Article written by:
Tyler Gabalski, CPA
The qualified business income deduction under Code Section 199A offers plenty of opportunities to save for owners of pass-through entities. However, some have pointed out that business owners with similar situations could be impacted very differently based on their choice of entity type.
How it works: The qualified business income deduction gives owners of pass-through entities a possible deduction of 20% of qualified business income (QBI). At a base level application, owners of a pass-through entity that generates $100,000 in QBI could potentially receive $20,000 in tax deductions applied to income. The deduction is limited to the LESSER OF: 20% of qualified business income or 50% of the total wages paid by the business to its employees. Other limitations apply, including for “specified service businesses”, but will not be discussed for purposes of this article. The limitations do not apply if the taxpayer’s total TAXABLE income is less than $315,000 (joint), or $157,500 (single). The limitations apply fully at $415,000 (joint), or $207,500 (single) and are phased in between these thresholds.
Implications: Section 199A states that QBI should not include reasonable compensation paid to the taxpayer, guaranteed payments or any other payments rendered with respect to the trade or business. Unfortunately, there is no additional guidance on the qualified business income deduction and its proper application available yet. Under the current wording, it appears that entity type could have a significant impact on the application of this deduction. To better understand these concepts, let’s look at a few scenarios.
Scenario A: Joe and his wife Anne file a joint return and are the owners of a business that makes $450,000 in QBI. There are no employees besides Joe and Anne.
- S-Corporation: One requirement of an S-corporation that doesn’t apply to other pass-through entities is that shareholders must receive reasonable compensation for their work. As such, Joe and Anne pay themselves a total of $100,000 in wages. This lowers their pass-through income from $450,000 to $350,000, but their taxable income is still $450,000. After the application of the 199A deduction, one would think they would receive a deduction of $70,000 ($350,000 * 20%). However, since their taxable income exceeds $415,000, their income is limited to 50% of wages, or $50,000.
- Partnership: In this case, all of the facts are the same except since Joe and Anne’s business operates as a partnership, they cannot receive wages. Since they cannot receive wages and, based on a literal reading of the statute, guaranteed payments are not included in the wage limitation, no deduction is allowed.
- Sole Proprietorship: If Joe instead decides to operate as a sole proprietor, no deduction would be allowed as he is unable to pay himself wages as a sole proprietor.
Scenario B: Let’s take the facts from Scenario A except there is one employee in addition to Joe and Anne who earns $50,000.
- S-Corporation: As Joe and Anne are still required to receive reasonable compensation of $100,000, their flow-through income is reduced to $350,000. However, since there is an additional employee, total wages are now $150,000, making the wage limitation $75,000. As such, Joe and Anne can now take the full 20% deduction of $70,000.
- Partnership: Although it isn’t required, Joe and Anne decide to take $100,000 in guaranteed payments. Their deduction would also appear to be $70,000. But since it appears that guaranteed payments aren’t included in the wage limitation, the deduction is limited to $25,000 ($50,000 * 50%).
- Sole Proprietorship: Like the partnership, the deduction is limited to 50% of wages, or $25,000.
Scenario C: Consider the same facts from Scenario A except Joe and Anne’s company earns $250,000 during the year. They do not earn any other income, so their taxable income is below the $315,000 threshold for the wage limitation.
- S-Corporation: Joe and Anne still decide to take $100,000 as reasonable compensation. Since their pass-through income is reduced from $250,000 to $150,000, their deduction would be $30,000 ($150,000 * 20%).
- Partnership: Joe and Anne take $100,000 in guaranteed payments. Like the S-Corporation, their deduction would be $30,000.
- Sole Proprietorship: Joe and Anne could take the full 20% deduction of $50,000 ($250,000 * 20%).
Conclusion: As shown above, the qualified business income deduction can differ significantly depending on the entity type. While several factors should be considered in determining choice of entity, this interpretation of the new law could be a significant factor. Keep in mind that the IRS will likely issue guidance clarifying some of these matters and that further legislation could be passed that impacts these differences related to entity type. Please consult your GBQ advisor to analyze the impact on your business.