What’s In Your Bubble?
After many years of discussing tax reform, we finally got meaningful legislation that is sure to impact every small and large business. Of course, the old adage “be careful what you wish for” is exactly what occurred with the Tax Cuts and Jobs Act (TCJA) legislation enacted in December 2017. Our politicians claimed the new tax reform legislation would simplify the Internal Revenue Code (IRC). The reality? It’s anything but simple.
The TCJA created new code sections and modified some of the existing ones. Specifically, IRC 199A is one of the two new code sections that will have the most impact on businesses and the economy. With significant tax cuts implemented through IRC §199A, time will tell if the result will be as intended when the policy was drafted.
In short, IRC §199A provides a 20 percent qualified business income deduction (QBI) to pass-through entities such as multi-member LLCs, S corporations, sole proprietorships, trusts and estates, REITs, disregarded entities, and real estate investors taxed as Schedule E on Form 1040.
Most small businesses operate as pass-through entities; therefore, IRC §199A will have some impact on their business. Unlike previous years where many small business owners did little to no tax planning during the year, this is not an option under IRC §199A. This new tax policy was drafted with what I refer to as a “bubble effect” and “anti-abuse” rules. Those who wait until next year to show up at their tax professional’s office for tax preparation will miss huge tax planning opportunities and may end up paying more in taxes than necessary.
While IRC §199A provides the opportunity for millions of small business owners to pay far less in taxes than before, it also creates an element of paying too much if you don’t plan properly. The law is opportunistic but also complex, because it provides tax breaks to pass-through entities with various limits depending on the filing status on your personal tax return.
Because the 20 percent QBI flows through to the shareholder’s personal tax return, it’s not a tax deduction at the corporate entity level.
The deduction is based on several key variables:
- The filing status of a taxpayer is a key element. The anti-abuse rule is triggered at $157,500 for single taxpayers and $315,000 for married couples. Unlike in previous years when we had the marriage penalty for couples, this tax reform legislation rewards marriage. It offers a higher income limit before the anti-abuse rule is triggered and the opportunity is lost.
- The type of business being operated. IRC §199A has two categories that determine the income limit for the deduction. Congress wrote the tax policy to categorize businesses as “specified service” and “non-specified service.”
Specified service businesses operate in some capacity as service-based, and may be operating as attorneys, accountants, tech consultants, marketing consultants, real estate agents and other service-based professionals. Those who fall in the specified service category qualify for the 20 percent QBI deduction if their taxable income is $315,000 or less if filing as married jointly, and $157,500 or less if filing as single. The anti-abuse rule triggers at $157,500 and $315,000; the bubble range phase out kicks in between $157,500 to $207,500 for single taxpayers and $315,000 to $415,000 for married couples.
Once the income reaches above $207,500 or $415,000, the 20 percent QBI deduction is phased out with no tax benefit. If the income is at or below the anti-abuse limits, the 20 percent deduction is available. However, the deduction is based on the lesser of a taxpayer’s taxable income less any capital gains plus the aggregate amount of qualified cooperative dividends, or 20 percent of QBI. A discussion on qualified cooperative dividends and its computation is beyond the scope of this article.
Of course, there are tax planning opportunities to get a business owner’s taxable income below these phase-out limits and create an opportunity to benefit from the 20 percent QBI deduction if tax planning is done during the year.
- Business qualifications. Businesses that fall in the non-specified service category qualify for the QBI deduction above the $157,500 and $315,000 anti-abuse limits. However, it becomes more complex because the deduction is based on several variables.
Business owners will qualify for the QBI deduction based on the lesser of 20 percent QBI, or 20 percent taxable income. However, QBI is limited based on wages and capital so the attributable portion cannot exceed the greater of 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of qualified property immediately after its acquisition. The deduction quickly becomes very complex for non-specified service businesses, including restaurants, construction companies, manufacturing companies or any business that sells or manufactures any kind of product.
Many small businesses across the country will fall in the non-specified service category, which is good and bad. The good thing is they can benefit from the QBI deduction at income limits above $157,500 and $315,000, but it gets complex and tax planning from a qualified and knowledgeable tax professional will be required.
Family-Owned Business Case Example
There are many types of scenarios relating to these complex tax laws. For example, consider Joe and Mary, a husband and wife operating their family-owned manufacturing company taxed as an S corporation with a 50/50 ownership. In this example, we will use figures to illustrate the anti-abuse rules' trigger and how to navigate the deduction in the best interest of the business owners.
