As you’re reading this, I’m guessing you’re aware that there is a new tax bill that became effective on January 1st, 2018. President Trump signed into law a bill that brought sweeping changes to the ways individuals, families, estates, and businesses are taxed.
As you might guess from the name of the bill, this change is a pretty broad tax cut. The president intends to make it more appealing to do business in America, and believes that lowering taxes on businesses and business owners will be good for both the economy and our country.
For owners of pass through businesses (or more specifically, any business that isn’t a C-Corp), the bill includes a 20% deduction on your personal tax return for qualified business income. To put it lightly, it’s now more advantageous from a tax standpoint to own a business than it was in 2017.
That said, the 20% qualified business income (QBI) deduction doesn’t apply across the board. The deduction could be limited depending on:
- The industry you’re in
- Your income level
- The aggregate W-2 wages your business pays
- The total value of undepreciated property the business owns
Because of these caveats, there are potentially large tax planning opportunities here. If you own a pass through business (or any business other than a C-Corp), you could save thousands in taxes over the next several years by ensuring you qualify for the maximum deduction.
This post will review why entity selection is important under the new law, and why you may want to consider changing your business's. Being thoughtful about this could keep a boatload of cash in your pocket, and out of Uncle Sam’s grasp.
A Quick Primer on the QBI Deduction
Let’s start with an intro to what the QBI deduction is and how it works. To start, to be eligible for the deduction your business earnings must be considered “qualified business income”. This is your net income from pass-through business entities (sole props, partnerships, LLCs, S-Corps), after all business deductions have been claimed.
Qualified business income is calculated separately for each business, then split pro rata based on ownership share. NOT included in the definition of qualified business income are:
- Salaries paid to owners of S-corporations
- Guaranteed payments allocated to partners in partnerships or multi-member LLCs
Based on these rules, owners of S-Corps might consider taking all their business's income out as profit distributions. Doing so would mean you'd pay yourself $0 in W-2 salary, making the maximum amount of business income eligible for the deduction.
Not so fast. The IRS requires you to take a "reasonable compensation" out as W-2 wages, for your efforts working in the business. This is a bit of a gray area, but prevents us from taking everything out as profit distributions. (Side note: taking more money out of S-Corps as profits & less as W-2 wages is a popular strategy for minimizing FICA taxes too. You can read about it here).
On top of all this, QBI is limited to 20% of your household’s total taxable income. We don’t yet know exactly where the QBI deduction will appear on Form 1040 this year, but it’s likely to be in line 42: after deductions, before taxable income.
Since another section of the tax bill eliminated personal exemptions, the QBI deduction is likely to take over the vacated line:
Here’s an Example:
Let’s say Johnny owns a deli that’s structured as an LLC. He nets $100,000 in business income after his expenses, all of which is reported on his schedule C. This $100,000 is considered qualified business income.
If Johnny is single and takes the standard deduction this year (which is now $12,000), he’ll have $88,000 in taxable income: $100,000 - $12,000. Without the QBI deduction, Johnny would find himself in the 24% tax bracket, owing $15,409 in federal income tax.
With the QBI deduction, he’d take another $17,600 ($88,000 * 20%) deduction. Remember that even though he might have $100,000 in QBI, it’s limited to 20% of his taxable income. This leaves his taxable income at $70,400. He’d then be in the 22% bracket, and owe only $11,427 in federal taxes.
S-Corp vs. LLC
Now let’s say Johnny’s deli is an S-Corp rather than an LLC. He still has the same $100,000 left at year end after his expenses. But since the business is an S-Corp, he can take some of the $100,000 out as W-2 wages, and the rest out at profits. On top of that, he’s required to take a reasonable amount out as W-2 wages in exchange for his efforts in the business.
Let's assume that Johnny takes $70,000 out as W-2 wages, leaving $30,000 left over as profits. Doing so would mean he’d only have $30,000 in qualified business income, compared to $100,000 by operating as an LLC.
The 20% deduction would bring his taxable income down from $88,000 to $82,000, and he’d owe $13,979. Operating as an S-Corp instead of an LLC would have cost him $2,552 in taxes:
Operating as an S-Corp
- QBI Deduction: $6,000
- Taxable Income: $82,000
- Taxes Owed: $13,979
Operating as an LLC
- QBI Deduction: $17,600
- Taxable Income: $70,400
- Taxes Owed: $11,427
High Income Limitations
Beyond the requirements listed above, there are further limitations on the QBI deduction for high income earners. [You didn’t think stuff would be simple, did you?!]
If your taxable income falls below $157,500 for individuals or $315,000 for married couples, you’re entitled to the full QBI deduction. These levels coincide with the top of the 24% bracket & bottom of the new 32% bracket.
If your taxable income is above these levels, your deduction may be further limited by:
A specified services phaseout
A wages or wage + property limit
Let’s start with specified services. In the law, they’re specified as:
What’s interesting here is in another section of the bill, engineers and architects are explicitly excluded from the specified services definition, since they produce physical deliverables, unlike other traditional service businesses.
