The 20 percent tax break for owners of small businesses has been big news for small business owners for months. Taking a deduction for 20 percent of your taxable income could make a big difference in your tax planning and business budget. Since tax planning has been our topic for the beginning of fall, we thought we should alert you about a few of the details behind this new tax break.
A Tax Break With A Few Strings
The new 20 % deduction for small businesses has been causing a buzz ever since the release of the Tax Cuts and Jobs Act.
As CNBC stated months ago, this new “law is no free-for-all.”
Three Points for Starting to Understand the 20 Percent Deduction (Tax Break)
On the surface, the “tax-break” or deduction for small business owners seems pretty straight forward. “The Tax Cuts and Jobs Act offers a 20 percent deduction for qualified business income from so-called pass-through entities, which include S corporations and limited liability companies.”
So, here are our three main points to keep a clear head when dreaming of this nice tax-break:
1. It exists. It’s not a myth, but it’s not a random gift-giving tooth fairy either. Subject to certain regulations, some entrepreneurs will qualify for a 20 percent deduction on their business.
2. To qualify, your income must fall within a certain taxable income range. It must be below $157,500.00 if you are single. And your taxable income must be under $315,000.00 if you are married and filing jointly. (By the way, your accountant can help you check these qualifications.)
Become an LLC or Not
One wrinkle in the plan is that becoming an LLC may come with additional requirements. You will want to think twice.
Small business owners may benefit from this new tax break. But your business might need to become an LLC if the time and profit margin are right.
Some businesses, as they plan their next months, have resisted the urge to become incorporated, so they could remain qualified for this 20 percent business income tax-break. The Tax Cuts and Jobs Act offers a 20 percent deduction for qualified business income from so-called pass-through entities. Thus, the deduction can include S corporations and limited liability companies. (More about that, later.)
3. Remember, under the “old” tax code, income from these small businesses would “pass-through” to the owner on his or her own taxes. This meant you were subject to individual income tax rates as high as 39.6 percent.(“Ouch!”)Therefore, structure your business with care. And remember your accountant can help you with the data to create such tax planning decisions.
What Trades or Businesses Qualify for the 20% Tax Break?
We found some good answers to this question at the Tax Adviser, an online resource of the AICPA. Note that they refer to the legislation as section 199A of the tax code. Therefore they have some details and a little math to help you decide if you might qualify.
Sec. 199A allows taxpayers other than corporations a deduction of 20% of qualified business income. Moreover, this income must be earned in a qualified trade or business. Thus, we know it is subject to certain limitations.
Below you will find the mathematical formula you will need for qualification.
The 20 percent deduction is limited to the greater of the following two sums:
(1) 50% of the W-2 wages with respect to the trade or business,
(2) or the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. This typically refers to the tangible property subject to depreciation. (And you can refer to section 67 of the tax code for more data on this.)
(3) The new business tax deduction also may not exceed either your:
a. taxable income for the year over.
b. Or your net capital gain plus aggregate qualified cooperative dividends.
Now, entrepreneurs are subject to a tax break on the income their businesses generate. However you might be in a quandary: Is it now time to incorporate — and if so, what entity should you choose? “Everyone wants to form an LLC,” said Sepi Ghiasvand, who is of counsel at Hopkins Carley in Palo Alto, California. “This is a time when an LLC can save you on taxes, but with a caveat.”
A Few Notes on Types of Businesses
On the one hand, tax filers who are below the above listed thresholds may take the 20 % tax break, no matter what business they’re in. Our single caveat is to be extra careful with intermingling your private and corporate spending.
Rick Keller, chairman of First Foundation, “We’ve seen plaintiffs’ counsel pierce the corporate veil because business owners treat the corporation as a piggy bank and don’t maintain by-laws.”
This sort of slip-shod bookkeeping behavior simply won’t do if you plan to claim the 20 percent tax break. The Gavrilov & Co Tax Squad says, “Keep pristine and meticulous records.” And of course, we could help you with that.
On the other hand, what if you make a little too much money to fit under the threshold? The experts say, “…once taxable income exceeds those thresholds, the law places limits on who can take the break.” Here is a list of entrepreneurs who might not qualify if their income is too high:
- Entrepreneurs with Service businesses,(SSTB’s have special rules, just for them.)
- Doctors,
- Lawyers,
- And Financial advisors.
The Irony of the 20 Percent Tax Break
Are you in a partnership-based business? Ironically, one owner might get the 20 percent deduction. The other one might be in such a different tax situation that he or she won’t qualify.
For example, “a partner with a high-income spouse may wind up exceeding the taxable income threshold.” Perhaps two people who work for the same pay are partners, but other factors force one out of the qualifications for the deduction.
Getting the 20 Percent Deduction
Once you know you are qualified, the deduction is not difficult to claim.
1. It does not lower your adjusted gross income.
2. It is a “between the lines” deduction.
3. This means you don’t even need to itemize on your taxes in order to take it.(Now, there’s a reason to cheer.)
QBI The First Baby Step to Understanding the 20 % Deduction
To put it simply, know your QBI (Qualified Business Income.) According to the IRS, Your QBI is“the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business.”
- Only items included in taxable income are counted.
- Addition, the items must be effectively connected with a U.S. trade or business. (Of course.)
- Notice that items such as capital gains and losses, certain dividends and interest income are excluded.
In the end, you have a choice. Choose the lesser of these two:
Tax Break 1: your deduction is 20 percent of your QBI. Additionally, you may deduct 20 percent of your qualified real estate investment trust(REIT)dividends and qualified publicly traded partnership (PTP) income.
Tax Break 2: Alternatively you can choose 20 percent of your QBI minus your net capital gains for your tax deduction.
In our next blog, we’ll bring you some mini-case-studies that help to clarify this deduction. Likewise we will reveal the secrets of the SSTB limitation on this new rule. If you are making an income from a specified service trade or business, you will want to know.
Once again, we thank you for reading our blog and we wish you Happy Tax-Planning as you enjoy the arrival of the autumn season.