Tax planning is very different in 2018. You can face the facts while it’s still 2018, and there is time to do something about it, or you can look back in 2019 and wish you had done something different.
One of the big changes for business owners and real estate investors is the new Section 199A, aka 20% income deduction.
First, let’s look quickly at the rules:
- You have to have a pass-through entity with QBI (qualified business income.) Pass-through entities include partnerships, S Corps, Schedule C and Schedule E. In some cases, trusts qualify as well, but check with your CPA first on that. QBI is ordinary income. Capital gains doesn’t count as QBI, neither does salary you might draw from your pass-through entity. IQBI is the income from that pass-through entity after you’ve taken out your salary and other deductions.
- If your taxable income is above the income threshold, there are additional rules. This is your personal taxable income. It’s not income per entity, but the total of all income, losses and the itemized or standard deduction have been calculated. The income threshold is $315K (married, filing jointly) or $157.5K (single). The biggest mistake that people make here is thinking that the taxable income is per entity. It’s not. It is the total taxable income on your personal tax return.
- The next question, after determining whether your taxable income is above the income threshold, is what type of business you have. Is it a service business, under this specific Code Section? There is a fairly strict definition that isn’t always intuitive. For example, if you are a financial planner, you may be a service business, you may not be a service business or you may have a blended business. If you receive commissions, you’re not. If you take a fee, you are. A service business has a second income threshold. Again, remember this is your total taxable income. The second taxable income threshold is $415K (married, filing jointly) or $207.5K (single).
- If your income is above the first income threshold, you may still receive the 20% income deduction, subject to a wage limitation. The wage limitation rule applies per entity. If the entity is a service business, the amount you can take phases out when your income is between the first and second income threshold. Over the second income threshold, you can’t take any deduction with your service business.
- The wage limitation is the greater of 50% of W-2 wages paid per entity or 25% of W-2 wages paid plus 2.5% of depreciable assets held in that entity. Note that this is applied per entity. You are supposed to aggregate your passive real estate investments, but are not required to aggregate your businesses.
These are the five foundational rules for the Section 199A, 20% income deduction but the complications come when you try to apply them.
I recently spoke to a client who had one S Corporation and two separate Schedule C businesses. The S Corp paid a salary to him, as required for a profitable S Corporation, but no salaries were paid by the Schedule C.
His taxable income was over the income threshold.
In his case, he had just a few weeks before year end to fix the Schedule C problem. The problem is that the income deduction for the Schedule C companies would be subject to a wage limitation. No wages. No deduction.
One idea was to move the Schedule C companies into the S Corp. The businesses were similar and it wasn’t a stretch to include them together. By doing that, he saved $15,000 in taxes.
In another case, a client had one business with $100,000 of net income and another business with a loss of $20,000. The 20% income deduction would mean a deduction of $20,000 ($100,000 x 20%). If he had merged the two businesses, he would have a net income of $80,000 ($100,000 – $20,000). That meant a 20% deduction would mean $16,000.
There was more of a deduction by keeping the companies separate.
Tax planning has never been one size fits all and now it’s even more customized.
To take the best deduction, make sure you know the rules and are working with a CPA who understands the best strategies.
If you don’t already have your copy of Taxmageddon 2018, now is the time to get up to speed quickly. Go to www.Taxmageddon2018.com to pick up your copy. Once you have it in your hand, register your copy by following the instructions in Chapter 16. You’ll find bonus material and the forum for updates on the new law.