Benefiting from Qualified Business Income Deduction

Question: Under the new tax law, can I deduct 20% of my S corporation income?

Answer: The 2017 Tax Cut and Jobs Act entitles owners of S corporations, partnerships, limited liability companies and sole proprietorships to a deduction on their personal income tax returns for business income. These so-called “pass-thru” entities are not subject to tax on their income. Rather, the income reported is taxable directly on the income tax returns of the entity owners. Owners of these “pass-thru” entities may now be able to deduct 20% of this qualified business income (“QBI”).

Various requirements must be satisfied to claim the deduction. You must first recognize that in the S corporation context, only income that flows through directly from the business is eligible for the deduction. That is, income of the corporation that is reportable by and taxable to you on your personal income tax returns may qualify; your salary and other compensation reported to you on your IRS Form W-2 does not qualify. This issue is only relevant with S corporations as business income paid or reported to partners in partnerships, members or owners of limited liability companies and sole proprietors is not treated as salary for tax purposes; all of the income from these non-corporate entities may be eligible for the deduction.

Although an obvious tax planning opportunity is to reduce the salary you take from your corporation to increase the corporation’s QBI, various factors must first be taken into account. S corporation owners who claim unreasonably low wages may face challenges from the IRS. In the past, these challenges have arisen in circumstances where S corporation owners have maintained low salaries in attempting to reduce payroll taxes. Reducing salary may impact your share of company retirement plan contributions which are often allocated proportionately based on the amount of employee compensation. The same holds true with company fringe benefits such as group life insurance where the amount of coverage may be based on wages paid. A reduced salary may also impact the amount of your social security benefits.

The amount of the deduction you may take will be limited if the taxable income on your personal tax return exceeds a threshold amount, $315,000 for married taxpayers filing joint income tax returns with their spouses and $157,500 for all other filers. Through a rather complex formula, for taxpayers whose income exceeds the applicable threshold, the amount of income eligible for the QBI deduction cannot exceed the greater of (a) 50% of the aggregate wages paid by the business or (b) 25% of the aggregate wages paid by the business plus 2.5% of the business equipment and other property for which depreciation deductions may be taken. These limits are phased in for the first $100,000 or $50,000 of taxable income in excess of the threshold, depending on the taxpayer’s filing status. As noted above, in some cases decreasing an owner’s salary may increase the allowable deduction as this serves to increase QBI. Conversely, where the owner’s taxable income exceeds the threshold and the wage limitations are applicable, increasing an owner’s salary may increase the QBI deduction as the aggregate amount of wages paid will have increased. You should recognize that if your taxable income exceeds the threshold, you must carefully determine the optimal amount of salary needed to generate the maximum QBI deduction. In some cases you will benefit from a salary increase and in other cases from a salary decrease.

Another hurdle is that the 20% deduction is unavailable to an owner of a specified service trade or business where the owner’s taxable income exceeds the threshold. If you are engaged in the practice of medicine, law, accounting and a number of other service-oriented businesses and your income exceeds the threshold, then you are ineligible for the 20% deduction. Expressly excluded from the specified service trade or business classification are architects and engineers.

The maximization of deductions will be paramount for owners of pass-thru entities impacted by the thresholds, particularly those engaged is specified service trades or businesses. One of the areas where business owners should place special emphasis to enhance the opportunity of qualifying in whole or in part for the 20% deduction is increasing allowable retirement plan contributions.

The new tax law creates an exceptional opportunity for persons operating a business as a S corporation, partnership, limited liability company or sole proprietor. With some careful navigation through the complex rules, a significant tax benefit can be realized.

The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.