By Ryan A. Brown, Esq., Managing Partner, Arlington Law Group
The tax code grew by about 500 pages with the introduction of the Tax Cuts and Jobs Act (TCJA) of 2017, which was rushed to completion at the end of December. While tax compliance and preparation for some individuals with only W2 wages and few deductions may be streamlined, the rules affecting businesses and business owners have grown significantly more complex with the TCJA.
The tax code grew by about 500 pages with the introduction of the Tax Cuts and Jobs Act (TCJA) of 2017, which was rushed to completion at the end of December. While tax compliance and preparation for some individuals with only W2 wages and few deductions may be streamlined, the rules affecting businesses and business owners have grown significantly more complex with the TCJA.
The federal corporate tax rate, applying only to entities taxed as a “Subchapter C” corporation, is now a flat 21%, whereas the prior code had brackets from 15% to 39.6%. This new rate only applies to the corporation’s tax obligation. When the corporation declares a dividend and passes its profits onto its owners, those shareholders pay an additional dividends tax of 15% - 23.8%, resulting in a top total rate of 39.8%.
Most small businesses are taxed instead under some pass-through regime, including sole proprietorships (including LLCs with one owner and no other tax elections), partnerships (including LLCs taxed as partnership), or “Subchapter S” corporations (including LLCs that have elected to be taxed under “Subchapter S”). Pass-through entities report their income and expenses, but do not pay their own taxes. Rather, the owners of the pass-through entity pay their pro-rata share of the tax obligation for the business.
The TCJA adds a new §199A to the tax code, giving a reduction of up to 20% of taxable income to some pass-through businesses. If the business income qualifies for a deduction under §199A, then the top marginal rate for the business owners on that business income would be 29.6%. However, there are several complex rules to determine what income receives the 20% reduction:
Qualified Business Income
Only “Qualified Business Income” (QBI) is eligible for the 20% reduction. QBI is the net amount of qualified items of income, gain, deduction, and loss (but not capital gains or wages paid to the business owners), from a qualified trade or business, which is effectively connected to the United States.
Income Level of Business Owners
(i) If the individual business owner has an adjusted gross income (AGI) of less than $157,500 (single) or $317,000 (married filing jointly), then all of the QBI is eligible for the 20% reduction.
(ii) If the individual business owner has an adjusted gross income (AGI) of less than $207,500 (single) or $417,000 (married filing jointly), then the QBI reduction is phased out, unless the wages or capital test is met (see below).
(iii) If the individual business owner has an adjusted gross income (AGI) of more than $207,500 (single) or $417,000 (married filing jointly), then the QBI reduction is not available, unless the wages or capital test is met (see below).
Wages and Capital Tests
If the business owner’s adjusted gross income (AGI) is too high, the QBI may still qualify for the deduction up to the maximum deduction of the greater of:
(i) 50% of the owner’s allocable share of W-2 wages paid by the business OR
(ii) 25% of that W-2 wage share plus 2.5% of the original cost basis of qualified property
.. unless the business is a disqualified service business (see below). These rules are nominally designed to promote job creation and capital investment in businesses in the United States.
Disqualified Service Businesses
If the business provides:
(i) services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners (section 1202(e)(3)(A), but without regard to engineering or architecture); or
(ii) services that consist of investing and investment management; trading; or dealing in securities, partnership interests, or commodities.
… then the QBI reduction only applies if the income levels of the business owners are below the thresholds above. In the same business, some owners could receive the deduction while others might not, depending upon each owner’s AGI.
These complex rules lead to many yet unanswered follow-up questions. For example, a structural engineering firm provides engineering services and consulting services. Do they get the QBI deduction (since “engineering” has been carved out from the definition of disqualified service business) or do they not get the QBI deduction (since they do “consulting”) or is it a split of the two?
While everyone is currently focused on getting their 2017 tax returns filed, all of which are under the old tax code, businesses and their owners need to begin talking with their attorneys, accountants and financial planners about the TCJA to determine what (if any) changes they need to make now in order to get the best outcome under the new tax laws. Don’t wait until December, or early 2019, to figure out how the TCJA applies to you.
Want to learn more? Join us at the Small Business Roundtable on Wednesday, March 28 from 11:45 a.m.-1:00 p.m. at the Arlington Chamber.
Most small businesses are taxed instead under some pass-through regime, including sole proprietorships (including LLCs with one owner and no other tax elections), partnerships (including LLCs taxed as partnership), or “Subchapter S” corporations (including LLCs that have elected to be taxed under “Subchapter S”). Pass-through entities report their income and expenses, but do not pay their own taxes. Rather, the owners of the pass-through entity pay their pro-rata share of the tax obligation for the business.
The TCJA adds a new §199A to the tax code, giving a reduction of up to 20% of taxable income to some pass-through businesses. If the business income qualifies for a deduction under §199A, then the top marginal rate for the business owners on that business income would be 29.6%. However, there are several complex rules to determine what income receives the 20% reduction:
Qualified Business Income
Only “Qualified Business Income” (QBI) is eligible for the 20% reduction. QBI is the net amount of qualified items of income, gain, deduction, and loss (but not capital gains or wages paid to the business owners), from a qualified trade or business, which is effectively connected to the United States.
Income Level of Business Owners
(i) If the individual business owner has an adjusted gross income (AGI) of less than $157,500 (single) or $317,000 (married filing jointly), then all of the QBI is eligible for the 20% reduction.
(ii) If the individual business owner has an adjusted gross income (AGI) of less than $207,500 (single) or $417,000 (married filing jointly), then the QBI reduction is phased out, unless the wages or capital test is met (see below).
(iii) If the individual business owner has an adjusted gross income (AGI) of more than $207,500 (single) or $417,000 (married filing jointly), then the QBI reduction is not available, unless the wages or capital test is met (see below).
Wages and Capital Tests
If the business owner’s adjusted gross income (AGI) is too high, the QBI may still qualify for the deduction up to the maximum deduction of the greater of:
(i) 50% of the owner’s allocable share of W-2 wages paid by the business OR
(ii) 25% of that W-2 wage share plus 2.5% of the original cost basis of qualified property
.. unless the business is a disqualified service business (see below). These rules are nominally designed to promote job creation and capital investment in businesses in the United States.
Disqualified Service Businesses
If the business provides:
(i) services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners (section 1202(e)(3)(A), but without regard to engineering or architecture); or
(ii) services that consist of investing and investment management; trading; or dealing in securities, partnership interests, or commodities.
… then the QBI reduction only applies if the income levels of the business owners are below the thresholds above. In the same business, some owners could receive the deduction while others might not, depending upon each owner’s AGI.
These complex rules lead to many yet unanswered follow-up questions. For example, a structural engineering firm provides engineering services and consulting services. Do they get the QBI deduction (since “engineering” has been carved out from the definition of disqualified service business) or do they not get the QBI deduction (since they do “consulting”) or is it a split of the two?
While everyone is currently focused on getting their 2017 tax returns filed, all of which are under the old tax code, businesses and their owners need to begin talking with their attorneys, accountants and financial planners about the TCJA to determine what (if any) changes they need to make now in order to get the best outcome under the new tax laws. Don’t wait until December, or early 2019, to figure out how the TCJA applies to you.
Want to learn more? Join us at the Small Business Roundtable on Wednesday, March 28 from 11:45 a.m.-1:00 p.m. at the Arlington Chamber.
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