Small business owners are particularly sensitive to taxes and may find some relief with The Tax Cuts and Jobs Act of 2017. Internal Revenue Code Sec. 199A, known as the qualified business income deduction or “pass-through deduction”, offers one of the largest tax breaks available to small business owners such as S-corps, partnerships, and sole proprietors.
At nearly 200 pages, the rules contained in Sec. 199A can be complex, but for those who qualify, up to 20 percent of taxable income from qualified business income can be deducted to reduce taxes. The regulation defines a qualified trade or business as that which is not a specified service trade or business (SSTB) in fields such as health, law, accounting, athletics, financial services, to name a few.
For taxpayers who do participate in a SSTB, the disqualification does not apply if total taxable income does not exceed $157,500 for single filers, or $315,000 for joint filers. For example, all taxable income means that a husband’s W-2 income would be considered in the phase-out calculation and added to the income from the wife’s accounting practice income. If their combined joint-filed income is less than $315,000, the wife would be able to deduct up to 20% of the income from her accounting practice. When taxable income moves above the threshold amounts, the deduction is reduced until a full phase-out amount is reached at either $207,000 for single filers or $415,000 for joint filers.
For non service-based businesses that are defined as a specified service trade or business the rules are slightly different and easier to apply. For these businesses the formula applied is the lesser of 20% of qualified business income or 50% of wages paid to employees. Non SSTB businesses are not encumbered by the phase-out amounts as SSTBs are.
High-income taxpayers involved in a SSTB and approaching phase-out amounts still have planning opportunities available that can help reduce income to qualify for the deduction. Because the Sec. 199A deduction is calculated only upon taxable income, strategies that reduce income to below the phase-out amounts should be considered.
One possibility to reduce taxable income is to shift income from one tax year to the next. This may not always be possible, but service firms that have some control over billing clients may want to wait several weeks to incur any additional income in the latter part of the year considering if enough cash flow is available to continue the operations of the business.
Increasing contributions to retirement plans will also lower taxable income, allowing the taxpayer to qualify for the QBI deduction. This has the additional benefit of tax-deferred growth in the retirement account. Business owners that are charitably inclined may also consider a donor advised fund to reduce their taxable income in a tax year they can contribute enough to surpass the standard deduction.
Finally, because service-based and non service-based businesses are treated differently, any business that participates in both may consider splitting their operations segregating the sources of income between both types of business.. A deduction may still be available for the part of the business income derived from the non-service portion.
The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the author and not necessarily those of RJFS or Raymond James.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Any opinions are those of Sergio Garcia, CFP®and not necessarily those of RJFS.