In August, the Internal Revenue Service published proposed regulations that shed light on how the 20% deduction of qualified business income is calculated.
It would take several columns to discuss all of the implications of the new regulations, but here are a couple of quick highlights that most business owners will want to consider.
By way of a reminder, if you are a sole proprietor or the owner of a pass-through business (for example, an S corporation, partnership, or limited liability company), and you hire employees and use buildings and equipment to manufacture, sell and/or distribute your product, then you will very likely see a 20% drop in the tax you pay on your business income starting this year.
That's the good news. The less than good news is that there are many limitations on the 20% pass-through business income deduction. Owners of businesses known as "specified service trades or businesses" (SSTBs) do not get the deduction over certain income limits, and there can be limitations based on the size of your payroll or the amount of property used in the business.
It can get complicated, but it can pay to review these rules with your tax adviser.
Choice of entity
Some business owners could see a greater benefit from the business income deduction if they change their type of business entity. When the tax rate on C corporations was reduced to 21%, many commentators suggested that pass-through businesses would want to switch to being C corporations.
However, when all other factors are considered, it turns out that the advantages of being a pass-through entity often outweigh the advantage of the 21% tax rate. There is no universal answer, so run the numbers on your business and think about your succession plan or other exit strategy before deciding to go or not to go to a C corporation.
Even if you decide to keep your pass-through entity, the type of pass-through entity used can make a tax difference. For example, depending on the level of business income, a sole proprietor may do better than the owner of an S corporation. Conversely, at higher levels of qualified business income, an S corporation owner may be able to claim a larger tax deduction. Of course, non-tax reasons for being or not being a separate entity must also be considered.
SSTBs such as doctors, lawyers, accountants, investment advisors and others generally do not get to deduct 20% of their business income over a stated level of income. Not surprisingly, many tax advisers have suggested breaking service businesses into separate components so a portion of the business might qualify for the business income deduction.
But the proposed regulations set forth rules that limit this planning. If 80% or more of the property or services of a non-SSTB entity are provided to an SSTB, then, if there is a 50% or more overlap of ownership between those two entities, they will be combined and considered one SSTB.
There are still planning opportunities for businesses to separate lines of business, but business owners must be mindful of the rules in the proposed regulations before making changes.
Planning strategies may also be available for business owners to combine related businesses for purposes of the pass-through deduction. Say that you own two related businesses that operate as S corporations out of the same facility and share administrative resources, but for business and legal reasons, they are separate entities.
One business generates a large income on a small payroll. The other generates a small income on a large payroll.
The wage limitation on the business income deduction would likely limit the overall deduction. These businesses would probably be entitled to a much larger deduction if their income and payroll were considered together.
Can this be done? Yes, if you follow the rules in the proposed regulations, including: there is at least a 50% overlap in ownership among the businesses; such common ownership exists for most of the tax year; none of the aggregated businesses are an SSTB; and the related businesses satisfy other specific tests to show that they part of a larger, integrated trade or business.
The regulations are proposed and may change, but they contain helpful guidance on how to qualify for the 20% business income deduction, or how to increase the amount of the deduction.
Talk to your professional tax adviser to see if you do, or can, qualify for the deduction.
Click here to read the original article in Crain's Cleveland Business.