If your business is considered a specified services business, your QBI deduction phases out above taxable income of $157,500 (individuals) or $315,000 (married couples). The range for this is $50,000 (single) & $100,000 (joint).
I realize this is confusing, so let’s go back to our example:
Let’s say that instead of owning a deli, Johnny is owns a law firm. Legal advice & representation would clearly qualify as a specified service business, potentially limiting his QBI deduction. But since the deduction doesn’t phase out until $157,500 in taxable income, he’s free to deduct as much as he would when he owned the deli. (Remember his taxable income was $88,000 after taking the $12,000 standard deduction).
On the other hand, let’s say Johnny’s net business income is $192,000. He takes the $12,000 standard deduction, bringing his taxable income (before the QBI deduction) to $180,000. Since the deduction phases out over the $50,000 “window” between $157,500 and $207,500, he’d be exactly 45% of the way through the phaseout.
This would allow him to keep the other 55% of his deduction, or $180,000 * 20% * 55% = $19,800. (Note that this is less than 20% of his taxable income of $168,000, so he’s not limited further). As soon as his taxable income exceeds $157,500 + $50,000 = $207,500, he won’t be able to claim the deduction at all.
The Wage & Property Test
If you’re not in a qualified services business, your QBI deduction may also be limited if your taxable income is above the $157,500/$315,000 thresholds. If this is you, your deduction will technically be the lesser of 20% of qualified business income, or the greater of:
50% of total W-2 wages paid; or
The sum of 25% of total W-2 wages paid, plus 2.5% of the unadjusted value of qualified business property
For all intents & purposes, “unadjusted” means the property’s value before any depreciation. Any tangible property for which depreciation deductions are allowed (under IRC section 167) qualifies for the test, as long as it hasn’t completed its depreciable period. This will typically be real estate, machinery, or equipment, but could be anything that qualifies under section 167.
Let’s go back to our example:
Our friend Johnny is having quite a career. Let’s say he’s back at it at the deli. But instead of netting $100,000, he’s grown the business and his brand into a multi-location operation. He now nets $800,000 from the business and employs 15 people. The business also has $1,000,000 worth of unadjusted property on its balance sheet.
The deli doesn’t qualify as a specified service business. So even though his income is well above the phase out window of $157,500 -$207,500, he can still claim a QBI deduction. However, the deduction could still be limited by the wage & property tests.
Let’s also assume that the average compensation for his 15 employees is $15,000 per year, as many are part time. They’re also all W-2 employees, as opposed to independent contractors.
The total W-2 compensation for the business is $225,000, 50% of which is $112,500.
Wage & Property Test:
For the wage and property test, the limitation would 25% of total W-2 comp plus 2.5% of unadjusted property. This ends up being ($225,000 * 25%) + ($1,000,000 * 2.5%) = $81,250.
Since we’re taking the greater of the two tests, Johnny’s QBI deduction would be limited to $112,500.
Without the wage & property limitation his taxable income would be $800,000 - $12,000 = $788,000, as he still takes the standard deduction. A 20% QBI deduction of $157,600 ($788,000 * 20%) would bring his taxable income down to $630,400, resulting in a tax bill of $198,936.
But since the wage & property test limits his QBI deduction to $112,500, his taxable income is higher ($788,000 - $112,500 = $675,500). His tax bill would be $215,623, or $16,687 greater.
At this point you can probably see the planning opportunities for Johnny. In the last example his QBI deduction was significantly limited since his business income was so much greater than the income he pays employees.
If Johnny employed a group of independent contractors on a 1099 basis, he could bring them on as W-2 employees, raising the total W-2 compensation paid by the business. This would work to reduce the wage & property deduction limitation.
Another thought might be to purchase buildings for his delis rather than rent them. This would add property to the business's balance sheet, favorably affecting the wage & property test.
There are many planning opportunities in our example, and in most any pass through business thanks to the TCJA. But for now let’s focus on entity structure. Johnny’s deli is an LLC. In our first example, the LLC structure greatly helped Johnny from a tax perspective. He had $100,000 in income, all of which was eligible for the 20% QBI deduction since he fell under the $157,500 income threshold.
But in our latest example Johnny is well above the threshold, with business income of $800,000. He’s limited by his total W-2 wages paid. In this circumstance he may be better off filing his taxes as an S-Corp. (Conveniently he could still keep the business structured as an LLC, while filing his taxes as an S-Corp). By doing so he could choose to take some of the business profits out as W-2 salary as opposed to self-employment income, raising his wage & property ceiling.
Look Before You Leap
As you may already be thinking, the best entity structure for your business depends on a lot more than taxation. There are significant legal ramifications involved when changing entity type, and it would be wise to consult an attorney before actually making a change.
That said, entity structure is something every business owner should consider as a result of the tax bill. While business is unique, something thoughtful planning and a minor tweak or two could end up saving you thousands.