The Tax Cuts and Jobs Act, passed into law in December, included a tax-code revision known as the qualified-business-income deduction. The deduction, available for the 2018 tax year and through 2025, can benefit many small businesses structured as sole proprietorships, partnerships, S-corporations and limited-liability companies, where business profits are passed through to owners and declared as income on tax returns.
To gain insight on application of the new qualified-business-income deduction, North Bay Business Journal interviewed Joseph Kitts, partner at BPM accounting firm based in Santa Rosa, along with Nicholas Biller, tax director at the company.
Have you had a chance in the two months since the law passed to analyze the new QBI deduction?
Kitts: There haven’t been any regulations yet to clarify. People are talking about the deduction as a great benefit, determining whether a business is the right entity (structure).
The QBI deduction is a below-the-line benefit that comes after a business determines its adjusted gross income?
Kitts: That’s right. They have made that clear. It’s not a deduction that will reduce your AGI. It comes afterwards (after AGI is determined). The (tax) form will look a little different, with another line item. For each qualified business an owner may be engaged with, each is looked at separately — whether it individually qualifies with QBI. One rental (property) you might think would qualify, but your large (overall) taxable income is subjected to standards. You have to apply a wage limitation, or 25 percent of wages plus assets. But if you had fully depreciated old real estate, then you might not meet a wage standard or asset standard.
Biller: You are limited on the deduction. One person can have two or three or 10 different things — a K-1 (such as income from a partnership), a rental and a sole proprietorship. For each one, the deduction is calculated separately. The wage limitation and other items are calculated on each separate item.
The legislative intent of the deduction is to give a boost to small businesses?
The projected deficit over the next 10 years is something like $419 billion because of this one deduction. It’s huge in its anticipated benefit.
For very high earners, is the deduction limited?
Kitts: To create parity, they gave corporate structures (C-corp. tax) reduction from 35 to 21 percent. To give non-C-corp. structures a similar deduction, they have this benefit. Everyone qualifies for the deduction for income through $157,500 (for single taxpayers, and $315,000 for married couples filing jointly.) It phases out at $207,500 and $415,000. After those income levels, you may still qualify for the deduction, but you are subject to wage and asset limitations. Those may limit your ability to get it (deduction), or if you are an accountant or other professional who doesn’t get it at all.
Biller: All services (law, accounting, consulting, medicine) except architects and engineers.
Kitts: Some groups that are excluded could be changed to get within the definition.
Change an accountant to an accounting engineer?
(Laughs) Yes. You’re an accountant but you’re going to sell pencils.
Why are architects and engineers able to benefit from the deduction?
Kitts: It shows the strength of different lobby groups or interests. It doesn’t seem to be rooted in a logical or reasonable basis. Why are earnings subject to the highest rate possible, and another person’s capital gain — they didn’t do anything but hold onto some property — they get a preferential rate. Our whole system is a little odd.
You expect logic out of the federal government?
No, no, no. It shows, because of special-interest groups, it’s how our (tax) code has been developed. It continues to evolve that way.
Under the new law, it seems not advantageous to change from an S-corp. or LLC or sole proprietorship to a C-corp. to benefit from the 35-to-21 percent tax reduction?
Kitts: Generally that’s right. But you have to look at each individual situation much more than in the past. If you are a business that retains profits throughout its life, not distributing profits, you want to grow it, the C-corp. would be (beneficial). You find that in high-tech. They throw every nickel into it. Then they sell it or do an IPO. With a 21 percent rate, it can make sense to do that. But with corporate-level tax and individual-level tax, that is still less advantageous than being subjected to a single-level individual tax.
With a pass-through entity?
Kitts: Exactly. Some new businesses should consider C-corp., partly because they have qualified small-business stock, and now the 21 percent (corporate rate) benefit, if they are high-tech and will be plowing back earnings forever.
Does the Tax Cuts & Jobs Act favor S-corps. over sole proprietorships or LLCs?
Biller: If a taxpayer is higher income and going to get a potential 20 percent deduction, one limitation is based on wages or a lesser percent of wages and other assets. An S-corp. pays wages to the owners. You could have a business with one or two owners, maybe with no employees other than themselves, but now they have W-2 wages and can qualify for the benefit. If it were a partnership or LLC, guaranteed payments are not wages.
Kitts: If it’s in a sole-proprietorship or partnership form, neither pays wages. For a high-income earner over the $415,000 (married filing jointly), you’d be subjected to limitations.
If a sole proprietor is making $500,000, doing well, with no W-2, wages would be zero. It would benefit that business to create an S-corp. (or LLC elected to be taxed as S-corp., Forms 8832 and 2553)?
