The Tax Cuts and Jobs Act (TCJA) provided a significant tax deduction to business owners of pass-through entities – partnerships, S corporations, sole proprietorships, rental properties, and farms. The deduction is now 20% of your qualified business income or QBI. QBI is defined as the net amount of income, gain, deduction, and loss with respect to your trade or business.
With this change, it has become increasingly important to determine what entity structure is best for your business (Read about Business Entities here). With the new deduction for pass-through entities, you will notice that your family income tax planning and your business income tax planning relate in one continuous circle of calculations and strategies.
The 20% QBI deduction can be limited based on household income. If the household income is greater than $315,000 (Married filing jointly), the QBI deduction will be limited to the greater of:
1. 50% of the W-2 wages with respect to the trade or business
OR
2. the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (generally, tangible property subject to depreciation under Sec. 167).
This is when your business entity becomes critical to consider. As an LLC, an owner is not allowed to take wages (= $0). The lesser of 20% of net income or zero is zero. So, as an LLC you may be in a much worse position if you aren’t getting this deduction.
We just spat a lot of numbers at you. But what does all of that really mean for your business? Let’s look at a few examples to hopefully clear some things up.
Example 1
Your business brings in a net profit of $500,000.
Assume that this is the only thing in your life; your spouse doesn’t bring in an income and you have no interest or capital gains.
Let’s look at your business taxed as a Sole Proprietor, an S-Corporation and a Partnership or LLC.
| Sole Proprietor | S-Corporations | Partnership/LLC | |
|---|---|---|---|
| Business Income | $500,000 | $500,000 | $500,000 |
| W2 Wages | n/a | $125,000 | n/a |
| Guaranteed Payments | n/a | n/a | $125,000 |
| Net Income | $500,000 | $375,000 | $375,000 |
| QBI | $500,000 | $375,000 | $375,000 |
| Tentative Deduction | $100,000 | $75,000 | $75,000 |
| 50% of W2 Wages | $0 | $62,000 | $0 |
| Total Deduction | $0 | $62,500 | $0 |
So, you can see that your best option here is to be taxed as an S-Corporation. The other two businesses don’t see a deduction at all because they paid out $0 in wages. The lesser of 20% of net income or zero is zero. And 50% of zero is also zero.
As an S-Corp, you pay yourself $125,000, but that counts as a deduction. Your net profit now is only $375,000.
The lesser of:
QBI deduction — 20% of $375,000 = $75,000
OR
50% of wages — 50% of $125,000 = $62,500
$62,500 is the lesser of both, so this would be your deduction.
Example 2
Your business brings in a net profit of $200,000.
Again, assume that this is the only thing in your life; your spouse doesn’t bring in an income and you have no interest or capital gains.
Because you aren’t bringing in more than $315,000, W2 wages don’t come into play in this scenario.
| Sole Proprietor | S-Corporations | Partnership/LLC | |
|---|---|---|---|
| Business Income | $200,000 | $200,000 | $200,000 |
| W2 Wages | n/a | $80,000 | n/a |
| Guaranteed Payments | n/a | n/a | $80,000 |
| Net Income | $200,000 | $120,000 | $120,000 |
| QBI | $200,000 | $120,000 | $120,000 |
| Tentative Deduction | $40,000 | $24,000 | $24,000 |
| 50% of W2 Wages | n/a | n/a | n/a |
| Total Deduction | $40,000 | $24,000 | $24,000 |
In this scenario, being an S-Corporation hurts because W2 wages are considered an expense. You would only get 20% of the $120,000 with a $24,000 deduction. If a household income is less than $315,000, the business should probably never be an S-Corporation. There are many other factors that come into play, but here we’re assuming it’s one person running the business. In this case, you would come out best by being taxed as a sole proprietor since you would get the $40,000 deduction.
As you can see, it is very important to do appropriate planning for your business. It can mean the difference between getting a $62,500 deduction or nothing. That is potential “free” money, down the drain.
Still unsure? That’s okay! Verdant has experts who are trained to tell you which scenario is right for your business. Contact us today to schedule a FREE consultation!