How to Slice Your Taxable Income by 20%
The Tax Cuts and Jobs Act gave birth to a new provision, Section 199A, which permits owners of sole proprietorships, S corporations or partnerships to deduct up to 20% of the income earned by the business.
When Congress embarked upon tax reform last year, the tax treatment of businesses took center stage. Despite what you may have seen on TV and on Facebook it does have some provisions that are beneficial to custom A/V, security and integration businesses, especially those with less than $10 million in revenue.
The Tax Cuts and Jobs Act established a new tax deduction — called the Section 199A deduction — for owners, including trusts and estates but excluding any taxable corporations or pass-through businesses (which, for this purpose, includes sole proprietorships and single member LLCs).
Owners of pass-through entities who qualify can deduct up to 20 percent of their net business income in determining their income taxes, reducing their effective income tax rate by 20 percent. This deduction is effective for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026.
Hopefully, most closely held integration business owners have established their entities as, or converted them to, Subchapter S corporations, LLCs (that are either partnerships or S corporations for tax purposes), or Limited Partnerships.
These types of entities generally pay no income tax at the entity level (excluding certain S corporations that were formed as traditional corporations). While a traditional (C) corporation pays taxes on its income, these other entities do not.
They have “pass-through” income, which means that the income is recognized and reported by its owners although it has been earned by the entity (whether or not such income has been distributed to the owners).
For example, a traditional C corporation with $100,000 of net income would pay taxes at the corporate level. When the stockholders take the cash out of the corporation it is a dividend and the stockholders pay tax again at their personal rates.
A pass-through entity would pay no tax on the $100,000 of net income, but its stockholders, partners or members would pay tax on their proportionate share of the income, whether or not the cash was distributed. This is referred to as passthrough income.
The Act allows for a deduction of 20 percent of certain qualified business income (QBI). This could be a very nice deduction. For example, if your company has $100,000 in pass-through income you could qualify to deduct $20,000, reducing your income taxes by $4,800 if you’re in the 24 percent income tax bracket.
Clearly, all security and integration company owners should understand this deduction. It is complex, and most tax professionals are trying to determine whether or not their clients qualify for it.
Additionally, if you are in the top tax bracket then this deduction would, in effect, reduce your applicable rate from 37 percent to 29.6 percent. Following are the requirements to take it.
You Must Have a Pass-Through Business + You Must Have QBI
You have to have a pass-through (and a legitimate one at that) business to qualify for this deduction and the pass-through business must be a trade or business within the United States.
Emphasis on legitimate because Congress didn’t intend for your receptionist to form a Subchapter S corporation and take a 20 percent deduction against his/her salary. A pass-through business is any business that is owned and operated through a pass-through business entity.
You Must Have QBI
Individuals (and trusts and estates) who earn income through pass-through businesses may qualify to deduct from their income tax an amount up to 20 percent of their QBI from each pass-through business they own.
QBI is the net income that the pass-through business earns during the year. This is determined by subtracting regular business deductions from total business income.
QBI includes rental income so long as your rental activity qualifies as a business (as most do). It also includes income from publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives.
QBI does not include short-term or long-term capital gain or loss. You won’t get the deduction on the proceeds from selling your monitored security accounts. QBI also does not include dividend income, interest income, wages paid to S corporation shareholders, guaranteed payments to partners in partnerships or LLC members, or business income earned outside the United States.
QBI is determined separately for each business entity that you have an ownership interest in. If one or more of your businesses lose money, you must deduct the loss from the QBI of your profitable businesses.
If you have a qualified business loss — that is, your net QBI is zero or less — you get no pass-through deduction for the year. Any loss is carried forward to the next year and is deducted against your QBI for that year. This serves as a penalty for having a money-losing business.
You Must Have Taxable Income
To determine your pass-through deduction you must first figure your total taxable income for the year (not counting the pass-through deduction).
This is your total taxable income from all sources (business, investment and job income) minus deductions, including the standard deduction ($12,000 for singles and $24,000 for marrieds filing jointly in 2018). You must have positive taxable income to take the pass-through deduction. Moreover, the deduction can never exceed 20 percent of your taxable income.
If your taxable income is below $315,000 if married filing jointly, or $157,500 if single, your pass-through deduction is equal to 20 percent of your QBI. This is the maximum possible pass-through deduction.
For both service providers and nonservice providers: If your taxable income is less than the $315,000/$157,500 thresh-olds it is very simple, you get 20 percent.
