We have all read the news about the reduction in tax rates from 35 percent to 21 percent for businesses that are taxed as a C Corporation. But what about businesses organized as sole proprietors or passthroughs? Shouldn’t the new law reduce their taxes, too? As an example, how does the new law affect Goldilocks who owns her own hair salon?
Starting Jan. 1, 2018, new Section 199A allows these businesses, but not C Corporations, to take a new 20 percent deduction. The new Qualified Business Income (QBI) deduction is calculated by multiplying Goldilocks’ QBI by 20 percent. This additional deduction is deducted directly on her Form 1040.
The new QBI deduction will be available to taxpayers with business income from:
- S Corporations
- Limited Liability Companies not taxed as a C Corporation
- Sole proprietorships reported on Schedule C
- Rental properties reported on Schedule E
- Farm businesses reported on Schedule F
Investors that own REIT stock or interests in Publicly Traded Partnerships (PTPs) will also get a QBI deduction.
For Goldilocks, her QBI deduction is 20 percent times the net income shown on Schedule C. For owners in S Corporations and Partnerships, the deduction claimed on their individual income tax return will be based on the amounts shown on their Schedule K-1 for trade/business income, rental income and gain/(loss) from sales of business property. Employee wage income and partnership guarantee payments are not included in QBI. QBI only includes a business’s domestic, U.S. source, income.
- The new QBI deduction is subject to the following limitations:
- Taxable Income Limitation
- Wage Limitation for Taxpayers with Taxable Income over Threshold Amount
Limitation on Specified Service Businesses
Taxable Income Limitation
The new 20 percent QBI deduction is the lesser of: 1) 20 percent of QBI or 2) 20 percent of taxable income computed without the QBI deduction and reduced for qualified dividends and long-term capital gains.
Wage Limitation for Taxpayers with Taxable Income over Threshold
For married filing joint taxpayers with taxable income greater than $415,000, and $207,500 for all other taxpayers, the deduction is limited to the greater of 1) 50 percent of the business’s W-2 Wages or 2) 25 percent of the business’s W-2 Wages plus 2.5% percent of the original cost of qualified businesses property. For married filing joint taxpayers with taxable income greater than $315,000, and $157,500 for all other taxpayers, this limitation is phased-in. Tax planning opportunities exist for those taxpayers that exceed the $315,000/$157,500 threshold. As taxpayers that own rental property usually do not have W-2 Wages, their limitation will be based on 2.5 percent of the original cost of qualified business property.
Limitation for Specified Service Businesses
For businesses in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, there is no QBI deduction if their taxable income, before considering the deduction, exceeds the $415,000/$207,500 threshold. For taxpayers with taxable income less than $315,000/$157,000, their deduction is allowed in full. For taxpayers with taxable income between $315,000/$157,500 and $415,000/$207,500, this limitation is phased-in. Tax planning opportunities exist for those taxpayers that exceed the $315,000/$157,500 threshold. Engineers and architects are not subject to this limitation.
How much will Goldilocks save?
Goldilocks operates her hair salon as a sole proprietorship, nets $100,000 after deducting one-half of her self-employment tax and she claims the standard deduction. Her QBI deduction will be $17,600 (20 percent of her taxable income of $88,000) as this is less than $20,000 (20 percent of her QBI). Her income tax savings from claiming this deduction will be approximately $4,000. The QBI deduction, however, will not reduce Goldilocks’ self-employment tax.
As you can see, the new QBI deduction calculation is complex. In the coming months, the IRS will issue guidance, which will add to our understanding of the new deduction. The deduction is set to expire at the end of 2025.
Megan Lawson is a CPA at Opsahl Dawson, a local accounting firm with offices in Longview and Vancouver. She can be reached at firstname.lastname@example.org.