Suppose in 2018, the company has gross income of $2.1 million less operating expenses of $1.6 million, arriving to a net income of $500,000. The QBI is $500,000, putting Joe and Mary above the $315,000 taxable income threshold triggering the anti-abuse rules. Without complicating things unnecessarily, we need to discuss the difference between QBI and taxable income since those two figures are never the same.
QBI does not take into account any capital gains or losses, while taxable income accounts for capital gains and losses. QBI is simply the net income from business operations that will flow through Joe and Mary’s K-1 from the S corporation tax return. In this example, since Joe and Mary operate a manufacturing company categorized as a non-specified service business, and they have QBI income of $500,000 flowing through to their personal tax return that triggers the anti-abuse rules, we must compute the QBI deduction based on three variables.
IRC §199A requires Joe and Mary to use the lower of 20 percent QBI, or 20 percent of taxable income. Since the business owners are above the anti-abuse income limit, we must use the wage and capital factor as the third variable to compute the QBI deduction. The wage and capital factor is the greater of 50 percent of the W-2 wages or 25 percent of W-2 wages and 2.5 percent of the unadjusted basis of qualified property. Let’s assume that of the $1.6 million in operating expenses, total labor is $800,000, of which $600,000 is W-2 and $200,000 is 1099 contract labor. The $200,000 of 1099 contract labor does not qualify as wages for the QBI deduction. Therefore, we can only use the W-2 wages paid to actual employees, which in this example is $600,000. Of the $600,000 in W-2 wages, $300,000 qualifies for the QBI computation ($600,000 x 50 percent). Additionally, let’s assume the business owns $1.3 million of manufacturing equipment that is qualified property. Our wage and capital factor is $182,500, 25 percent of W-2 wages $150,000 plus $32,500 for the capital factor ($1.3 million qualified property x 2.5 percent). Therefore, we use $300,000 of W-2 wages for the QBI computation since that is the greater of two. Typically, 50 percent of W-2 wages will be the greater amount to use for the wage and capital factor in computing QBI unless there is little or no W-2 wages.
Now assume that Joe and Mary are homeowners with mortgage interest, property taxes and charitable donations totaling $32,000 for 2018. Their itemized deductions of $32,000 exceed the new standard deduction of $24,000; therefore, we will use the itemized deductions to compute taxable income. Joe and Mary have taxable income of $468,000 ($500,000 QBI pass-through from K-1 minus $32,000 itemized deductions).
Now that we know the taxable income, we must analyze to compute the 20 percent QBI deduction. Here are the figures for the taxable income and 50 percent of W-2 wages as the wage factor, which we will use for the 20 percent QBI deduction:
- Joe and Mary's taxable income - $468,000
- 50 percent of W-2 wages - $300,000
IRC §199A states that we must take 20 percent of the lowest of the two components. The wage component is the lowest of the two amounts, which provides a $60,000 QBI deduction ($300,000 x 20 percent). Joe and Mary’s final taxable income for federal tax purposes will be $408,000 ($500,000 gross income minus $32,000 itemized deductions minus $60,000 QBI deduction). Joe and Mary will have a federal tax liability of $93,846. Assuming they had the same taxable income in 2017 under the old tax law, their tax liability would be $109,857, a difference of $16,011. With tax planning during the year, Joe and Mary can get their taxable income down to the ideal figure of $315,000 and have a much lower tax liability of $64,179, providing an additional tax savings of $29,667. Who wouldn’t want that?
Service Business Case Example
Let’s look at the impact of the law on specified service businesses. To illustrate, let’s assume Stephanie is single and operating a small marketing firm as an S corporation with three employees paid W-2 wages.
Stephanie’s firm generates gross income of $470,000 and pays expenses of $289,000, of which $126,000 are W-2 wages paid to her employees. The net income from her business is $181,000 ($470,000 gross income minus $289,000), which on the surface looks like it will disqualify Stephanie from benefiting from the 20 percent QBI deduction.
However, when we consider Stephanie’s deductions on her personal tax return, we realize that Stephanie owns a nice condo on Miami Beach, paying $16,400 for mortgage interest, $4,800 for property taxes and $4,700 in charitable donations. As a result, her 2018 itemized deductions total $25,900, which is greater than the $12,000 standard deduction for a single taxpayer under the TCJA legislation. Stephanie’s taxable income is $155,100, which gets her below the anti-abuse threshold of $157,500, allowing her to benefit from the 20 percent QBI deduction. Stephanie’s 20 percent QBI deduction is based on the lesser of the 20 percent QBI ($181,000) or her taxable income ($155,100). Based on the two variables, we must compute her 20 percent QBI deduction using the taxable income of $155,100, which provides her with a QBI deduction of $31,020 ($155,100 x 20 percent QBI deduction).
