Qualified Business Income
The most recent tax reform push has certainly been a rollercoaster, but fortunately Congress was able to come together and push through a sweeping overhaul. Despite what you may have heard, the tax reform bill provides significant relief to business owners in the form of simplified accounting processes, a larger exemption from Alternative Minimum Tax, full expensing of capital asset purchases, and lower, broader tax brackets. As you may or may not know, any time a tax plan is passed or even discussed, everybody opining on its positive and negative attributes immediately becomes a tax expert.
Obviously I'm being facetious, but this tax bill has produced a number of wild claims I would like to debunk. First, the corporate tax rate is not 20%, as some claim, it's a flat 21% rate. Second, the conclusion that doctor and professional service groups should consider switching back to professional service corporations to accumulate income taxed at 21% is probably not a great one, because most owners of those companies would end up paying a 39.802% (21% federal income tax plus 23.8% qualified dividends tax on the remainder after federal income tax) combined tax on the income passed through as a dividend from a PSC, versus a top marginal income tax rate on wages and passthrough income of 37%. Third, and perhaps most ridiculous, you will not be able to form a pass through entity and auto-magically lower your tax rate to 20%.
The first claim above is simply a mistake, but the second and third claims are misleading and focus on a new concept introduced by the Tax Cuts and Jobs Act. The concept is called the Qualified Business Income (QBI) deduction, and it essentially allows you a 20% deduction (not a 20% tax rate!) for your qualified business income. This is deducted below the Adjusted Gross Income line, much like an itemized deduction, and could provide pass through business owners significant savings.
Absent further guidance and regulations from the IRS, we know QBI includes pass through income from partnerships, sole proprietorships, and S Corporations. QBI does not include capital gains and dividends passed through partnerships and S Corporations, nor does it include reasonable compensation to S Corporation shareholders and partnership partners via wages and guaranteed payments, respectively.
The QBI deduction is generally allowed for all pass through businesses up to $315,000 of taxable income for married filing joint filers and $157,500 for single filers. Once this income limit is hit, two limitations come into play; first, service businesses like doctor's groups, accounting firms, investment firms, and any business where the skill or reputation of one or more of its employees is a major business asset begin phasing out their deduction over the next $100,000 ($50,000 single) of taxable income. Second, wages and business property come into play as a limiting factor. The deduction for non-service businesses is limited to the greater of 50% of W-2 wages; that is, wages paid to its nonshareholder or nonpartner employees, or 25% of wages plus 2.5% of the unadjusted basis immediately after acquisition of "qualified property".
I don't want to get too far into the minutia here - it should be obvious that the implementation of this deduction will require considerable thought and careful planning. Instead, let's focus on a few examples:
- A S Corporation manufacturing company with $1,000,000 of net income after reasonable compensation to its shareholders and $2,500,000 of W-2 wages. Each shareholder should be fully qualified for the QBI deduction. Assuming the shareholders are in the top marginal tax bracket of 37%, the tax savings attributable to the QBI deduction alone are $74,000. Overall, the shareholders will save $100,000 when you factor in the effect of lower tax rates on the remainder of the business's income.
- A multi-member LLC doctor group with $1,000,000 of net income after reasonable compensation to its members via guaranteed payments and $1,000,000 of W-2 wages. This is a tricky situation, because certain members may be treated differently than the rest. If a member has less than $315,000 of taxable income and files jointly with their spouse, they will generally qualify for the QBI deduction. If, however, the doctor's taxable income is greater than $415,000, they will not qualify for the QBI deduction because a doctor goup is a service business.
- A multi-member LLC real estate holding firm with $300,000 of net rental income and no W-2 wages holding a $3,000,000 building (qualifying property). The members of this LLC would be qualified for a QBI deduction of up to $75,000 (2.5% of $3,000,000). The QBI deduction would be $60,000 (20% of $300,000), which would save the members up to $22,200 of federal tax.
We are curious to see how contributions to retirement plans are handled for multi-member LLCs and sole proprietorships. If QBI is not reduced by the retirement plan contribution, there may be a compelling reason to change one's business structure.
There are numerous quirks to this new QBI deduction - all of which are far beyond the scope of this article - and it will certainly take some time for the IRS to iron out all of the kinks. We think the QBI deduction will be a powerful tax saving measure for most small businesses, and for that we're rather excited.
Are you interested in learning more about the QBI deduction and how it will impact your tax situation? Contact Chris at email@example.com or (513)554-4600.