December 4th, 2018 Dominique Molina (Taxloopholes.com Tax Strategist)
Many people are aware that the 2017 Tax Cut and Jobs Act doubled the standard deduction. But fewer people know about the new Section 199A deduction. This provision allows most small businesses to deduct up to 20 percent of their income.
Small business owners or participants qualify for the deduction if their gross incomes are less than $157,500 ($315,000 for married couples who file joint returns.) The deduction is the lesser of 20 percent of the taxpayers QBI or 20 percent of taxable income minus capital gains. Qualified Business Income is essentially all income other than capital gains, interest income, and most dividends.
Claiming the Deduction
Taxpayers can claim Section 199A whether they claim a standard deduction or itemize. That’s important because most observers expect fewer than 10 percent of American taxpayers to itemize beginning in the spring of 2019. For tax year 2017, the itemization rate was about 30 percent.
Assuming they meet the income threshold, most sole proprietorships can simply claim the deduction. Easy peazy lemon squeezy.
Other pass-through entities, most notably partnerships and LLCs, will have to work harder. By law, partnership partners and LLC members cannot receive salaries. Instead, they usually receive guaranteed payments. These transfers are exempt from the dreaded and feared self-employment tax. Since they are not wage-like income, guaranteed transfers are also exempt from the 199A write-off.
So, it may behoove some pass-through organizations to reclassify partner/member payments as payments from net profits. These transfers are much more like wages, so the self-employment tax applies. However, the 199A deduction also applies. A tax planning professional must simply do the math and determine which approach is better for that particular organization.
Alan, Betty, and Clark each own a third of ABC LLC, which is a tax law firm. The firm earned $300,000 last year, so each member is poised to receive a $100,000 guaranteed payment. Much to their chagrin, our intrepid barristers learn that the guaranteed payment arrangement makes them ineligible for 199A. So, Alan, Betty, and Clark amend their operating agreement and reclassify their guaranteed payments as profit distributions. The $100,000 transfer becomes $80,000 following the 199A deduction.
This scenario assumes that Alan, Betty, and Clark qualify under the income qualifications described above. If they do not, they cannot take a 199A deduction, since a law firm is an SSTB (Specified Service Trade or Business) Most professional organizations, as well as “any trade or business where the principal asset is the reputation or skill of one or more of its employees,” are SSTBs.
Karen, who is an investment adviser, has $100,000 in QBI, $100,000 in capital gains income, and $30,000 of itemized deductions, resulting in a taxable income of $170,000. She’s entitled to a 199A deduction, but she cannot deduct $34,000 (20 percent of her taxable income). Instead, she can only deduct $14,000 (20 percent of $70,000 which is the excess of her taxable income over her capital gains income).
Again, Karen’s 199A eligibility hinges on her income. At $170,000, she is above the threshold for SSTBs. Investment advisers are on the list. However, if Karen is married to someone who doesn’t earn much money and the happy couple files a joint return, she is good to go.
Ralph the architect earned $40,000 in QBI. Ralph is single, so he can claim a $12,000 standard deduction, placing his taxable income at $28,000. Under Section 199A, he can deduct an additional $5,600 (20 percent of his taxable ordinary income). He cannot claim 20 percent of his business income, because that would be $8,000.
As you can see, these are the types of strategies that can make a big difference in how tax reform benefits you. Contact us today if you’d like to know how to maximize reform to put more money in your pocket!