If your taxable income exceeds $315,000 if married, or $157,500 if single, calculating your deduction is much more complicated and depends upon your total income and the type of work you do.
While the Act states that certain specified “service” businesses are not eligible for the deduction (and then allows it under the income thresholds) it is not clear as to whether or not a security or systems integration company would be considered a specified service business.
The Act lists several types of businesses that are not eligible (doctors, lawyers, accountants, etc.); nothing similar to a security or systems integration company is listed.
Our firm has asked for a Technical Ruling from the Internal Revenue Service and will look to provide an update when we hear back.
There is a final catchall category that includes any business where the principal asset is the reputation or skill of one or more of its owners or employees. This likely includes many individuals who provide services not listed above. However, all the details have yet to be worked out by the IRS. Architecture and engineering services are expressly not included in the list of personal services.
Pass-through owners of a specified service business are not favored under the pass-through deduction. Indeed, instead of the application of the W-2 and depreciable assets tests discussed below, they lose the deduction entirely at certain income levels. There are no such limitations on pass-through owners of a business that do not provide specified personal services.
Presumably, Congress decided that nonservice providers who sell goods or make things are better for the economy and deserve more tax benefits than specified service providers.
Deduction for Nonservice Providers
If your business is not included in the list of specified service providers, and your taxable income is over the $315,000/$157,500 thresholds, how you figure your deduction depends on your taxable income.
If you’re a nonservice provider and your taxable income is over $415,000 if married filing jointly, or $207,500 if single, your maximum possible pass-through deduction is 20 percent of your QBI, just like at the lower income levels.
However, when your income is this high a W-2 wage/business property limitation takes effect. Your deduction is limited to the greater of:
- 50 percent of your share of W-2 employee wages paid by the business (another potentially complicated determination if the entity has special allocations or changes in owners during the year);
- 25 percent of W-2 wages plus 5 per-cent of the acquisition cost of your depreciable business property (total give up to real estate owners who tend to have relatively few employees).
Thus, if you have neither employees nor depreciable property, you get no deduction. This is intended to encourage pass-through owners to hire employees and/or buy property for their business.
Fortunately, most security and systems integration companies have large payrolls and fixed assets and should qualify. If you are still treating your installers and sales-people as “independent contractors,” and you think that you may be subject to this limitation, this is a good time to re-think this strategy.
The business property must be depreciable long-term property used in the production of income. For example, the real property or equipment used in the business (not inventory).
The cost is its unadjusted basis — the original acquisition cost, minus cost of land, if any. The 2.5 percent deduction can be taken during the entire deprecation period for the property; however, it can be no shorter than 10 years, even if the actual depreciation period is less than 10 years.
If your taxable income is $315,000 to $415,000 if you’re married filing jointly, or $157,500 to $207,500 if you’re single, the W-2 wages/property limitation is phased in — that is, only part of your deduction is subject to the limit and the rest is based on 20 percent of your QBI.
The phase-in range is $100,000 for marrieds and $50,000 for singles. At the top of income range ($415,000 for marrieds, $207,500 for singles), your entire deduction is subject to the W-2 wages/business property limit: If you have no W-2 wages or depreciable business property, you get no deduction.
To calculate the phase-in, first determine what the amount of your deduction would be if the W-2 wages/property limit didn’t apply at all — this is 20 percent X your QBI.
Next, calculate your deduction as if the W-2 wages/property limit applied in full. Only if the W-2 wages/property calculation is less than the 20 percent calculation, your phase-in amount will be based on the difference between these two calculations multiplied by your phase-in percentage.
Deduction for Service Business Owners (income greater than $315,000/$157,500)
If you have no employees or property your deduction is phased-out by 1 percent (that is 1 percent X 20 percent or .2 percent) for every $1,000 your income exceeds the $315,000 threshold, and when your income reaches $415,000 you get no deduction.
If you’re single and have no employees or property, your deduction is reduced by 2 percent (i.e., 0.4 percent) for every $1,000 your income exceeds the $157,500 threshold and you get no deduction if your income reaches $207,500.
Generally, all pass-through income (both specified personal service and other income) will be treated the same and get the full deduction (subject to net income limitations) as long as the applicable income is at or below the $315,000 and $157,000 thresh-olds described herein.
Between $315,000/$157,500 and $415,000/$207,500 the specified service income deduction will be reduced and the other income deduction may be reduced by certain phase in calculations. At and above $415,000/$207,500 the owners of the specified service business get no deduction.
Mitch Reitman is Managing Principal of Reitman Consulting Group in Fort Worth, Texas.
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