The New Tax Law Delivers Tax-Saving Opportunities
But Not With Perfect Clarity
First in a Series of (at least) Two Articles
The new tax law – the Tax Cuts and Jobs Act (TCJA) – carves out a brand-new tax deduction for owners of pass-through entities including partners in partnerships, shareholders in S corporations, members of limited liability companies (LLCs) and sole proprietors.
On the surface, this new tax break seems very straightforward. Beginning in tax year 2018, many small business owners may be eligible to deduct 20% of their “qualified business income” (QBI). Said another way, qualifying pass-through entities will only be taxed on 80% of their pass-through income.
That said, what’s a new tax law that doesn’t leave taxpayers and tax professionals scratching their heads? And that’s the start of this series of two articles where we’ll look at Definitions; Restrictions; and need for IRS guidance.
Our objective is not to get too “deep into the weeds” but rather raise issues and questions and urge you to seek professional advice to understand how the new law affects you in your specific circumstances. Of particular note is that this new 20% deduction is the most complex aspect of the TCJA.
The reason for the complexity in the 20% deduction is limitations based on your taxable income and the industry in which you work. Additionally, there are new terms that you need to become familiar with. What follows are the two most significant definitions and restrictions.
Note: If your taxable income is under $315,000 (filing jointly) or $157,500 (filing single) the following limitations do not apply to you.
Definitions & Restrictions
QBI: Qualified business income (QBI) is the net amount of income, gain, deduction, and loss that are effectively connected with the conduct of a trade or business. So that’s the net income from your business not including compensation and investment income received by you from your pass-through entity.
Specified Service Businesses: The TCJA specifically includes businesses in this definition as Health, Law, Accounting, Actuarial Sciences, Performing Arts, Consulting, Athletics, Financial Services, and any other trade or business where the principal asset of the business is the reputation or skill of 1 or more of its employees.
Notably, to their benefit, engineers and architects were excluded from the definition of “service businesses.”
Wage and Capital Limit: The deduction is limited by a formula that references thresholds of both W-2 wages paid and depreciation on property used in a specified service business. There is a “phase-in” provision in the new law whereby the 20% deduction may be reduced, pro-rata, or eliminated based on taxable income that exceeds thresholds as indicated in the new regulations.
Why all this complexity? Apparently to restrain business owners who do substantial work from identifying wages as QBI eligible just to enjoy the deduction.
Above the Line and Below the Line Deductions
Both reduce your taxable income, but with important differences as it relates to the 20% deduction we are discussing here. First, what is the “line”? It is the entry on your tax return that identifies your adjusted gross income (AGI).
Above-the-Line Deductions reduce your gross income as well as your AGI. Among others, examples of these deductions are contributions to health saving accounts and retirement plans. Of importance is that your AGI is the determining factor to be eligible for certain tax credits. Additionally, it will impact your eligibility for below-the-line deductions.
Below-the-Line Deductions are reported subsequent to determining your AGI. The 20% QBI deduction falls into this below-the-line category. So what is the significance for small business owners?
The new tax bill eliminated a slew of itemized deductions and increased the standard deduction. Therefore many small business owners will benefit from the standard deduction. Depending on your circumstances, here’s the BIG WIN! The 20% QBI deduction is not considered an itemized deduction which means it may be claimed in addition to the standard deduction.
Note: Side-hustles count. If you have a side job that treats you as an independent contractor, you’ll want to determine how you may qualify to have a fifth of your income essentially tax-free.
The foregoing is presented as just the basics of this very complex deduction. There is little doubt that the IRS will soon issue guidance with regard to pass-through entities. At this point there seems to be more questions than answers. Stay tuned for a fairly steady stream of clarifications as the grey areas emerge.
Touted as the most comprehensive overhaul of the tax code in over three decades, the TCJA is also quite complex and subject to questions and interpretation. In the next issue of The Blair Bulletin we’ll tackle the continuing news and events that surface regarding this new law and the significant tax breaks for small businesses.