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How Business Owners Can Qualify for the New 20% Tax Deduction
This is part one of a two-part series on the new IRC Section 199A deduction (also known as the pass-through deduction) for business owners. For part two, Strategies for Business Owners to Maximize your New 20% Pass-Through Deduction, click here.
There’s a new tax deduction created by The Tax Cuts and Jobs Act of 2018 (TCJA), and if you own a business or a partnership you need to be informed. The new IRC Section 199A deduction (also known as the pass-through deduction) will allow some businesses to be taxed on only 80% of their income. This significant tax break is highly complicated, but the planning opportunities for business owners or members of a partnership are tremendous. Here are the basics you need to know about the deduction:
What is the pass-through deduction
The new pass-through deduction allows you deduct up to 20% of your Qualified Business Income. This will effectively permit pass-through businesses to be taxed on only 80% of their income. The new deduction was created to even the playing field between pass-through businesses and corporations, as it provides an incentive to businesses who elect not to become a C Corporation despite the lower corporate tax rates now available with the passing of the TCJA in 2018.
Who the pass-through deduction is for
The new Section 199A deduction is available for owners of any business that is not a C Corporation. This includes S Corporations, Partnerships, LLC entities, and sole proprietors who are paid directly as independent contractors. To get the deduction, a business must have “Qualified Business Income” (QBI). QBI is defined as any business income after regular expenses (expenses would include your salary if you operate as an S Corp). Put simply, QBI is your profit.
Limitations on the pass-through deduction
The pass-through deduction can provide a huge tax break for many business owners. However, there are several limitations that need to be navigated through to maximize the benefit. First, your pass-through deduction is limited to 20% of your taxable income. So, if all your household income comes from QBI (i.e. you have no other income to report from a salary, spouse, etc.) then your typical standard or itemized deductions will eat into your pass-through deduction.
The other big factors that can affect your deduction are the nature of your business and your taxable income.
Lawyers, Doc’s, and Money
While the 20% deduction is attractive, it isn’t distributed equally. If you are a professional in a “specified service business,” which includes (but is not limited to) industries of health care, law, finance, and accounting, the 20% deduction is phased out and eventually eliminated once certain income levels are met. The phaseout range is $157,500-$207,500 for single filers and $315,000-$415,000 for those who are married.
Notably, the phaseout is based on income shown on your personal tax return income, not just the amount of your business income. For example, as a physician you may earn $250,000 in profits, putting you under the $315,000 limitation. But if you file taxes jointly and your spouse separately earns $250,000, your personal tax return income of $500,000 now exceeds the limit, and your deduction will be eliminated.
Non “Specified-Service” Businesses
For those who don’t own a “specified-service” business – for example, income generated from a real estate business – the pass-through deduction is still available even when you earn more than the $207K/$415K income limitation. For non “specialized-service” business owners to still qualify for the deduction above the high-income limits (below the income limit you qualify regardless), you need to pass a wage and property test. The deduction will be the lesser of 20% of QBI, OR the greater of either:
- 50% of the w-2 wages in the business: or
- 25% of the W-2 wages plus 2.5% of the basis of all qualified property in the business.
For example, if you own real estate providing an annual QBI of $500,000, your deduction “should” be 20% of that $500,000, or $100,000. But this $100,000 potential deduction first needs to be compared to the wages you pay any employees (including yourself) and the basis in your properties based on the rules above.
Strategies to maximize your pass-through deduction
Understanding what the pass-through deduction is and how to qualify for it, your next step is to take possible action to maximize your tax-savings. For an exploration of planning opportunities in part two, Strategies for Business Owners to Maximize your New 20% Pass-Through Deduction click here.
Source: Michael Kitces at Nerd’s Eye View
We Can Help
The new IRC Section 199A pass-through deduction can provide business owners with large tax breaks and tremendous planning opportunities. However, it is highly complicated and demands a personalized strategy. If you would like to discuss any options that are specific to your situation, you can reach us at Windgate Wealth Management by calling (844) 377-4963 or emailing firstname.lastname@example.org. You can also book an appointment online here.