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2017 Tax Cuts and Jobs Act: Understanding the QBI Deduction

Pass through entities, such as LLCs taxed as an S-corporation or a partnership, are the backbone of the American small business community, and benefit most from sweeping changes in the 2017 Tax Act. First, the 2017 Tax Act substantially reduces individual income tax rates, which are the rates that apply to income flowing through to the small business owner.  Further, new tax law allows small business owners to reduce their taxable business income by 20%. Thus, for example, a married couple owning a small business with $200,000 of taxable income would pay an effective tax rate of only 18.3%!

To qualify for the QBI deduction, the business must be a qualified business, the definition of which excludes service providers (lawyers, CPAs, doctors, financial planners, realtors, consultants, etc.).  However, these excluded businesses receive the QBI deduction if their adjusted gross income does not exceed $315,000 for joint filers, $157,500 for individuals (over which amounts the QBI deduction is gradually phased out).  Wages paid to the business owner are not reduced by the QBI deduction. While owners of qualified businesses are not subject to these income limitations, there are other limitations that could apply. The QBI deduction is applied to the aggregate of all business income/loss for all businesses the taxpayer owns, and is limited to: 1) 20% of the QBI for each separate business, and 2) the greater of (a) 50% of the W-2 wages the business owner received from each separate business[1] or (b) 25% of the wages the business owner received from the business plus 2.5% of the qualified property owned by the business. Qualified property is defined as depreciable property owned and used by the business.  Qualified property is valued at its original cost basis and remains qualified property over its depreciable life not to exceed 10 years.

The structure of the 2017 Tax Act as it applies to small businesses reflect congressional efforts to incentivize investment into capital assets. The economic effect of which increases demand for assets such as equipment, machines, furniture, and real property. Increased demand results in more manufacturing, which leads to more jobs thereby reducing unemployment; when demand for labor increases, prices for human resources increase leading to higher wages. More production results in an overall growth of our economy and GDP. Further, lowering the tax bill on small business owners will put more money into the hands of middle class Americans which, with more disposable income, results in more spending and investing at the grass roots level. This is clearly a tax plan designed to grow the American economy by lowering the tax bill on small business owners and promoting business investments into property, plant, and equipment.

Because of the way the QBI deduction is allowed and limited, business owners should consider separating ownership of various profit centers.  For example, a doctor that owns the building out of which she operates is subject to the QBI income limitation. If the doctor spins ownership of the building into a separate LLC and leases the building back to the medical practice, then the QBI income applicable to the medical practice does not apply to income arising from the real estate leasing entity.

For the foregoing reasons, it’s wise for business owners to visit with their business and tax advisors to review how the 2017 Tax Act will affect them, and to consider reorganization options to maximize their ability to benefit from our new tax laws.

[1] The 50% of W-2 wages provides incentive for the business owner to pay themselves a wage subject to the Medicaid and Medicare portions of employment taxes. Flow through income from S-corporations escape employment taxes thus the new tax laws added the W-2 limitation to make sure the QBI deduction feature is not abused.  

About the Author Whitney Sorrell

Whitney Sorrell is a lawyer, CPA, and former IRS Revenue Agent and senior partner of Sorrell Law Firm, PLC, in Scottsdale, AZ.  Mr. Sorrell’s law practice focuses on business organizations and federal tax planning, IRS dispute resolution, asset protection planning for small business owners, and estate planning for nigh net worth individuals.

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