If you are an entrepreneur and have heard about the qualified business income deduction (also called Section 199A), you may be asking yourself if it could help you to save on taxes. Many business owners, or prospective business owners have a desire to form an LLC because it can save money on taxes. It is important, however to be aware that the new tax law’s 20% deduction on qualified business income is subject to limitations.
To qualify for the full deduction, your taxable income must be below $160,700 or $321,400 if you’re married and you and your spouse file jointly. If your income is below the threshold, you may take the deduction no matter what business you are in. However, if your income is higher, there are limits on who can take the break.
Below outlines some of the finer details of qualification:
- What exactly is a qualified business? According to the IRS, this break benefits sole proprietorships, partnerships, S corporations, and some trusts and estates. C corporations are specifically excluded.
- There are special rules and limits for “specified service trades or businesses.” The IRS defines these as businesses such as health, law, accounting, among others, “where the principal asset is the reputation or skill of one or more of its employees or owners.”
- The deduction doesn’t lower your adjusted gross income, and you do not have to itemize on your taxes to take it. If you qualify, the 20% break will apply to the lesser of your qualified business income or your taxable income minus capital gains.
- There’s a wage and capital limitation that is the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of unadjusted basis of all qualified property. There is a 20% deduction of REIT dividends and distributions from publicly traded partnerships.
- In counting qualified business income, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans like SEPs, SIMPLEs and qualified plan deductions are included.
- You have to decide how you should set up your business. As noted above, multiple entities are eligible for the pass-through treatment, but there are other implications you need to consider, such as how Social Security taxes will be paid.
- Do not assume that the creation of a pass-through entity automatically creates a windfall. You will want to weigh how much you’ll save on taxes versus how much you’ll pay to set up an eligible entity.
How can you optimize the deduction? Here are a few ways:
- Consider operating as a PTP, or publicly traded partnership, which is not subject to the W-2 wage limit or the qualified property cap.
- Consider multiplying the $157,500 per person threshold by gifting business ownership interest to children or non-grantor trusts.
- For partners, consider switching from guaranteed payments, which don’t qualify, to preferred returns, which do.
This is just an introduction to a complex topic. Also, new guidance from the IRS may change some of the details, which means many provisions are not etched in stone. For example, the IRS issued in late September Revenue Procedure 2019-38, which offers a safe harbor allowing certain interests in rental real estate, including interests in mixed-use property, to be treated as a trade or business for purposes of the QBI deduction, under Section 199A. The bottom line is to ask for professional advice to make sure that you are making the right decisions about your pass-through entity.