The Impacts of the Tax Cuts and Jobs Acts
As of January 1, 2018, the Tax Cuts and Jobs Acts offers a 20% deduction for qualified business income pass-through entities. The owner of a sole proprietorship, S-Corporation, or partnership is entitled to take a deduction equal to 20% of the “qualified business income” earned from the business. Qualified business income is the non-investment income of the business – the revenue the business was intended to generate minus expenses. It does not include income such as interest, dividend income, or capital gains from the sale of property.
Prior to the Tax Cuts and Jobs Act, income from these small businesses would pass-through to the business owner on his or her own taxes and was subject to individual rates as high as 39.6%. Now, the qualified business deductions effectively lower that top marginal tax rate down to about 29.6%.
The qualified business deduction is limited to the lesser of:
- 20% of qualified business income, or
- 50% of the W-2 wages of the business.
In some, very rare cases, the deduction may be equal to 25% of the W-2 wages of the business plus 2.5% of the unadjusted bases of the business’s assets.
If the business owner is married and files jointly and the total taxable income of the business owner is less than $315,000 annually ($157,500 if single), the 20% of qualified business income is automatically taken. If the total taxable income of the business owner is more than $415,000 annually ($207,500 if single), the 50% of the W-2 wages of the business applies in full. Between $315,000 and $415,000 of taxable income, there is a phase-out and the business owner is able to deduct the lesser of the 20% of the qualified business income or 50% of the W-2 wages of the business.
For example, Mark, a married taxpayer, operates a business as a sole proprietor. The business has one employee who is paid $50,000 during 2018. The business has no significant assets. During 2018, the business generates $200,000 of income to Mark and Mark’s total taxable income, after deductions, is $215,000. Mark is entitled to a deduction of $40,000 ($200,000 x 20%). The W-2 wage limitation – which would have been $25,000 ($50,000 x 50%) does not apply because Mark’s taxable income is less than $315,000.
If all these facts remain true but the business generates $400,000 of income to Mark and, after deductions, his taxable income is $450,000, Mark’s deduction is limited to $25,000. Mark’s income is now over the $415,000 threshold so he is limited to the lesser of:
- 20% of $400,000, which equals $80,000
- 50% of W-2 wages $50,000, which equals $25,000.
The qualified business deduction includes certain rules designed to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction. For taxpayers who are married filing jointly with taxable income above $315,000 ($157,000 if single), an exclusion from qualified business income begins to be phased in for income of “specified service” trades or businesses.
Specified services are defined as any trade or business involving the performance of services in the fields of health, laws, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees. However, architects and engineers are excluded from the definition of specified services.
The qualified business deduction is a significant potential tax break for business owners, but it comes with a great deal of complexity and uncertainty. At this time, how the tax forms will be modified to accommodate the new deduction and what information will be required to be reported by pass-through entities to their owners to calculate the deduction is unclear.