Article written by M. Eldridge Blanton III, Esq.
The Tax Cuts and Jobs Act of 2017 (TCJA) took effect on January 1, 2018. Taxpayers filing in 2019 will use TCJA provisions to report their 2018 taxes.
Owners of small businesses will be able to claim significant deductions from their income if they are structured as pass-thru entities. These entities include sole proprietorships, partnerships, S-corporations and LLCs.
Under the TCJA the C-corporation tax rate was reduced from a top rate of 35% at the entity level to a flat rate of 21%. Combined with the top rate on dividend income of 20% at the shareholder level, the C-corp top rate was reduced from 48% to 36.8%. The C-corp tax cuts were made permanent.
By contrast, pass-thru entities are not taxed at the entity level but at the owner’s individual rates. The top individual rate was reduced from 39.6% to 37%. Because Congress wanted to incentivize the creation of small businesses, section 199A was added to the TCJA. Section 199A provides for a 20% reduction against small business income, resulting in a top tax rate on such income of 29.6%. Both the lower individual rates and the 199A deductions are due to sunset at the end of 2025.
Consider two examples:
Dan was the sole shareholder of a C-corp. The C-corp had taxable income of $100,000. Under prior law, the tax at the entity level would have been 35% or $35,000. The remainder of $65,000, would have been taxed as dividends at the shareholder level at 20% or $13,000. The combined tax would have been $35,000 plus $13,000 or $48,000, 48%.
If Dan’s firm had been organized as an LLC, there would have been no tax at the entity level. All taxable income would have been passed thru to Dan and taxed (at the highest individual rate) at 39.6% or $39,600.
After the enactment of the TCJA, Dan’s C-corp has taxable income of $100,000. The entity level tax is 21% or $21,000. The remaining $79,000 in dividends is taxed at the shareholder level of 20% or $15,800 for a total tax of $36,800 or 36.8%.
If Dan’s firm (post-TCJA) had been organized as an LLC, there again would be no tax at the entity level. The taxable income of $100,000 would be reduced by 20%, leaving $80,000 which would be passed thru to Dan. At his new(top bracket) rate of 37%, his tax would be $29,600, 29.6%.
So, for the next 8 years (income in years 2018-2025) owners of small businesses will be eligible for significant deductions against their small business income. It is beyond the scope of this newsletter to recount all of the details of 199A, but certain basic concepts should be noted AND ACTED UPON FOR THE FILING OF 2018 TAXES.
It’s widely assumed that only certain types of businesses are eligible for the 199A deduction. This is only partially true. ALL pass-thru entities are eligible for the deduction, up to a point. Only certain types of pass-thru businesses can deduct income over and above these thresholds.
The thresholds for 2018 income are $157,500 for single taxpayers and $315,000 for joint returns. These thresholds apply to the taxpayer’s TOTAL taxable income (after deductions), not just to the income from the small business. The eligibility is phased out if the taxpayer’s TOTAL exceeds the relevant threshold, and is lost completely at $207,500 for single filers and $415,000 for joint filers (a $50,000 and $100,000 phaseout window respectively).
However, the thresholds cited here DO NOT APPLY if the small business is accorded favored treatment. Engineering and architectural firms are specifically exempted and can apply the deduction against ALL of the firm’s net income. The 199A language uses the term “Specified Service Trade or Business” (SSTB), which is a way of saying which types of pass-thru businesses CANNOT use the deduction to offset income in excess of the thresholds. These disfavored businesses include those in the fields of:
- financial services
- brokerage services
- “Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. “1
In other words, if the success of the business is tied to the reputation (good will) or skill of the owners, the owners can use the 199A deduction up to the threshold (and phase out) levels but not beyond. All other pass-thru businesses, and specifically including engineering and architectural firms, despite their reputation or skill can use the deduction against ALL of the net income of the business.
AMOUNT OF THE DEDUCTION
The amount of the deduction is premised on a number of factors, but the starting point is Qualified Business Income (QBI). QBI is the net amount of taxable income, less capital gains and losses and certain dividends and interest income. Importantly, QBI is computed on a per business, not on a per taxpayer, basis. For a taxpayer with multiple businesses, the QBI for each is calculated and the per business QBls are netted, to yield a total QBI for the taxpayer.
The 199A deduction is, generally, the LESSER of:
- 20% of QBI, plus 20% of REIT dividends and 20% of qualified publicly traded partnership income
- 20% of taxable income minus net capital gains.2
At this point a few more examples may be helpful. 3
John grosses $100,000 in a sole proprietorship. After taking $30,000 in deductions, his taxable income is $70,000. John can use the 199A deduction to further deduct 20% of $70,000 or an additional $14,000.
Abby earns $425,000 as a partner in a law firm. Her husband Andrew is between jobs and has no earnings. Due to various deductions, Abby and Andrew have taxable income of $315,000. They file jointly. Despite Abby’s income coming from an SSTB, they are entitled to a 199A deduction because their taxable income does not exceed the threshold for joint filers. Their deduction is 20% of $315,000 or $63,000.
George earns $200,000 as a sole proprietor consultant and also recognizes $100,000 of long term capital gains. Because his personal deductions total $150,000, his taxable income is $150,000. His taxable income adjusted for the net capital gains is $50,000.
George can use the 199A deduction, but his deduction is only $10,000. (20% of $50,000).
One prong of the 199A formula calculates his deduction as $40,000, his QBI of $200,000 times 20%.
But the second (lesser of) prong yields a deduction of only $10,000 ($150,000 of taxable income minus $100,000 of long term capital gain or $50,000 times 20%).
As is evident from this discussion, the 199A deduction can be dauntingly complex in some situations and will require help from an accountant. 4 However, for many taxpayers, the deduction will be easy to calculate and the savings can be significant. Consider a retired couple with modest investments and receiving social security. However, they own a number of residential rental properties which net them $100,000 a year after the normal deductions for expenses. If this couple were to form an LLC and have the LLC own the properties, they could save $20,000 per year ($100,000 times 20%). Of course, they could also declare the rentals to be a sole proprietorship, which is considered a pass-thru entity and achieve the same tax result.
The 199A deduction is NOT available for shareholders/ owners of C-corps. Conversion from a C-corp to an S-corp or LLC involves the dissolution of the C-corp, usually with adverse tax consequences in the form of depreciation recapture. There are, however, many small C-corps with few if any depreciable assets. The owners of these entities may well want to consider such a conversion.
1 IRC Section 199A(a) and (b)
2 IRC Section 199A (a) and (b).
3 Stephen L. Nelson, CPA, Maximizing Section 199A Deductions, pp.11-12, 2018.
4 There are 184 pages of Proposed Regulations governing Section 199A.