By: Kirk Licata, CFP®
As small business owners across the country begin gearing up for their annual pilgrimage to their accountant’s offices, there is a new deduction that could have a major impact on their wallets: the qualified business income deduction.
As a result of the Tax Cuts and Jobs Act of 2017 (TCJA), this new deduction is available for every form of business except the C-corporation; which has seen its top tax rate fall from 35% to 21%. (Comprising most larger companies, C-corporations are corporations that are taxed separately from their owners.) The deduction was created specifically to allow these smaller business owners to keep pace with this significant corporate tax cut offered by the TCJA. Sole proprietorships, partnerships, LLC’s, and S-Corporations are the most common forms of businesses that can benefit from the deduction.
In the most general sense, these small business owners will only pay tax on 80% of their qualified business income (QBI). The higher the earnings and corresponding tax rate, the more substantial the savings from this deduction becomes.
Example 1: Alexa and Joseph are married and earned $250,000 in 2018 which includes $150,000 in wages from Alexa’s job managing a sales team and $100,000 in net income from Joseph’s tutoring business (which is reported as a sole proprietorship on his schedule C). Joseph is eligible to claim a $20,000 QBI deduction which produces a $4,800 tax savings at their 24% tax bracket.
Example 2: Steve and Maria are married and earned $500,000 in 2018 which includes $100,000 in wages from Maria’s job as a physician assistant and $400,000 in net income from Steve’s partnership in a clothing store. Steve is eligible to claim an $80,000 QBI deduction which produces a $28,000 tax savings at their 35% tax bracket.
Now if you’re somewhat cynical as I am, at this point in reading, you’re fully ready for “the catch” so here it is. For 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, or any trade or business where the principal asset of the business is the reputation or skill of 1 or more of its employees1, there is an income limit for the QBI deduction with phaseouts beginning at $157,500 in taxable income for individual filers and $315,000 in taxable income for married filers. High-income individuals may also have their QBI deduction limited if they do not employ a substantial number of people relative to the size of the business (under a new “W-2 wages” limit), or invest into a substantial amount of property (under the “wages-and-property” limit)2.
The following graphic from Michael Kitces’ financial blog Nerd’s Eye View provides a simplified flow chart if you’re wondering whether your QBI deduction may be limited. You can find more information on what qualifies as a specified service business by clicking here.
We are not tax professionals at LongView but we believe in taking a comprehensive approach to your financial planning and investment needs, which often involves communication with your tax preparers and/ or other members of your wealth management team. This new legislation has undoubtedly brought new questions and new planning opportunities: Is it beneficial to make retirement plan contributions and reduce your taxable income if your QBI deduction is limited due to the income thresholds? Does a Roth conversion possibly create greater benefits or less? Is your business income structured in the most advantageous way?
These are just a few of the questions that may now be pivotal in regards to your business and personal financial planning. Your LongView advisor is here to provide the guidance and consultation needed to navigate this recent legislation. Give us a call to start the process.