One of the major changes in the tax law enacted last December in the Tax Cuts and Jobs Act (“TCJA”) was the creation of a new deduction for “qualified business income.”
As a general rule, this deduction allows individuals who are either sole proprietors or who own interests in businesses that are formed as limited liability companies, partnerships, or S corporations to deduct from their gross income an amount that may be as high as 20 percent of their share of that entity’s income.
However, not all businesses are treated equally when it comes to the deduction for qualified business income. Although this new deduction is a potential windfall for lawyers and accountants when it comes to generating new business advising clients on ways to restructure compensation and dividends, Congress was not so kind to the lawyers and accountants when it came to allowing them to take a deduction for their qualified business income.
For specified service trade or businesses, the qualified business income deduction is limited and even eliminated for taxpayers whose income exceeds a certain dollar limit. The businesses that are subject to this limitation are businesses involved in the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the skill of one or more of its employees.
For these business owners, in 2018, the deduction is reduced if the business owner has taxable income in excess of $157,500 for a single taxpayer or $315,000 for a married taxpayer filing jointly. The deduction is completely eliminated if the business owner has taxable income in excess of $207,500 for a single taxpayer or $415,000 for a married taxpayer.
For instance, if an attorney has a solo practice with gross revenue of $600,000, pays wages of $80,000 to an employee, and has $80,000 of other expenses, the attorney’s taxable income, if he is married and filing jointly and has no other income or deductions, is $416,000 ($600,000 gross revenue less wages, other expenses, and $24,000 for the standard deduction for him and his wife). This attorney would not be entitled to take the deduction for qualified business income because his taxable income of $416,000 exceeded the $415,000 income limit. The federal income tax owed on the $416,000 would be $96,979.
One way to change this result is to set up a profit sharing plan to reduce the attorney’s taxable income. If the attorney created a profit sharing plan and contributed up to 20 percent of compensation for himself and his employee, he would contribute $16,000 to the plan for his employee and $55,000 for himself (based on contribution limits in effect for 2018). The $71,000 in contributions to the profit sharing plan would reduce the attorney’s income from the business to $369,000. His initial taxable income after the $24,000 standard deduction would be $345,000. Since his taxable income does not exceed $415,000, he would be entitled to claim a deduction for his qualified business income; however, the deduction would be limited because his initial taxable income was still in excess of $315,000.
The attorney’s qualified business income from his law practice would be $369,000. His deduction, before the reduction for excess income, would be the lesser of: (1) 20 percent of the qualified business income, which would be $73,800 (20 percent of $369,000) or (2) 50 percent of the W-2 wages he paid, which would be $40,000 (50 percent of $80,000).
However, because the attorney’s taxable income exceeds the threshold amount of $315,000 by $30,000, the allowable deduction would be reduced by 30 percent. Thus, the allowable qualified business income deduction would be $28,000 ($40,000 less $12,000). Accordingly, the attorney’s taxable income would be $317,000. This would result in a federal tax liability of $64,819.
By adopting a profit sharing plan, the attorney would now be entitled to take the qualified business income deduction. The deduction would result in a tax savings of $32,160. Granted he would have incurred an additional $16,000 payment for his employee. However, even after that payment he is still ahead by $16,160.
This article was reprinted with permission from Albuquerque Business First.