This is one of the largest and most complex parts of the TAX CUTS AND JOBS ACT OF 2017. It introduces the concept of QUALIFIED BUSINESS INCOME and the deduction that pass-through entities get for it that will effectively allow for certain businesses to be taxed at only 80 percent of their income, rather than 100 percent.
Let me give you a little bit of background. A pass-through entity is any kind of business where the income actually flows on to your individual return and you get taxed at your rates. This would include S-Corporations, Partnerships, LLC’s, and maybe a Schedule C and some farms. Those are what pass-through entities are. What they try to do with this law is they took the C-Corporation rate, which was reduced from the maximum 35 percent down to a flat 21 percent, and they wanted to give that same benefit to individuals who have their business income actually taxed on their return, because C-Corporations pay their own tax.
Let’s start with a simple example –Wendy owns a small business. Her net income generated from the business after paying all her expenses is about $50,000. Prior to 2018, this entire amount would be taxable to her. But, in 2018, assuming that the income is qualified business income and she is not phased out by any other income, she will only be taxed on $40,000, since $10,000 or 20 percent of that business income will qualify for the deduction. Being that she saves $10,000 in income for this year, 2018, if she is in the 22 percent tax bracket, it could be a $2,200 savings.
That sounds like an amazing deal for Wendy, but how does she know if the income is actually “qualified business income”?
That is still the million-dollar question. Since the final regulations have not yet been issued, we think we know what we know, but these things are always subject to change. Here is what we do know:
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- As long as your taxable income on your personal return (after standard deductions) is below $315,000 (MFJ) and $157,500 (Single), then most business income is going to qualify as Qualified Business Income.
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- Business income includes any venture that you are an active participant in, including what they added late in the bill—the income from the rental of real estate. It has to be a business that you own and operate.
- Certain income that is not included as business income would be W-2 wages, guaranteed payments (what partners in partnerships get), investment income (interest and dividends), unemployment benefits, retirement income and Social Security. Those are non-business income items and so that income would not qualify for this deduction.
It sounds like this rule could even get more complicated if your taxable income is over $315,000 if you’re married, correct?
That is correct. We talked about that magic $315,000 number. If you are over that number, then this particular deduction starts to phase out. It hits hard especially for those in the healthcare field, accountants, performing artists, athletes, financial service advisors, and brokerage service providers. Once you get over that $315,000 in income, a lot of these phase out to where you can’t take the deduction at all. If you are not that type of business, then the deduction is limited to 50 percent of the wages you paid to your employees. If you have a rental property, the deduction is limited to 25 percent of your W-2 or 2.5 percent of the original purchase price of the real estate (subject to additional limitation). These issues are very complicated which is why I definitely suggest talking to a CPA.
Can you give me an example of how the phase-out works overall?
Let’s use the example discussed earlier where Wendy’s business had net income of $50,000, and she was able to only pay tax on $40,000 of that income. If she is in the phase-out period, her deduction is limited to 50 percent of her W-2 wages that she pays to her employees. Therefore, if she has one employee and she pays $10,000 to that employee, she is only going to get $5,000 as a deduction, not the full $10,000 as if she wasn’t in the phase-out period.
Congress has provided a framework on what the deduction should be, but it is up to the federal government to write the regulations. We will update the content on our website as these regulations are written.
