The new law creates the most significant tax break for small business owners in decades
The Tax Cuts and Jobs Act is the nation’s first major tax overhaul in 30 years – and introduces a completely new concept to the Internal Revenue Code. For the first time, IRC Section 199A allows individual taxpayers (other than corporations) a deduction of 20 percent of qualified business income earned in a qualified trade or business.
The deduction – known as the Qualified Business Income deduction – stands as a significant tax break for small business owners – within rules and limitations, of course.
The rules for calculating the deduction can be quite complicated; its generosity depends on many factors, including the nature of the business activity, the business owner’s total taxable income, the wages paid by the business, and the value of the business property.
An experienced certified public accountant is best suited to help you maximize this tricky but beneficial deduction for your business, which is on the books through the end of 2025. Here’s an overview to help you understand the basics.
Who qualifies for the pass-through deduction?
The IRS and many states tax the business profits or losses that “pass through” to the business owner, who pays personal income tax on the earnings at an individual tax rate.
Businesses that qualify for the deduction include:
- Sole proprietorships
- S corporations
- Trusts and estates that own an interest in a pass-through business
Most small businesses are pass-through entities. In fact, more than 86 percent of businesses with employees are sole proprietorships.
Are there any businesses that don’t qualify?
A qualified business is defined as any trade or business other than a high-income specified service business, or a trade or a business that performs services as an employee. Individuals who own those types of companies can only claim the deduction if their annual income falls below $315,000 for married couples and $157,500 for single people.
That’s because the bill is meant to provide a break on capital income, which comes from assets that accrue value over time, instead of labor income, which is generated by workers.
A specified service business is any business in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading or dealing in securities, partnership interests or commodities, or any trade or business where the principal asset is the reputation or skill of one or more of its owners or employees. Excluded from this definition are architectural and engineering services.
Regular C corporations also do not qualify for this deduction – but the new tax code entitles them to a low 21 percent corporate tax rate.
What is the pass-through tax deduction?
Put simply, the pass-through deduction allows qualifying business owners to deduct up to 20 percent of qualifying business income (QBI) from each pass-through business they own. The deduction is calculated per business, not per taxpayer.
It applies to net income – business income minus expenses – and includes self-employment earnings and money received from qualified rental properties, publicly traded partnerships, real estate investment trusts, and qualified cooperatives.
QBI does not include capital gain or loss (short or long-term), dividend income, interest income, wages paid to S corporation shareholders or that you earn as an employee, guaranteed payments to partners or LLC members, or money earned outside the U.S.
Now read this carefully: QBI is calculated separately for each business you own. If any of your businesses lose money, you deduct the loss from the QBI of your profitable businesses. If you have a qualified business loss – that is, your net QBI is zero or less – you get no pass-through deduction for the year. And, as a penalty for having a money-losing business, the loss is carried forward and deducted from the next year’s QBI, too.
Let’s say you have $100,000 in business revenue and $20,000 in business expenses in 2018. Your QBI is $80,000 and you may be able to claim a pass-through deduction worth up to $16,000. But if you have another pass-through business that lost $90,000 in the same year – you wind up with a $10,000 QBI loss. This means no 20% deduction and the $10,000 loss must be carried forward and deducted from your QBI in 2019.
How do I know how much of a deduction I’m entitled to?
- If your taxable income is below $315,000 for married filing jointly, or $157,500 for singles, you are entitled to the maximum 20 percent pass-through deduction based on your QBI.
- If your taxable income exceeds $415,000 for married filing jointly or $207,500 for singles and your business does not qualify as a service provider, you are still entitled to the maximum 20 percent deduction. However, a W-2 wage/business property limitation also kicks in, and your deduction is limited to the greater of:
– 50 percent of your share W-2 employee wages paid by the business, or
– 25 percent of W-2 wages plus 2.5 percent of the acquisition cost of your depreciable business property
Basically, this means if you don’t have employees or depreciable property, you won’t get any deduction. This is intended to encourage pass-through owners to hire employees and buy property for their business.
- If your taxable income falls between $315,000 and $415,000 for married filing jointly, or $157,500 and $207,500 for singles, the W-2 wages/property limitation is phased in – meaning only part of your deduction is subject to the limit and the rest is based on 20 percent of your QBI.
- If your taxable income exceeds $315,000 for marrieds and $157,500 for singles, and your business does qualify as a service provider, the pass-through deduction is gradually phased out. If your income reaches or exceeds $415,000 for marrieds and $157,500 for singles, you don’t get any deduction at all.This cap was intended to prevent highly-compensated employees who provide personal services (like lawyers) from asking companies to change them to independent contractors so they can use the pass-through deduction.
What are some legal ways to maximize my deduction?
- Become an independent contractor instead of an employee. Such a move could offer substantial tax savings thanks to the QBI deduction. Just be sure to adjust for other employee benefits you may be receiving that will no longer be available if you make the change, such as employer-paid health insurance or matching retirement plan contributions.
- Hire employees for your business. Non-service businesses over the $315,000/$157,500 limit could potentially increase their deductions by hiring or paying employees more due to the 50 percent of wages rule.
- Funnel income to another business you own. If you have too much income to take advantage of the pass-through deduction, you can funnel some of your income to a C corporation or an LLC you also own that provides a service. For example, your S corp can pay your C corp to provide a consulting service, and every dollar the S corp spends counts as an expense and reduces its taxable income.
- Take advantage of other deductions. If your taxable income is close to the limitations, consider utilizing deductions that can reduce your adjusted gross income, such as contributing to a tax-deferred retirement account or contributing to a charity.
- Restructure your sole proprietorship as an S corporation. If your business doesn’t qualify for the pass-through deduction due to too much income and a lack of wages or depreciable property, a switch to the S corp may produce the tax savings you want by enabling you to pay yourself a reasonable salary.
- Pay yourself more. If you’re a non-service business S corporation, and your deduction is limited by the wages you’re paying yourself, consider paying yourself more. The downside is that you will also have to pay more Medicare tax, but the lower tax bill may be worth it.
The new tax law provides the best small business tax break in decades – if you know how to take advantage of it. An experienced certified public accountant can help you navigate the complex regulations and create concrete strategies that maximize its benefit for your business.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on the new tax code, and to find out how we can help your business exceed your expectations.