By: Ashley Brand, CPA, ADKF Tax Manager
The maximum individual tax rate in 2017 was 39.6%, and the rate for 2018 is now 37%. However, depending on your sources of income, your maximum rate could be 29.6%.
One goal of the Tax Cuts and Jobs Act (TCJA), passed into law last December, was to simplify taxation, and for many, the 2019 filing season will be simpler. The increase to the standard deduction, elimination of personal exemptions and some miscellaneous itemized deductions, and other various provisions that affect individual filers will simplify tax returns for millions. Additionally, the tax rate for C Corporation net income is a flat 21%. However, if you are a business owner and have elected to treat the business as a flow-through entity (S Corporation, Partnership or Sole Proprietor), your tax returns may be more complicated. The TCJA includes a significant tax break for these types of entities due to the Section 199A deduction, also known as the 20% Qualified Business Income Deduction (QBID), but the rules for this deduction are far from simple.
The purpose of the deduction is to closely align the rates of flow through entities with regular C Corporations. The deduction is the lesser of (1) the “combined qualified business income” of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any capital gain. “Combined qualified business income” is defined as the lesser of (1) 20% of the taxpayer’s “qualified business income” (QBI) or (2) the greater of (a) 50% of the W-2 wages from the business or (b) the sum of 25% of the W-2 wages from the business plus 2.5% of the unadjusted basis of qualified property in the business. QBI is a taxpayer’s net trade or business income effectively connected to earnings from the United States or Puerto Rico. QBI excludes investment income such as interest, dividends, capital gains, annuities and wages or guaranteed payments received by the taxpayer. The deduction phases out if the taxpayer is engaged in a “specified service trades or businesses” (SSTB) and if the taxpayer’s taxable income exceeds $315,000 for a joint return and $157,500 for a single filer. The deduction phases out entirely when taxable income exceeds $415,000 and $207,500 respectively. Not simple! We haven’t even addressed uncommon types of income that may qualify for the QBI deduction. Planning opportunities abound, and conversations with your tax advisor must take place now to maximize the deduction and minimize your tax burden.
One of the first questions to consider involves entity selection. If you’re currently taxed as a flow-through entity, should you elect to be taxed as a C Corporation? Or, will the taxation of distributions from the entity (dividends) eliminate any benefit the new 21% flat tax rate will bring? Since the 20% deduction phases out for SSTBs when taxable income levels are exceeded, a C Corporation might be an alternative. But don’t jump the gun on the conversion. We believe this will not be the best option in many cases.
A second area of consideration is wages. You could adjust owner and employee wages and bonuses up or down to maximize on the deduction. Partnerships and sole proprietorships are not allowed to pay the owner a wage. If you exceed certain income levels, W-2 wage limitations kick in; therefore, consider an S election so that the owners can receive a wage, thus increasing the W-2 wage limitation. There is also a “reasonableness” requirement related to S Corporation shareholder wages, so adjusting those wages down may or may not be an option. The use of independent contractors reduces W-2 wages; therefore, one better answer may be to convert the independent contractors to W-2 employees.
The QBID is calculated on a business-by-business basis. If a taxpayer is engaged in several separate business activities, some generating qualified business income but paying no wages, the deduction could be limited or not allowed at all. On the other hand, if the taxpayer’s other business is generating losses and paying substantial wages, again no deduction may be allowed because no qualified business income would be generated. In this scenario, employees and depreciable assets along with the positioning of income producing assets amongst the activities should be strategically considered.
If you engage in an SSTB and your taxable income projection exceeds taxable income limitations, then consider income reducing strategies. These could include increasing retirement plan contributions, increasing charitable contributions (if you are still able to itemize), accelerating deductions, and/or deferring income. “Married filing separate” filing status may also be a better option if one of the spouse’s income is causing joint income to exceed limitations.
While the Tax Cuts and Jobs Act has simplified taxes for many taxpayers, the complexity for small business owners has greatly increased. If you own a business, whether as a regular C Corporation or a flow-through, you should speak to a qualified CPA. A maximum tax rate of 29.6% sure beats 37%!
Ashley Brand, CPA, is a Tax Manager at Akin, Doherty, Klein & Feuge, P.C. (ADKF). ADKF is a full-service accounting firm with offices in San Antonio, Boerne, and New Braunfels. Ashley graduated from the University of Texas of the Permian Basin and has over 12 years of public accounting experience. She is involved in compliance and planning for individuals, partnerships, corporations, and trusts. Ashley lives in Pleasanton and spends her free time with her family and supporting her local community through the volunteer efforts of her church.
See the article in the September 2018 Issue of Boerne Business Monthly.