New 20% Tax Break: Where Does It Apply And What Are Its limitations?

A brand new deduction has been established by The Tax Cuts and Jobs Act for pass-through business owners. They will be able to take advantage of up to 20% deduction of their net business income when they file their income taxes. This means their effective income tax rate will be reduced to 20%. The deduction will start in 2018 and will be implemented until 2025. Unless the Congress decides to extend it, it will end on January 1, 2026.

If you’re a small business owner make sure you don’t run out of time. This deduction adds up and can significantly affect your income tax. Pass-through entities include S corporations and limited liability companies. They are considered “pass-through” because the business income is passed through to the entrepreneur on his or her own tax return where individual income tax rates will be based upon. It’s important that you understand this complex deduction in order to save taxes.

Where does the 20% apply to?

The 20% deduction is applicable to Qualified Business Income (QBI). It includes the income’s net amount, gains, deductions and losses related to the trade or business. Investment-related items such as capital gains or losses, dividends and interest income are not included. What people fail to realize is that the deduction only reduces the taxable income, not the adjusted gross income.

What are the Limitations for High-Income Earners?

People with high income may have to look into the set limit before they start claiming for deduction. 

• Professional Service Industries. High-income taxpayers will not be able to convert wages or other compensation from personal services into income qualified for deduction due to this new rule. The 20% deduction will also begin to phase out for people who earn more than $315, 000 (for couples) and $157, 500 (for singles) only for those who are in the professional service industries such as a health, law, consulting, athletics, and financial. Those whose income reaches $415, 000 (for couples) and $207, 500 (for singles) the deduction will be completely phased out.
• All Industries. There's another calculation use for high-earners in all industries under the new Act.  The limit would be set to whichever is higher: 50 percent of total wages paid or 25 percent of wages plus 2.5 percent of the cost of the tangible depreciable property. This means more deduction will be claimed by pass-through entities paying a larger amount of employee wages or are in capital-intensive industries. 

What Tax savings and Planning Opportunities Should You Do?

If you are a small business owner, you may want to look into doing some situational planning to maximize the 20 percent deduction. Some of the tax planning opportunities you can do are the following:

• Married taxpayers may want to look into the difference between married filing jointly and married filing separately. Depending on what status you choose, you may be able to get higher benefit due to the phase-outs and threshold amounts.
• Reducing W-2 wages is generally advantageous in minimizing self-employment taxes. However, it may also be necessary to increase W-2 salaries to a specific level to optimize the 20 percent deduction. It is, therefore, better to convert a 1099 contractor to a W-2 employee.
• The effective marginal tax rate for the 20 percent tax deduction qualifying small business could be reduced to 29.6 percent. The top income tax rate for C corporations according to the new law is reduced to 21 percent. Since C corporations are taxed once on the income and another on the returns to investors, converting an S corporation to a C corporation may not become necessary.

You may now be faced with a question of whether or not you should incorporate your business to help save on taxes and in case you do, what entity should you choose. It’s important for business owners to weigh in how much will you be able to save on taxes with an S-Corp compared to how much they will pay in setting it up and maintaining it. It is also imperative for taxpayers earning over the set income thresholds to work with a qualified tax professional who can offer assistance in navigating the rules of the 20% pass-through deduction under IRC Section 199A because of its complexity and in order to take full advantage of the deduction.