One of the key promises during President Trump’s campaign was to lower taxes for businesses from 35 percent to 15 percent and eliminate the corporate alternative minimum tax. The final version of the tax bill did eliminate the corporate alternative minimum tax, and lowered the tax for corporations to 21 percent in 2018. Furthermore, businesses organized as “pass-throughs” could get taxed at a less than 30 percent rate.
Taxes are never simple – despite the promise to simplify the tax code
Pass-through businesses are your LLCs, partnerships, S corporation, and sole proprietorships, in which the entity is not subject to income tax. Owners are taxed individually on the income, calculating tax on their share of the profits and losses. Because these business owners were at the mercy of their individual tax rates, some business owners could be taxed as much as 39.6 percent, not including the phase out of itemized deductions for high income earners.
In the finalized bill, pass-through businesses receive a 20 percent deduction of their qualified business income. Because taxes are never simple—despite the promise to simplify the tax code—the deduction is actually the lesser of: 20 percent of the taxpayer’s “qualified business income” or the greater of: 50 percent of the W-2 wages with respect to the business, or 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property.
OK, you want this in English. Qualified business income is income less ordinary deductions that you earn from a pass-through business, such as an LLC, sole-proprietorship, S corporation, or partnership. This does not include wages you earn as an employee. Let’s say you have an LLC (not a “specified service” trade or business), and your share of the qualified business income is $500,000. Multiply that by 20 percent and you get a deduction of $100,000. Woo hoo! Not so fast. There are limitations on the calculation that were added to prevent abuse of the rules.
How does this work? Let’s look at the example of your LLC of which you only own 40 percent. The company produced $1.25 million in ordinary income. The company paid W-2 wages of $455,000 and holds $200,000 in property. Your allocation of the wages is $182,000 and 50 percent of that is $91,000. One more calculation: 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property—in our example, this comes to $47,500 ($45,500 + $2,000). You’ve got two numbers: $91,000 and $47,500. The greater of the two is $91,000. This is your income limitation. So, your deduction on your $500,000 qualified business income is now $91,000 versus the simple 20 percent. Mindboggling, isn’t it? And this example was highly simplified for your convenience.
Now, not every LLC is making $1.25 million. Lots of small businesses make around $125,000 a year. There is an exception for you! If your taxable income is less than $157,500 or $315,000 for married filing jointly, you should be able to ignore the W-2 income limitations.
To make things more complicated if you are part of a “specified service” trade or business you will be faced with a phase out.
Wait, what? Yes, “Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” Will be deemed to be a “specified Service”.
This means if your income is above $207,500 for individuals and $415,000 for joint filers you will not be eligible for the deduction. Welcome to simpler taxes.
William G. Lako, Jr., CFP®, is a principal at Henssler Financial, a financial advisory and wealth management firm that has been delivering comprehensive financial solutions to its individual, corporate, and institutional clients for 30 years. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.