The new deduction for qualified businesses: gobbledygook on steroids
Using some of the worst gobbledygook* we have seen in a while, Congress in the 2017 tax reform act has provided a tax break for some business owners, starting in 2018. It comes in the form of a deduction equal to a portion of your business profits, with limits. You can claim the deduction whether or not you itemize deductions. Here is a 10,000-foot view of the legislation, intended primarily to enable you to determine whether you need to deal with this puppy in the first place.
What businesses qualify? Any trade or business that is not run through a corporation — so a sole proprietorship, partnership or limited liability company, S corporation or even a trust — qualifies for the deduction. However, a “specified service trade or business” does not qualify. A “specified service trade or business” is a business that provides services in the following fields: health (doctors but not, e.g., gym owners), law, accounting, actuarial sciences, performing arts (artists but not, e.g., agents or promoters), consulting, athletics (probably just the athletes but that remains to be seen), brokerage services, any other business in which “the principal asset of [the] trade or business is the reputation or skill of 1 or more of its employees” (but not architects or engineers), and services that consist of investing and investment management, trading, or dealing in securities, commodities or partnership interests. Let’s call these disqualified service providers “doctors, lawyers and Indian chiefs”. Doctors, lawyers and Indian chiefs don’t get the deduction unless their income falls below defined thresholds.
The defined thresholds. If you are a doctor, lawyer or Indian chief you do qualify for the deduction if your joint–return taxable income – line 43 of your tax return – is $315,000 or less ($157,500 or less if you file singly). However, the deduction that you might claim shrinks as your taxable income increases over $315,000 ($157,500 for single filers) and the deduction is gone altogether — you no longer qualify for it — once your taxable income reaches $415,000 ($207,500 for single filers).
Just to be clear, the taxable income phase-outs described in the previous paragraph only apply to doctors, lawyers, and Indian chiefs. If you are in any other trade or business you qualify for the deduction whatever your income is.
So what is this deduction? Just because you qualify for the deduction doesn’t mean that you actually get it. The description of the actual amount of the deduction is gobbledygook on steroids, but here goes:
- The general rule. If your taxable income for the year is below $315,000 ($157,500 for single filers), the deduction is 20% of your business profits (or, if you have partners, your share of the profits). Period, full stop (except for the taxable income limitation discussed below). Generally you compute those profits as you normally would for tax purposes (there are some exceptions) but you don’t expense anything that you pay to yourself. The business must be conducted in the United States.
- The W-2 wages limitation. If your taxable income for the year is above $415,000 ($207,500 for single filers), the deduction is still 20% of your business profits but it cannot exceed 50% of the W-2 wages that the business pays (disregarding wages that you pay to yourself). So, for higher-end taxpayers “no employees” generally means “no deduction”. For example, if your business has profits of $500,000 (a potential deduction of $100,000) and pays W-2 wages of $100,000, the qualified business deduction is $50,000 (50% of the W-2 wages), not $100,000. And if you had no employees the qualified business deduction would be zero: for higher-end taxpayers the deduction is intended to encourage providing jobs.
- The alternative W-2 wages limitation. Nonetheless, there is some relief from this 50% W-2 limitation if you have a lot of capital invested in the business: under an alternative W-2 limitation, if 25% of the business’s W-2 wages, plus 2.5% of the purchase price of its depreciable assets, add up to more than 50% of the W-2 wages, then your qualified business deduction is limited to that higher figure. So, for example, with business profits of $500,000 (a potential deduction of $100,000), W-2 wages of $90,000, and $1,000,000 invested in depreciable assets, your qualified business deduction would be $47,500 (25% of $90,000 + 2.5% of $1,000,000) rather than $45,000 (50% of $90,000). If you paid no wages your deduction would be limited to $25,000 (2.5% of $1,000,000).
- The phase-in of the W-2 limitations. If your taxable income is between $315,000 and $415,000 ($157,500 and $207,500 for single filers) then the W-2 wage limitations are phased in as your taxable income grows. As taxable income rises, a greater percentage of the W-2 limitations has to be taken into account, and once your taxable income reaches $415,000 (or $207,500 if you file singly), then the W-2 limitations fully apply.
- The taxable income limitation. Finally, the deduction (however it is calculated or limited) cannot exceed 20% of your taxable income (line 43) after backing out your “net capital gain”. The term “net capital gain” apparently means (i) the excess of long-term capital gains over short-term capital losses for the year plus (ii) dividend income (although it’s hard to tell for sure whether “net capital gain” includes dividend income). Why back out net capital gain? You don’t get this deduction if you are growing rich on trading your stocks and bonds (or, presumably, earning the dividends that they pay). Whereas if your business income comprises most of your income, you should get the deduction.
That’s a high-altitude view of this legislation. You can’t bet the farm on it because there are exceptions and qualifications, some businesses get special treatment, and the language of the law absolutely leaves your head spinning and will no doubt require clarification and probably some technical corrections going forward. But it gives you an idea of what to expect. It’s over to your tax advisor to tell you whether this deduction has any value for you.
* “Gobbledygook”: language that is meaningless or is made unintelligible by excessive use of technical terms. Oxford English Dictionary.