A little more than 22 months ago, President Trump signed into law the tax reform act commonly referred to as the Tax Cuts and Jobs Act, providing $1.5 trillion in tax cuts over a 10-year period.
Those cuts include a 20% deduction on income for individuals, trusts, and estates (i.e., a business conducted as a sole proprietorship or by a partnership, S corporation, trust, or estate). It’s often referred to as the section 199A or qualified business income deduction. The deduction is not available for wage income or guaranteed payments from partnerships, nor is it available for capital gains, most dividends, or interest income.
This article discusses three strategies to help increase your business income deduction by avoiding or reducing the effect of limitations on the deduction: (i) manage your taxable income, (ii) separate service-flavored revenue into a separate business, and (iii) change business operations to increase W-2 wages. Before diving into these strategies, let’s go over the limitations.
Background on the limitations
The amount of the deduction is subject to three limitations:
The deduction is limited to 20% of the excess of your taxable income over net capital gain income.
Wage and asset limitation
The deduction is limited to the greater of:
- 50% of your share of the business’s W-2 wages, and
- 25% of your share of W-2 wages plus 2.5% of your share of the original cost of certain depreciable business property.
In some cases, you can elect to treat two separate businesses as a single business in applying the wage and asset limitation. Combining a business with lots of wages but no income, with a business with no wages but lots of income, can increase the amount of the deduction.
This limitation does not apply in 2019 if your taxable income is less than $160,700 ($160,725 for married filing separate, and $321,400 if you are married and file a joint return.)
Service business limitation
The deduction is generally not available for income from certain personal service businesses such as health, law, accounting, consulting, and financial services, among others. If a single business has a few revenue streams, some of which come from personal services and some of which do not, the limitation generally applies to all of the income from the business.
However, none of the income is treated as service business income if gross receipts from personal services are less than 10% of the total gross receipts from the business for the year (5% in the case of businesses with more than $25 million in gross receipts).
Like the wage and asset limitation, the service business limitation does not apply if your taxable income is less than the $160,700/$321,400 filing thresholds.
If your section 199A deduction is expected to be limited in 2019 or future years, there are three tax planning strategies that can help you reduce the effects of the limitation.
Strategy 1 – Reduce your taxable income before year-end
While the wage/asset and service business limitations are not applicable to taxpayers with less than $160,700/$321,400 of taxable income, careful year-end tax planning may permit you to stay under the income threshold and fully benefit from the 20% deduction.
Any of the typical year-end planning strategies to reduce your income should work (e.g., contributing to a retirement plan, deferring income, or accelerating deductions).
Example: William is married and operates a law firm as a sole proprietor that uses the cash method to report income. William and his wife anticipate generating $450,000 of taxable income for 2019. At the advice of his accountant, William makes a large retirement plan contribution, pays all of his accounts payable, and takes other proactive planning measures, reducing his taxable income to $300,000. The change allows William to claim the full 20% deduction with respect to the income from his law practice.
Strategy 2 – Separate one business into two (applies to taxpayers over the income threshold)
If the service business limitation applies to a business that has both service and non-service income, separating the business into two separate businesses will allow the non-service income to be eligible for the 20% deduction. It is not always clear when more than one business exists but here are four factors the IRS may consider:
- Whether the businesses have separate books and records
- Whether the businesses are conducted through separate legal entities (e.g., wholly-owned LLCs)
- Overlap in customers, employees, and management
- Level of transactions between the businesses and other interdependencies
Example: Eye Care, Inc., an S corporation, provides optometry services and sells eyeglass frames, lenses, and accessories through several locations. Some patients receive optometry services and buy their glasses from other vendors. Some customers purchase glasses using a prescription obtained from another optometrist. The company bills customers separately for the optometry services and the glasses. About half of the gross receipts come from optometry services and half come from selling glasses. Eye Care, Inc. has not historically separately tracked the revenue and expenses associated with the optometry services and the glasses. The owner is expected to generate $700,000 in taxable income for 2019. The entire business is a service business subject to the limitation because 10% or more of its gross receipts relate to the performance of services in the field of health.
To be eligible for the 20% deduction, Eye Care, Inc. works with its CPA to establish a process to separately account for the income and expenses associated with optometry services and sales of glasses and related accessories. Having separate financial statements will provide information that is helpful in making management decisions (like pricing and which products to offer), and in this case, appears to allow Eye Care, Inc. to separate into two separate businesses, allowing the income from the glasses portion to be eligible for the 20% deduction.
Strategy 3 – Change business operations to increase W-2 wages (applies to taxpayers over the income threshold)
If the amount of the deduction is limited by the amount of W-2 wages paid, there may be ways to modify business operations to increase the amount. Here are a few possible ideas to consider:
- Revisit intercompany allocations of wage expense where employees perform services for related entities. For example, if an employee of one business performs services for another related business, make sure the employee’s wages are appropriately allocated between the two businesses to reflect the relative amount of time the employee performed services for each business.
- Consider hiring employees to perform work currently performed by outside vendors if feasible from a business perspective.
- Increase owner salaries, if appropriate, to bring their compensation in line with the market.
- Make an S election so that compensation paid to owners is included in W-2 wages. Note that there are several other factors that need to be weighed before deciding to make an S election.
Example: Abby is the sole owner of AB, Inc., an S corporation engaged in a nonservice business generating ordinary business income of $400,000. Abby is the only employee of the company and takes an annual salary of $30,000 from the business each year. The company leases all of its equipment and does not own any depreciable assets. Abby is married and the taxable income from her joint tax return is $500,000.
In absence of the wage and asset limitation, Abby would be entitled to an $80,000 section 199A deduction with respect to her income from AB, Inc. ($400,000 business income x 20% = $80,000). However, her deduction is limited to 50% of W-2 wages, or $15,000 ($30,000 wages x 50%).
If Abby had paid herself a salary of $100,000, the employer and employee payroll taxes would have increased by $10,710, but Abby would have received $14,124 of benefit from the increased section 199A deduction and the deduction for the employer’s share of payroll taxes. Paying a higher salary provides a net savings of $3,414. Reasonable compensation standards limit the ability to modify owner salaries — ultimately, the salary paid to the owner needs to be a commercially reasonable salary or the IRS can recharacterize the additional salary as a distribution.
Changing a salary without an underlying change in the facts (like a change in duties, amount of work, etc.) could cause the IRS to challenge the level of salary paid in earlier years as being unreasonably low, exposing you to back payroll taxes and penalties. You should consult with your CPA before adjusting your salary to understand the risks.
How we can help
While tax reform simplified several aspects of the tax code, the business income deduction is certainly not one of them. We can help you reap the full benefits of tax reform by working with you to implement planning strategies like the ones discussed here to help maximize your business income deduction in a way that works for your situation.