If your company is not a “specified service businesses,” you may qualify for the 20% pass-through tax deduction in your current business or by restructuring your existing business to an S-corporation to avoid taxable income limitations that apply to the new 20% Sec. 199A pass-through deduction. Pass-through business owners who qualify for the 20% Sec. 199A can take a deduction of up to 20% of their net business income on their tax return, reducing their effective income tax rate by 20%.
Congress created the new 20% tax deduction to make up for the tax reform’s reduction of the C-corporation tax rate to 21%, from which other forms of business activities do not benefit. The 199A deduction is for taxpayers with other business activities such as sole proprietorships, rentals, partnerships, and S-corporations. Unlike C-corporations, which are directly taxed on their profits, the income from the other business activities flows through to the owner’s tax return and is taxed at the individual level at the individual’s tax rate, which can be as high as 37%. The 20% Sec. 199A tax deduction is 20% of the pass-through income from these business activities. But not every owner of these flow-through businesses will benefit from this deduction because of certain tax limitations.
So, the question is, what is a pass-through business? A pass-through business is any business that is owned and operated through a pass-through business entity including any business that is: a Sole Proprietorship, S-corporation, Partnership, Limited Liability Partnership (LLP), or Limited Liability Company (LLC).
Qualifications also depend upon a taxpayer’s 1040 taxable income figured without the Sec. 199A deduction. Married taxpayers with a taxable income below $315,000 (or below $157,500, for others) will benefit from the full 20% deduction.
Limitations begin to apply when a taxpayer’s 1040 taxable income exceeds those amounts. The most restrictive limitation is the one placed on “specified service businesses.” Once married taxpayers filing jointly have a 1040 taxable income exceeding $415,000 (or above $207,500, for others), they receive no Sec 199A deduction benefit from any pass-through income derived from a specified service business. Specified service businesses include trades or businesses involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services or any trade or business in which the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners. It should be noted however, engineering and architecture businesses are not considered a specified service business for the pass-through deduction, which allow these businesses to take advantage of the pass-through deduction.
Some taxpayers can still benefit from pass-through income from other business activities, even when the taxpayer’s 1040 taxable income exceeds the $415,000/$207,500 limits, provided the business activity pays wages and/or has qualified business property, the combination of which make up what is referred to as the wage limitation. Without getting too complicated, the Sec. 199A deduction is the lesser of 20% of one’s pass-through income or the wage limitation. If the wage limit is 0, then the Sec. 199A deduction would also be 0 for these high-income taxpayers. The wage limitation itself is the greater of 50% of the wages paid by the business activity or 25% of the wages paid plus 2.5% of the cost of qualified business property. Let’s look at some examples:
1.) John and his wife have a 1040 taxable income of $436,000. John has a self-employed business, from which he has a net profit of $300,000, and his tentative 199A deduction is $60,000 (20% of $300,000). Because John’s taxable income exceeds $415,000, his Sec. 199A deduction is the lesser of $60,000 or the wage limit. John has no employees or qualified business property, so his wage limitation is 0; thus, his Sec. 199A deduction is also 0.
2.) Now, let’s look at John’s entity. John’s business is organized as an S corporation. Of his net profit of $300,000, it is determined that a reasonable compensation (wage) John receives from the S corporation is $150,000. The other $150,000 is pass-through income. Now, John’s Sec. 199A deduction is the lesser of 20% of the pass-through income – $30,000 (20% of $150,000) – or the wage limitation, which is 50% of the wages paid by the S Corporation or $75,000 (50% of $150,000).
We can see in those examples how businesses can benefit from being organized as an S-corporation. S-corporations are required to pay working shareholders a reasonable wage for their services provided in operating the business. They can divide the pass-through income between reasonable wages and pass-through income to enable a 199A deduction for a higher-income taxpayer. Other business entities do not provide this option, which is the reason why high-taxable-income taxpayers might explore the benefits of organizing new businesses as an S-corporation or reorganizing their existing businesses to an S-corporation.
Some sole proprietors may not find it worth the effort to switch to a different business entity. However, the higher the taxpayer’s income, the more beneficial it becomes. The same issues also apply to partnerships. To determine if organizing or reorganizing your business into an S-corporation or another business entity can reduce your tax liability, call us for a free consultation at (727) 449-1835 or send us an email at CFO@mytotalaccounting.com.