Had Stephanie’s taxable income been more than $157,500 and under $207,500, she would be in the bubble range, and her opportunity to benefit from the 20 percent QBI deduction would be phased out due to the anti-abuse laws. In comparison with the 2017 tax law, Stephanie’s taxable income of $155,100 would generate a tax liability of $36,409. However, under TCJA, Stephanie saves $12,340 in federal taxes.
Tax Planning Is Key Right Now
It is powerful how much small-business owners and self-employed individuals can save if they do tax planning—sooner than later. Even if Stephanie was over the limit, with tax planning, she could still get her taxable income down below the anti-abuse limit, allowing her to reap the benefits of IRC §199A. Tax planning for self-employed individuals might take into account planning through their business with equipment or other purchases, or it can be on the personal return with retirement planning, charitable contributions and other opportunities allowable through the TCJA legislation.
In the example with Joe and Mary, a distinction was made between W-2 wages and 1099 contract labor. Although it is all tax deductible as labor on the corporate tax return, only the W-2 wages are accounted for in the QBI deduction computation. Worker classification has always been problematic for the IRS, but IRC 199A provides the opportunity for the IRS to somewhat alleviate the worker misclassification problem that has plagued the government for many decades. Be aware that laws are easily misinterpreted, and many businesses inadvertently misclassify their employees as independent contractors. While a discussion on this topic is beyond the scope of this article, in-depth information on how to classify your workers properly can be found in my March 2018 article “Get it Right the First Time— Independent Contractor vs Employee Status” at pubs.ppai.org.
It is clear that the TCJA laws are favorable for millions of small- and mid-size businesses and self-employed individuals. TCJA also created IRC §1400Z—known as the Opportunity Zone Fund—which allows for the deferral of capital gains for a period of five or seven years, and a step-up basis to fair market value on the new asset, allowing investors to benefit from real estate investments.
IRC §1400Z provides tax credits if you start a new business in an area designated as an Opportunity Zone Fund. Effective June 14, 2018, the U.S. Treasury approved Opportunity Zone Fund areas in every state, including U.S. territories. Last year, at the request of Sen. Orin Hatch (R-UT), chairman of the Senate Finance Committee, I submitted an 11-page tax reform proposal. I specifically expressed to Congress that it needs to provide lower capital gains rates to real estate investors who acquire properties in inner cities and poor communities that need to be revitalized, and that
it should also provide tax credits to small businesses that hire new employees located in communities across the country that need to be revitalized. Maybe I was ahead of my time—the recommendations resulted in what now resembles the Opportunity Zone Fund.
As you can see, the TCJA is anything but simple. For millions of Americans who work as W-2 employees and are not homeowners or investors, the TCJA will simplify their tax return and allow them to self-prepare it. However, for the millions of taxpayers who are small- business owners, self-employed, real estate investors or have passive income that qualifies for the 20 percent QBI deduction, tax preparation and planning just got more complex than it has ever been.
I encourage you to begin tax planning by early fall and consult an experienced and knowledgeable tax professional to provide you with proper tax planning. As the saying goes, you get what you pay for—and this is true now more than ever, as it pertains to tax preparation.
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Andrew G. Poulos, EA, ABA, ATP is principal of Poulos Accounting & Consulting, Inc., in Atlanta, Georgia, where he works with individual and business tax clients and represents clients before the IRS and state labor agencies. An entrepreneur, tax analyst and real estate investor, Poulos is also an author and national speaker and regularly appears on ABC, CBS, NBC and Fox News. He has been referenced as a tax expert in published articles in TIME, Forbes, USA Today and U.S. News & World Report and was interviewed on President Trump’s tax policies. He is the producer of the QuickBooks Ultimate Lesson Guide DVD Series and author of various tax articles. andrew@poulosaccounting. com; www.savvytaxguy.com, 1-888-9-POULOS (976-8567).
Copyright © 2018 Poulos Accounting & Consulting, Inc. and Poulos Productions LLC. This article may not be copied, reproduced or repurposed in part or in its entirety without the written consent of the author Andrew G. Poulos and Poulos Accounting & Consulting, Inc. and Poulos Productions LLC.
This article is for information only and is not intended as tax advice.