New Tax Deduction for Sole Proprietors and Owners of Partnerships/LLCs and S Corps
The recently-enacted tax legislation provides for a new tax deduction for qualified business income earned through sole proprietorships and passthrough entities (partnerships/LLCs and S Corps). The requirements and limitations related to this new deduction are some of the most complicated provisions in the new tax law. The following is a general description of the new deduction. To understand how this deduction may specifically apply to you and your business, please consult your tax advisor or schedule a consultation appointment with one of the Treehouse Nerds.
Who can claim the deduction?
Taxpayers operating a U.S. business in non-corporate form may claim the deduction. This means:
Sole proprietors (i.e., independent contractors – no taxes deducted from your checks)
Owners of partnerships, LLCs, and S Corps
What type of income is eligible for the deduction?
The deduction applies to “qualified business income” or QBI, which is the NET income from active U.S. business operations. In other words, whether you are a freelance photographer, a consulting partnership, or offer radicalized healing services, your QBI is basically your profit after calculating your business expenses.
Below the income cap (discussed below): QBI includes all types of active business income, including income from service businesses.
Above the income cap: QBI excludes income from most service businesses, except architecture and engineering. Income earned in the fields of performing arts, consulting, health, law, and finance, among others, is not eligible for the deduction.
What is the income cap?
The deduction is subject to additional limitations for taxpayers with taxable income over the applicable income caps.
Married taxpayers filing jointly: the income cap is $315,000 of combined joint taxable income from all sources (QBI and other income).
All other taxpayers: the income cap is $157,500 of taxable income from all sources (QBI and other income).
Phase-out of deduction: Above the income caps, a reduced deduction will be allowed subject to phase-out percentages for an additional amount of income equal to $100,000 for married taxpayers filing jointly (total cap of $415,000) and $50,000 for all other taxpayers ($207,500 total). The phase-out calculation is complicated – consult an advisor if you have income above the income cap but below the phase-out amount, or schedule a consultation with one of the Treehouse Nerds.
How much is the deduction?
For taxpayers below the income cap: The deduction reduces taxable income by an amount equal to 20% of QBI (i.e., 20% of net income from the qualified business).
For taxpayers above the income cap: The deduction reduces taxable income by an amount equal to the lesser of:
20% of QBI (i.e., 20% of net income from the qualified business); or
50% of the W-2 wages paid to employees working in the qualified business, or
25% of the W-2 wages paid employees working in the qualified business plus 2.5% of the cost of tangible property used in the business. (This 25%/2.5% limitation was added to the legislation to benefit real estate businesses with few employees.)
How about some examples?
Example 1: A performance artist operating as a sole proprietor earns $175,000 from her performance gigs in 2018 and spends $25,000 on travel and supplies related to her performances – resulting in net income of $150,000. She has no other source of income and her filing status is single. Because her total income ($150,000) is under the income cap ($157,500), she will be able to claim a QBI deduction of $30,000 (20% of $150,000). Her taxable income will be $120,000 ($150,000 net income - $30,000 QBI deduction).
Example 2: A performance artist operating as a sole proprietor earns $300,000 from her performance gigs in 2018 and spends $50,000 on travel and supplies related to her performances – resulting in net income of $250,000. She has no other source of income and her filing status is single. Because her total income ($250,000) is over the income cap ($157,500), and because she earned this income from one of the excluded service industries (performing arts), she cannot claim any QBI deduction. Her taxable income will be $250,000.
Example 3: An architect operating as a sole proprietor earns $300,000 in 2018 and spends $50,000 in wages paid to her assistant – resulting in net income of $250,000. She has no other source of income and her filing status is single. Her total income ($250,000) is over the income cap ($157,500); however, she did not earn the income from an excluded service industry (architects are an exception), and she did pay W-2 wages. As a result, she will be able to claim a QBI deduction of $25,000 (the lesser of: 20% of $250,000 QBI or 50% of $50,000 W-2 wages paid). Her taxable income will be $225,000 ($250,000 net income - $25,000 QBI deduction).
When is the deduction effective, and how long will it last?
Under the tax legislation, the deduction may be claimed for tax years starting in 2018, and it will expire (unless extended by an act of Congress) after 2025.
Should I restructure my business based on the new deduction?
There are many factors in the new tax legislation to consider when thinking about what form of business to operate – sole proprietorship, LLC, partnership, S Corp, C Corp, etc. The new 20% QBI deduction is one such factor, as is the new reduced 21% corporate income tax rate. The factors to consider when making this decision will depend on the specific facts and circumstances that apply to a particular business and its owners. If you would like to discuss this in more detail, please consider scheduling a tax consultation appointment with one of the Treehouse Nerds.