Who May Benefit
This article may benefit you if:
- Your income is over $157,500 ($315,000 if married filing jointly),and
- You are:
- Self-employed, or
- A partner in a partnership or a member of an LLC that is taxed as a partnership
Suggestion: You may spare yourself some reading by jumping to the two examples I provided below.
The tax changes in 2018 include some provisions that are very favorable to businesses. One important change was to drop the tax rate for C corporations to a flat 21%. This is a significant reduction, but doesn’t apply to businesses that operate as partnerships, LLCs, S corporations or sole proprietorships.
To provide a similar benefit to these businesses, the IRS introduced Section 199A Qualified Business Income deduction. This allows individuals with income from businesses that operate as partnerships, LLCs, S corporations or sole proprietorships to take a tax deduction of 20% of their share of Qualified Business Income (QBI)… But there are rules, definitions and restrictions:
The rules and restrictions include a phase-out of the deduction, when your income exceeds certain thresholds. BUT these restrictions are reduced or eliminated if your business has W-2 payroll expenses or substantial investment in qualified assets.
S Corps are required to pay a reasonable W-2 salary to their owners, but partnerships, LLCs and sole proprietors cannot. That’s why you may want to form an S Corp.
Why is the QBI Deduction Important?
You can take a tax deduction of up to 20% of the net income generated by your business. It can be a very big deal.
What is QBI?
Qualified Business Income is the income from your trade or business.
There are no restrictions on the types of businesses income that qualify for the QBI deduction, as long as the idividual claiming the deduction has taxable income under $157,500 (or $314,000 if married filing jointly). For those with higher taxable income, you will not be able to claim the deduction if you are in a Specified Service Business, as described below.
QBI is not intended to include income from personal services, so it specifically excludes employment income, as well as income from Specified Services Businesses – in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletic, financial and brokerage services. Engineers and architects, however, are eligible for the QBI deduction. Speak to your tax professional for a more thorough and complete discussion of your eligibility.
Owners of rental properties may also qualify for the QBI deduction, but the value of the properties will help you qualify if your income is above the phase-out thresholds, so the benefit of an S Corp would probably be irrelevant. And would also bring up other complex issues.
Payroll Expenses Can Save the Day
The QBI deduction phases out to nothing if your income exceeds $207,500 (or $415,000 if married filing jointly)… UNLESS your business had W-2 payroll expenses or substantial qualified assets. Let’s focus on the payroll:
If you are above the taxable income threshold, and if your income is not from a Specified Services Business, you can still claim the QBI deduction in an amount up to 50% of the W-2 payroll of the business.
Partnerships and other businesses may have employees, and their wages would count in this calculation, but many businesses don’t pay any W-2 wages at all, so they would lose the QBI deduction. Certainly, sole proprietors and partners in partnerships can’t pay themselves salaries… BUT S Corps can.
Example 1 – Sole Proprietor
A real estate broker operating as a sole proprietor earns $275,000 from his business activities, and reports his income on Schedule C of his tax return. He is not married, so he will pay tax on the entire $275,000. His income is over the threshold, so there is no QBI deduction.
If the same real estate broker operated his business as an S Corp, he would be required to pay himself a reasonable salary – say $125,000. Ignoring a few other details, his Qualified Business Income would be $150,000 ($275,000 income, less $125,000 W-2 salary paid to him by the company). His QBI deduction would be the lesser of (a) 20% of his QBI – $30,000, and (b) 50% of the W-2 wages – $62,500.
In this case, the real estate broker gets a tax deduction of $30,000 by forming an S Corp.
Example 2 – Partnership (or LLC taxed as a partnership)
The partnership earned $400,000. Partner A owns 50%, and received guaranteed payments for his services of $125,000. His income of $325,000 ($125,000 guaranteed payment, plus $200,000 share of partnership income) is fully taxed at ordinary tax rates. He is single, so his income is too high to qualify for the QBI deduction.
If the partnership filed an election to be treated as an S Corp, his guaranteed payment of $125,000 would be paid as W-2 wages, and his QBI would be $200,000. Assuming his business partner also received the same salary, and again ignoring a few details, his QBI deduction would be the lesser of (a) 20% of his QBI – $40,000, and (b) 50% of his share of W-2 wages – $67,500.
In this case, the partner gets a tax deduction of $40,000 by electing to have the partnership taxed as an S Corp.
NOTE: Even though the deadline for S Corp election has passed, the partnership can apply for late filing relief, and there is a good possibility that the S Corp election can be made effective for 2018.
This is not intended to be a thorough analysis of Section 199A of the tax code. Nor is it a full discussion of the pros and cons of an S Corp. Rather, it is an attempt to find good tax planning solutions. There are a lot of variables in the choosing the most appropriate business entity, and every situation is different. I would be happy to discuss your situation, and help you arrive at the most advantageous result.