The fifth and final in our series on the qualified business income deduction, created by the Tax Cuts and Jobs Act (TCJA, or the Act) as part of federal tax reform. To learn more about this deduction, check out our other posts in the series.
Updated March 2019 to reflect final regulations.
Complexity creates opportunity, at least when it comes to taxes. The more complex a tax deduction, the more planning opportunities it offers to creative tax CPAs and attorneys.
Following are strategies to consider when planning to maximize the benefit of your qualified business income deduction.
Choice of Entity
Should you change your business entity in an effort to reduce your federal income taxes? It’s a common question stemming from changes in the Act. And like the answer to many tax questions, it just depends.
The federal income tax rate for C corporations is now a flat 21 percent rate, and it’s permanent. But distributions are also taxed to the owner at individual tax rates, so double taxation figures into the equation.
It really comes down to how much of the business’ earnings you intend to keep in the corporation.
The top marginal rate for sole proprietorships and pass-through entities is 37 percent, less a potential (and temporary) qualified business income deduction of 20 percent. Under the best possible circumstances, the deduction reduces the top marginal tax rate for the business owner to 29.6 percent. Worst case, you’re the owner of a specified service business with taxable income above the threshold amount and you don’t qualify for the deduction at all. Your top marginal tax rate remains at 37 percent.
If you are a sole-proprietor and your taxable income is greater than the W-2 phase-in threshold amount, you might consider transitioning from sole proprietorship to an S corporation. As an S corporation you still pay taxes on your individual tax return, but you can pay yourself a reasonable wage to possibly increase the amount of your deduction.
Similarly, guaranteed payments from multi-member LLCs and partnerships aren’t considered wages for calculating the deduction. However, if those same payments are made to the owner of an S corporation as wages, they do qualify — potentially increasing the amount of the deduction.
That said, taxes and related deductions aren’t the only considerations in choosing an entity. Any change in entity requires a careful evaluation of pros and cons. Think payroll reporting, various compliance requirements, treatment of fringe benefits, personal liability, limitations on loss deductions, levels of taxation, retirement plan options and the qualified small business stock tax exemption, to name just a few.
As previously noted, the deductibility of various forms of owner compensation is affected by the type of business entity and form of payment.
Assuming the business’ owner compensation can be deducted for tax purposes, there are options to increase the amount of W-2 wages for purposes of the calculation.
They include increasing the amount of owner compensation (as opposed to distributions) and providing new or increased bonuses.
Similarly, you may be able to increase qualified business income by paying less in owner compensation. The total owner compensation must still be reasonable in this case. But for a business that is paying excess wages to owners and only generating minimal qualified business income, it’s worth considering.
Finally, note that guaranteed payments made by partnerships and LLCs do not qualify as wages.
Threshold for Specified Service Businesses
It may be possible for a specified service business to qualify for the deduction by increasing deductible expenses to fall under the threshold amount.
One of many options is to increase contributions to retirement accounts. For example, if your business has a well-designed cash balance plan you may be able to contribute a very large amount of money per year to your own account, depending on your age and other factors.
Use of Multiple Entities, Multiple Trusts
Because the Act excludes specified service businesses (above threshold amounts) from qualifying for the deduction, it’s only natural to consider the possibility of creating multiple legal entities to segregate out various administrative, management, billing, wholesaling or other activities that don’t fall under the specified service umbrella.
Unfortunately, that approach may not get you where you want to go. Under the regulations, any business that is spun off of a specified service business is itself considered to be a specified service business for the portion of the trade or business that provides property or services to the specified service business.
If the original and spun-off businesses share at least 50 percent common ownership, they are subject to the above rule regarding providing property or services to a specified service business. In this context, ownership can include that of spouses, ancestors and lineal descendants.
Further, if you have multiple businesses with qualified business income that is attributable to more than one of the businesses, you must allocate that income to those businesses using a reasonable method.
Under the regulations, if a trust is formed or funded with a significant purpose of receiving a deduction under 199A, the trust is not recognized.
Employees and Independent Contractors
Independent contractors do not provide qualifying wages for purposes of the W-2 wage limitation. As a result, you might reconsider their qualifications as either employees or independent contractors using the IRS’ employee vs. contractor designation guidance.
The guidance includes such factors as behavioral control, financial control, and type of relationship.
Depreciation and Placed in Service Dates
With increases in allowable bonus depreciation and Section 179 expensing under the Act, businesses now have an increased opportunity to immediately write off purchased equipment — whether new or used. As a result, these deductions can directly impact the amount of your qualified business income deduction.
The fact that increases in capital assets can increase the amount of the deduction (by 2.5 percent of their unadjusted basis under the alternate W-2 wages limitation) provides an additional incentive.
Finally, remember that the qualified business income deduction is only temporary. Although Congress is considering making it permanent, it is currently set to expire after 2025.
The qualified business income deduction is an evolving and extremely complex area of the federal tax code. Consult with a tax advisor before making any business or financial decisions based on this deduction, including any change in business entity.
Want to know more about planning for the qualified business income deduction (Section 199A) or tax reform in general?