Can You Deduct Twenty Percent of Your Income?
If you own a service business in the fields of health, financial and brokerage services, athletics, accounting, law, performing arts, consulting, or "any business where the principal asset is the reputation or skill of one or more of its employees" (except for engineering and architecture), the answer is generally "no." If you own any other type of business, the answer is "maybe."
The Tax Cuts and Jobs Act of 2017 tweaked some areas of the tax law and completely changed others. One provision that is completely new is the twenty percent income deduction for owners of pass-through entities. As discussed below, pass-through entities are businesses where the income is taxed directly to the owners.
Businesses can be operated in many forms. These include a sole proprietorship, general partnership, limited partnership, limited liability company, and corporation. The type of entity does not necessarily determine the type of taxation.
Sole proprietorships and single member limited liability companies are taxed directly to the owner, and are generally reported on Schedule C of the owner's income tax return (Form 1040).
Corporations can be taxed in two ways. By default, a corporation is taxed as a C corporation under the Internal Revenue Code. The owner of a C corporation can pay himself a salary like any other employee. In that case, the company must withhold income tax and payroll tax and pay its own share of payroll taxes. Alternatively, the owner can leave income in the corporation. In that case, the company will pay income tax on the undistributed income. The corporate tax rate was 35%, but the new act lowered the rate to 21%. If the owner wants cash from the corporation, the corporation can pay the owner a dividend. Assuming the dividend is a qualified dividend, the owner will generally be taxed at 15% on the dividend, for a total tax rate of 36%.
Before the new tax act, total taxation on corporate income paid as dividends would generally be 50% – a 35% corporate tax and a 15% personal tax on dividends. As shown above, the new total tax rate will generally be 36%.
Certain corporations can elect to be taxed as an S corporation. An S corporation has restrictions on who can own its shares. It cannot have more than 100 shareholders, shareholders must be individuals or certain trusts or estates, shareholders cannot be partnerships or corporations, and shareholders must be US citizens or residents. In addition, an S corporation can only have one class of stock, e.g., it cannot have common stock and preferred stock.
If the corporation meets the qualifications and files an S corporation election with the IRS, it will be taxed as a "pass-through" entity. This means that all of the income will be taxed to the owners at their personal tax rates without paying the corporate tax.
Partnerships, both general and limited, are taxed as pass through entities. At formation, a limited liability company can elect to be taxed as a corporation or as a partnership (a pass-through entity).
Once an entity chooses its form of taxation, i.e., C corporation, S corporation, or partnership, it cannot change its form without approval of the IRS.
If an individual is in the 25% bracket, as the owner of the S corporation, he will generally pay 40% federal tax on the first $128,400 of income – 25% in income taxes and 15% in payroll taxes. Owners of S corporations can, however, pay themselves a salary, which incurs employment taxes, and dividends which don't. S corporations are required to pay wages to any shareholder who is also an officer and provides "significant services" to the corporation. The wages must be "reasonable," meaning that an officer cannot pay himself $1 in an effort to eliminate payroll taxes.
So, before the act, a taxpayer might pay 50% on C corporation income versus 40% on S corporation income. After the act, the owner of the C corporation might pay 36% while the owner of the S corporation would still pay 40%.
In order to give the owners of pass-through entities a benefit similar to the reduced corporate income tax rate, the act creates a deduction for individuals of 20% of qualified business income from pass-through entities. For example, if a taxpayer owns a convenience store that is taxed as a partnership and her share of the income is $50,000, she can now deduct 20% of that income, or $10,000. This deduction is not an itemized deduction, so it is still available to tax payers who take the standard deduction.
Of course the deduction is not as simple as a straight 20% deduction. First, it only applies to "qualified business income." Qualified business income does not include capital gains, interest income or dividend income. It also does not include W-2 income. If the owner of an S corporation pays himself W-2 wages of $50,000 and is allocated another $25,000 of corporate income, only the $25,000 counts as qualified business income.
The deduction is limited to the greater of: 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of the unadjusted basis of the entity's assets. For example, assume a taxpayer owns 50% of a partnership, the partnership has $500,000 of net income, the partnership pays W-2 wages to its employees of $300,000, and the partnership has assets of $1,000,000.
How does taxpayer calculate his deduction? The first step is easy. Taxpayer's share of the income is $250,000, and 20% of that amount is $50,000. Now, for the limitation. The deduction is limited to the greater of:
50% of taxpayer's share of W-2 wages, or 50% of $150,000 = $75,000; and
25% of W-2 wages ($37,500) plus 2.5% of $500,000 ($12,500) = $50,000.
Therefore, taxpayer's $50,000 is not reduced by the limitation rules.
Taxpayers whose taxable income is less than $157,500 ($315,000 for married filing jointly) don't have to take the limitations into account and can deduct the 20% without further calculations. This benefit is phased out for taxable income between $157,500 and $207,500 ($315,000 and $415,000 for married filing jointly).
The new 20% deduction can be a great benefit to certain business owners, however, the deduction is complicated, and may be made more so by regulations or IRS guidance. The information provided here is general and over-simplified, by necessity. Business owners will need to consult with a tax professional to determine exactly how the deduction will apply to them.