2 income limitations.
To make things more complicated if you are part of a “specified service” trade or business you will be faced with a phase out.
Wait, what? Yes, the law states that anyone who is in the business of being an employee and any “specified service trade or business” is not eligible for the 20 percent of qualified business income deduction. The law vaguely defines “specified service trade or business” as, any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and investing and investment management, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.
Basically, this exclusion seems to be targeting businesses that don’t sell goods or make products. They simply provide a service. The thought behind this is that the payment for a service is a wage, so any business that provides a service should have their income taxed like wages without a 20 percent deduction.
But, then there is another exception that even if you’re one of the “specified service businesses” and your taxable income is less than $315,000 joint or $157,000 for all other taxpayers, you can still claim the 20 percent deduction. The deduction phases out as taxable income increases above this threshold until it disappears at $415,000 for joint and $207,500 for all others.
For example, let’s look at Joe, an accountant. Joe is paid a salary of $100,000. For simplicity sake, Joe is married but his spouse doesn’t work so after his standard deduction, his joint taxable income will fall into the 12 percent tax bracket.
Joe decides to quit working for someone else and forms his own limited liability company to provide accounting services for $100,000. Despite Joe’s business being considered a disqualified service business, his taxable income is less than $315,000 MFJ, so he could take a 20 percent deduction on his qualified business income of $100,000. Depending on how he structures the business it could save him close to $8,500 in taxes. Sounds like a good deal, but then he is on the hook for his own health insurance and he must pay the full 15.3 percent Social Security and Medicare tax. Plus, there are retirement plans, insurance costs and other fringe benefits he might miss out on by not being an employee.
Let’s say Joe determines his LLC is worth the hassle, and his company brings in $170,000. He’s going along just fine enjoying his 20 percent deduction on qualified business income until his wife decides to rejoin the workforce. She is paid $175,000 a year in wages, which pushes joint taxable income to $321,000, $6,000 above the $315,000 threshold. Despite being in a disallowed service industry, Joe can still take a deduction after applying the phaseout mentioned above.
If Joe were to take on more clients and bring in $300,000 and his wife earned $175,000 in wages, their joint taxable income would be above $415,000, the top threshold of the phaseout of the 20 percent deduction. Joe’s pass-through business income is then taxed without a 20 percent deduction.
Joe could also consider being a C corporation. Each scenario is unique and requires detailed analysis and planning to determine if the tax savings would be worth a more complicated structure.
If you have questions, contact the Experts at Henssler Financial: