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The House and Senate versions of the Tax Cuts and Jobs Act both have sections providing tax benefits for owners of entities where business income is taxed on the owner’s individual income tax return.

The Democrats had Ben Bernanke and Janet Yellen at the Federal Reserve dispensing free money for the past 8 years. This deduction is in essence the Republicans’ version of a helicopter money drop.

This article explains the working of the Senate version. The House version involves a maximum tax on passthrough income. It is too convoluted for this article.

What is the benefit?

The Senate bill has a deduction equal to 23% of taxable business income of passthrough entities that is taxed on individual income tax returns.

Who benefits?

  • Owners of businesses taxed as passthrough entities.

    Sole proprietors
    Partnerships
    Limited liability companies taxed as partnerships
    S corporations

  • Non-service businesses
  • Specified service businesses where the owner has less than $250,000 of taxable income on his or her individual income tax return ($500,000 if filing jointly). These amounts are inflation adjusted after 2018.
  • Other service businesses not specifically targeted for the income limitation.
  • Owners of real estate investment trusts
  • Employees other than S corporation shareholder-employees are excluded. There will probably be endless regulations issued that are designed to prevent employment arrangements being disguised as businesses being operated as passthrough entities.

Limitations on the 23% benefit

  • Non-service businesses

    The deduction cannot exceed 50% of wages paid. For non-service businesses the owner’s allocated share of all wages is used, including the wages of shareholder-owners.

  • Specified Service Businesses

    For Specified Service Businesses, wages for computing the 50% limitation are the owner’s distributive share of income (reported on the K-1) plus guaranteed payments (if a partnership) or shareholder-employee wages (if an S corporation).

    The amount of Qualifying Business Income of an entity that is a Specified Service Business is phased out as income increases from $250,000 to $300,000 on an individual return, and from $500,000 to $600,000 on a joint filing.

    Specified Service Businesses are defined under Section 1202.

    1202(e)(3) Qualified trade or business.—

    The term “qualified trade or business” means any trade or business other than any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.

    This casts a wide net. Expect the regulations defining Specified Service Businesses to be voluminous. There are huge tax benefits to high-income taxpayers that own service businesses that are contingent on not being subject to the income limitation. If enacted, the litigation will be endless.

  • Other service businesses

    The rules for non-service businesses also apply to service businesses that are not specified in Section 1202.

  • The income must be from U.S sources.

    The intention of the law is promote domestic employment.

Computation of the deduction

  • The deduction is computed at the entity level.

    Qualified Business Income (QBI) is computed using the partner’s or shareholder’s information provided on form K-1.

    Non-business income and deductions related to non-business income must be excluded. Foreign income and deductions related to foreign income must also be excluded.

    QBI loss carryforwards of the entity must be subtracted from current year business income. For Specified Services Businesses only, the QBI on the partner’s or shareholder’s K- 1 are increased by the deductible payments of compensation to the partner or shareholder. These are guaranteed payments to partners and wages paid to shareholder-employees.

  • The deduction is the lesser of 23% of qualifying QBI or 50% of wages The QBI of Specified Services Businesses is phased out as taxable income on taxpayer’s individual income tax return increases from $250,000 to $300,000 ($500,000 to $600,000 on a joint return).

    There are examples of these computations for both partnerships and S corporations at the end of the article. The calculations are difficult to comprehend without looking at actual numbers.

Observations

  • The wage limitation will affect outsourcing decisions.
  • The deduction calculation for Specified Service Businesses is independent of owner compensation arrangements. Neither guaranteed payments nor S corporation shareholder wages affect the QBI calculation. Wages for the 50% limit equal income from K-1s plus shareholder-employee W-2 income of S corporations and guaranteed payments of partners.
  • The deduction calculation for non-service businesses that are S corporations is affected by shareholder wage declarations. These reduce QBI and increase wages for the 50% limit test. This will affect compensation arrangements, and payroll taxes of shareholder employees have to be considered.

    If 23% of QBI is less than 50% of wages, additional wage declarations result in increases to both income and payroll taxes. A deduction is lost equal to 23% of every additional dollar of compensation, and additional payroll taxes are incurred.

    If wages are less than the FICA limit, the increased tax is 15.3% of every additional dollar of compensation. Assuming a 25% tax rate, the tax cost is 21.05%. (What’s to like about this?) If the shareholder-employee already has wages above the FICA limit, the tax increase is 8.65%.

    Payroll tax increase 15.3% (if below FICA limit)
    Payroll tax increase 2.9% (if above the FICA limit)
    Income tax increase 5.75% (23%*25% rate)
    From lower QBI

    Payroll tax increase 15.3% (if below FICA limit)
    Payroll tax increase 2.9% (if above the FICA limit)
    Income tax decrease (2.875%) (23%*50%*25% rate)
    From higher wage limit

    Under either scenario, tax increases result from wage declarations to shareholder employees.

  • There will be a huge incentive to shift income to taxpayers whose taxable income is below the level where QBI phaseouts occur for Specified Service Businesses.
  • Taxpayers whose taxable income is high enough to result in a phaseout of QBI will favor investing in businesses that are not specified in Section 1202.
  • Business owners will have to consider separating out service and non-service

    There is no guarantee that the Senate version will be the final form of the bill. Business owners and investors need to keep their eyes on this.