By: Ron Morgan
Effective for tax years from 2018 through 2025, new Internal Revenue Code Section 199A generally provides for a deduction of 20% of “qualified business income” received from sole proprietorships or so-called “pass through” entities (partnerships, limited liability companies, and S corporations). The deduction does not apply to W-2 income that you receive from these entities. The deduction also does not apply to C corporations, which now get a flat rate of 21% instead of graduated rates from 15% to 35%. For many self-employed Vermonters, the deduction will result in very significant tax savings, potentially reducing their taxable income by up to a fifth, and possibly reducing the highest “marginal” tax rate on such income. The new deduction will not reduce your Vermont income tax liability, because Vermont’s definition of taxable income does not take into account the new deduction.
That’s the good news. The bad news is that the new law is extremely complex, and the deduction is subject to a bewildering array of limitations, many of which can be avoided or mitigated only by acting immediately to maximize your deduction for 2018. What follows is a series of steps to help you “triage” your situation and to identify potential planning opportunities. This is NOT anything close to a definitive guide to the new law; its purpose is to assist you in making a preliminary assessment of your situation. I cannot over-emphasize the importance of having your accountant “run the numbers” as soon as possible based upon your specific tax situation, and to talk to your attorney before you make any changes to how you are currently conducting or owning your business. For more in-depth reading on the new law, I recommend: https://www.forbes.com/sites/anthonynitti/2017/12/26/tax-geek-tuesday-making-sense-of-the-new-20-qualified-business-income-deduction/#536fb05c44fd. For those with shorter attention spans, here are some of the more important factors to get a handle on:
What is your taxable income likely to be in 2018? This is one of the most critical factors that can limit the amount of your deduction. If your taxable income is likely to be greater than $315,000 married filing jointly, or $157,500 for everyone else, some very important limitations will begin to apply, and proper advance planning will be essential. Conversely, if you are comfortably below these levels, many of the limitations will not apply to you, but even so I would strongly advise you not to skip an appointment with your accountant soon, particularly if you are paying yourself wages from an S corporation (see below). Here are the most important limitations to the amount of the 20% deduction:
Personal Service Income You may have read or heard that “service businesses”, such as doctors, attorneys, accountants, consultants, or similar personal service professions (other than architects and engineers) do not qualify for the deduction. While this will be a major limitation in some cases, and there will likely be a lot of gray areas, if your taxable income is below the thresholds, this limitation will generally not apply. If you are above the threshold, your deduction will be phased out over the next $100,000 (joint) or $50,000 (other) of taxable income.
W-2 Wage Limitation Another significant limitation to the amount of the deduction that you may have heard about is the one based upon the amount of W-2 wages paid by the business (typically, 50% of such amount). Again, if your taxable income is under the threshold, this limitation will not apply. There is an alternative limitation based in part upon the original cost of business assets acquired within the previous 10 years, but again this will not be relevant if you are under the threshold.
If your taxable income will likely be above the “threshold amounts”, consider ways to reduce your taxable income below the threshold.
Make Contributions to a Tax-Deferred Qualified Retirement Plan Business owners have a variety of options for establishing a qualified plan for themselves and their business, subject to different rules and restrictions. Contributions to a qualified plan will be deducted from your taxable income, subject to limitations on the amounts that can be contributed in a year, to be taxed later when the funds are eventually withdrawn. Consult with a qualified professional for advice on how to do this.
“Special allocations” of Partnership or LLC Income In situations where multiple family members have ownership interests in a business, it is possible to allocate specific items of partnership income or loss among the partners in a manner designed to optimize the short-term after-tax results to all of the partners (in exchange for mandatory offsetting allocations in the longer term). If some family members are above the taxable income thresholds and others are not, allocations of partnership income could be made to those who are below the threshold, while simultaneously reducing the income otherwise allocated to partners who are above the threshold, thus increasing the amount of the 20% deduction available to the family. However, keep in mind that lengthy and complex rules apply to ensure that such allocations have “substantial economic effect”, presenting significant additional planning complications.
Gifts of Ownership Interests In some situations, it may be appropriate and useful to transfer ownership interests to family members (directly or in trusts) who are below the threshold, perhaps in combination with special allocations discussed above.
If you are above the threshold amounts, but not in a disqualified “personal service” business, there may be opportunities to restructure business operations to maximize W-2 wages and/or investment in capital assets to increase the deduction limits.
Are you doing business as an S corporation? As noted above, W-2 wages you receive from your business do not qualify for the new deduction, whereas your share of S corporation net profits do qualify. However…before you decide to give yourself an immediate wage cut to take advantage of the new deduction: Remember that there is a reason your accountant always told you to pay yourself a reasonable wage: S corporation owners who work in the corporation are required by law to pay themselves a fair wage for the value of their services. The IRS keeps a sharp lookout for taxpayers who attempt to eliminate or reduce their wages in order to avoid the payment of employment taxes (and now to maximize their business income to get the new deduction). The safer alternative is to consider a change from an S corporation to another form of business such as an LLC so that you can qualify what you are now paying yourself as wages for the new deduction. There are, however, several important things to consider:
Self Employment Tax While the change to an LLC will generate a 20% deduction for the previous wage amount, it will also typically result in self-employment taxes being imposed on all of the LLC’s income, at a rate of 15.3% in 2018 (up to the limit of $128,400, after which rates of from 1.45% to 2.35% apply). This generally means that unless your total combined wage and business income is currently substantially more than the limit, the switch to an LLC will likely cost you money, not save it, but much will depend on your specific tax and wage situation, which should be carefully reviewed with your accountant.
Gain on Liquidation Another significant hurdle to clear is that liquidating an S corporation will result in a deemed sale of the assets at their fair market value, and tax will be due on the gain and in some cases, at ordinary income rates (e.g., depreciation recapture). For many owners, the value of the assets, such as office equipment, many be minimal, but corporations owning vehicles or real estate will require careful analysis before liquidating.
Multiple Shareholders If there are multiple shareholders, particularly if they are not closely related, and some are performing substantial services while others are not, the overall business relationship should be evaluated before major changes are made to the business structure. Similarly, if the corporation owns valuable contract rights or intellectual property, an attorney as well as an accountant should be consulted.
Effect of Other Limitations Again, if you are above the taxable income threshold amounts, careful thought should be given before you do any restructuring, since W-2 wage and other limitations will also have to be taken into account.
What if you are doing business as a C corporation? The new law subjects C corporations to a flat tax rate of 21%, which can result in significant tax savings if annual taxable income is more than $50,000. In most cases, the decision to convert from a C corporation to a pass-through entity form of business–typically an S corporation–will be driven by factors other than the availability of the 199A deduction, although it may make a conversion more attractive.
If you own a business, new § 199A provides substantial potential benefits, but in many cases it will be necessary to make adjustments to your current business practices in order to get the most out of it. For that reason, we suggest that you not wait until next March or April to talk to your accountant and/or attorney about doing some planning.