Economy

TAX LOOPHOLE? Advice for businesses looking to qualify for the 20 percent tax deduction

posted by Bil Lako - 1.09.18

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.

As a small-business owner, you’re probably thrilled to hear you may receive a 20 percent deduction on qualified business income from pass-through entities. This deduction does not apply to interest, dividends, and capital gains. This is a complex area where we are likely to see a lot of taxpayers restructuring to qualify for the deduction.

The law states that anyone who is in the business of being an employee and any “specified service trade or business” is not eligible for the 20 percent of qualified business income deduction. The law vaguely defines “specified service trade or business” as, any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and investing and investment management, 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 or owners.

Basically, this exclusion seems to be targeting businesses that don’t sell goods or make products. They simply provide a service. The thought behind this is that the payment for a service is a wage, so any business that provides a service should have their income taxed like wages without a 20 percent deduction.

As a small-business owner, you’re probably thrilled to hear you may receive a 20 percent deduction

But, then there is another exception that even if you’re one of the “specified service businesses” and your taxable income is less than $315,000 joint or $157,000 for all other taxpayers, you can still claim the 20 percent deduction. The deduction phases out as taxable income increases above this threshold until it disappears at $415,000 for joint and $207,500 for all others.

For example, let’s look at Joe, an accountant. Joe is paid a salary of $100,000. For simplicity sake, Joe is married but his spouse doesn’t work so after his standard deduction, his joint taxable income will fall into the 12 percent tax bracket.
Joe decides to quit working for someone else and forms his own limited liability company to provide accounting services for $100,000. Despite Joe’s business being considered a disqualified service business, his taxable income is less than $315,000 MFJ, so he could take a 20 percent deduction on his qualified business income of $100,000. Depending on how he structures the business it could save him close to $8,500 in taxes. Sounds like a good deal, but then he is on the hook for his own health insurance and he must pay the full 15.3 percent Social Security and Medicare tax. Plus, there are retirement plans, insurance costs and other fringe benefits he might miss out on by not being an employee.

Let’s say Joe determines his LLC is worth the hassle, and his company brings in $170,000. He’s going along just fine enjoying his 20 percent deduction on qualified business income until his wife decides to rejoin the workforce. She is paid $175,000 a year in wages, which pushes joint taxable income to $321,000, $6,000 above the $315,000 threshold. Despite being in a disallowed service industry, Joe can still take a deduction after applying the phaseout mentioned above.
If Joe were to take on more clients and bring in $300,000 and his wife earned $175,000 in wages, their joint taxable income would be above $415,000, the top threshold of the phaseout of the 20 percent deduction. Joe’s pass-through business income is then taxed without a 20 percent deduction.

Joe could also consider being a C corporation. Each scenario is unique and requires detailed analysis and planning to determine if the tax savings would be worth a more complicated structure.

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.