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Tax simplification? Maybe not. But the new tax provision for pass-through entities provides a generous deduction for businesses operating as S corporations, partnerships, or sole-proprietorships.
The new law allows a deduction equal to 20% of qualified business income from a partnership, S corporation, or sole-proprietorship. But, as with all tax laws, there are exceptions.
For taxpayers with taxable incomes below $157,500 for an individual filer, or $315,000 for a joint filer, there are no restrictions on the deduction, other than the income must be from a “trade or business,” and not disguised wages.
Once taxable income exceeds the threshold amounts, there are three requirements that must be met to qualify for the deduction. The business:
1. Cannot be a specified service business;
2. Must pay a specified amount of W-2 wages; or
3. Must have made an investment in tangible, depreciable property.
Specified service businesses include activities involved in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. The law also excludes from the deduction any “service business”, whether specifically listed or not, where the principal asset of the business is the reputation or skill of one or more of its employees. For instance, if a business does not have an extensive capital investment in equipment, does the definition of service extend to that business? Activities such as construction, remodeling, HVAC, or other similar activities could be pulled into the service business umbrella. The conference agreement excluded engineers and architects from the list of service activities, but these businesses could be included, based upon the reputation or skill criteria.
Once a business clears the specified service hurdle, the deduction is limited to either 50% of the wages paid, or the sum of 25%of the wages paid plus 2.5%of the unadjusted basis of all qualified property. Qualified property is depreciable property used in the trade or business at the end of the taxable year.
Examples may help illustrate how the new law will work.
Kevin and Janice both have small businesses. Kevin is a plumber and operates his business as an S corporation. In 2018, he receives a W-2 for $75,000 and S corporation income from his Schedule K-1 of $75,000. Janice is an accountant and operates her business as a sole-proprietorship. Her Schedule C net income is $75,000. Because their joint income is below the threshold of $315,000, there are no limitations on the deduction. The deduction will be $30,000, the sum of Kevin's S corporation income ($75,000) and Janice's Schedule C income of ($75,000) times 20%.
The W-2 income Kevin receives from his S corporation is ineligible for the deduction because it represents his wages. Note that Janice will receive the deduction on her full income from her Schedule C. All the income from Janice's Schedule C is considered self-employment income but, at the present time, this income is considered qualified income, and it's eligible for the deduction.
Specified Service Business
John is a neurosurgeon, and an employee and part owner of a medical practice, taxed as an S corporation. He receives a W-2 from the medical practice of $250,000 and his K-1 S corporation earnings are $200,000. Because his business income is from a specified service business, and his income exceeds the $157,500 threshold, he is not eligible for a deduction.
Non-Service Business
Kevin owns a manufacturing company that is taxed as a partnership. He receives a guaranteed payment of $100,000 and his K-1 income from the partnership is $350,000. His taxable income of $450,000 exceeds the $157,500 threshold, but Kevin's business is not considered a specified service business. The $350,000 of qualified business income will be eligible for the deduction, subject to limitations.
Kevin's business is capital intensive with relatively few employees. Total W-2 wages paid by the partnership equal $65,000 and the unadjusted depreciable basis of qualified property at year-end is $3,600,000.
The maximum deduction available to Kevin is $70,000 ($350,000 x 20%). The deduction is limited to the greater of 50% of W-2 wages, ($65,000 x 50% = $32,500) or 25% of W-2 wages and 2.5% of qualified property ($65,000 x 25% + $3,600,000 x 2.5% = $106,250). The full $70,000 will be allowed.
The new law provides a generous deduction for small business owners. It's not tax simplification, but it does ease the tax bite for small business owners.
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 34 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected].
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