That new entity could kick maybe a third of its earnings into W-2 wages and the other two-thirds into profits?
Kitts: Right. You can see that mathematically.
Kitts: Exactly. I have seen that in examples with a sole proprietorship turned into an S-corp. with wages. Once you have wages, you are permitted to get the 20 percent deduction. You wouldn’t have been otherwise.
In simplified terms, the way the math works, you are optimizing how much to pay in wages and how much to allocate to K-1 distributions? (Deduction is lesser of 20 percent of QBI in qualified business or 50 percent of W-2 wages in that business. In example with sole proprietor earning $500,000 changed to S-corp., if X=W-2 wages and Y=QBI for deduction, then X+Y=500,000, and .5X=.2Y to optimize deduction, so X=.4Y, with W-2 wages = $142,857 and QBI = $357,143.)
Kitts: That’s true with respect to this pass-through deduction. When you establish an S-corp. and pay wages, there are other requirements — for your wages to be reasonable. That’s not well defined. If you are making $500,000 and it’s just you and the company, you might pay yourself more than would optimize the situation for purposes of this deduction. You are definitely optimizing.
You are creating spreadsheets to do the arithmetic?
Kitts: That’s right. We are just on the cusp — beginning to do that. We would like our software programs to get caught up, at least in the planning sense. In the application of these rules, each taxpayer needs to crunch the numbers. Where might you end up if we optimize or use different entities (such as S-corp.).
Is it an advantage to have a single business structure, one entity, under which several business enterprises occur?
Kitts: The regulations may address that issue, when a single entity is comprised of several activities.
Like an umbrella?
Kitts: Yes. Whether or not they (IRS) would require you to look at them individually. Generally each separate business activity is subjected to the requirements. When you bundle your activities into one, would that change things. That might optimize — or scam the system. We do that grouping for passive activities — generally all passive or all active. If you have a hodgepodge in between, you get more surprises. If you could combine a wage company with a non-wage rental, they (IRS) might look through that if there’s enough information to segregate those activities.
Biller: With combining businesses, that assumes each business is profitable. If you have a business with a loss, you are better off keeping that separate. You don’t calculate a negative adjustment if there is a loss. You may want your profitable businesses together because they might be subject to the wage limitation.
Keep losers separate?
Biller: Yes. Keep the losers separate. It’s not just losers. There’s also a lot of accelerated depreciation under the new rule. In one business, you might buy a bunch of assets one year so you have a big loss. You can offset them (losses) on your tax return. There’s some planning — how and when to do that.
Kitts: Right. If combined, overall, you are making more than $415,000 (married, joint). Whatever QBI you have from profitable businesses after the net taxable income (limitation), at least you have maximized it.
The QBI tax deduction ends in seven years?
Kitts: Yes, it expires at the end of 2025.
Biller: Limiting the number of years helped keep it within their budgeting.
If a business is considering changing structure to an S-corp., for example, to take advantage of the new deduction for 2018, that change needs to happen now?
Kitts: Exactly. Those entities in their current form may not be working well — the proprietorship or partnership. If they should be an S-corp. (and the owner waits), you have blown it for this year. As we meet clients for taxes (2017), it’s on everyone’s mind. We have to go through all the planning. Based on 2017 information, if that applies in 2018, this is how much you’ll get in pass-through deduction. The earlier the better. It applies now.
Have client business owners come to you asking what to do?
Kitts: Not really. Everyone is still in a bit of shock that this has come down. People have to think about how much it will cost if they do change to a different form (business structure). We have to model the business for 2018.
In the accounting profession, is there clarity about the new pass-through deduction or confusion?
Kitts: Mostly there are questions. We need regulations (to clarify the law). Lots of things aren’t defined. This has been a massive change in a very short amount of time.
Is it fun?
Kitts: (Laughs) Fun or stressful. Our personalities — we like to know all the facts before we go into a meeting. It’s a little bit more helter-skelter here.
Biller: A lot of things we take for granted about how tax law works. Things have been the same way for a long time. With the modifications, we have to think of a lot of things — the 20 percent (QBI pass-through deduction) with other catches, such as limitations on losses, being able to offset wages, investment income, whether you can carry things (losses) back or forward. There are a lot of moving pieces here. These tax laws affect people.
The tax picture for a business has become more complex?
Kitts: Right. There is a lot of work to be done (by the IRS) to clarify the rules so people understand their playground.
James Dunn covers technology, biotech, law, the food industry, and banking and finance. Reach him at: email@example.com or 707-521-4257 .