OUR FAVORITE SUBJECT, I KNOW…
Alright, lend me your ears (or eyes, really) for this one. I’m going to dive into everyone favorite subject. That topic that makes everyone salivate and jump for joy and sit up straight in their chairs eager for what’s to come… taxes. Ha! I know, I know, but seriously, some of this stuff is super interesting. As a business owner, wouldn’t it be great to pay less in taxes, to keep more of your profit, or even just maximize the benefits that you deserve? I think so, so bear with me.
April is finally in our rear-view mirror, and we’ve got our first look at the impacts of the Tax Cuts and Jobs Act. One of the advantages born of that was, what is called, the Qualified Business Income Deduction. Like most provisions of our beloved laws, it’s confusing. Honestly, this is one of the most ironic things I’ve seen throughout my graduate education; some of the most confusing literature out there, consist of our codes, regulations, and statutes, which comically are written in the easiest form to digest… the outline form! Remember school papers, (A.) Paragraph, (1.) Subparagraph, (a.) Section, (i.) Subsection? The authors just butcher it all by filling it with the most ridiculous, convoluted sentences ever written. But I digress. Simple terms, what am I talking about? The TCJA makes available a deduction of 20% of your qualified business income if you’re a sole proprietor, partnership, LLC, or S corporation. Here is a, cough, nice little Q&A provided by the IRS. Actually, I found it pretty good.
WHAT DOES THAT EVEN MEAN?
For my friends that hate numbers, we’ll use easy numbers at first and make it crazy simple and strip it to just deductions (read subtraction). Let’s pretend you own a daycare center and we bring you our children. From the tuition paid, you have $200,000 before considering any of your costs. Let’s say it costs $100,000 to run your center $60,000 wages and $40,000 is the rest, all in (and assuming it’s all deductible and substantiated and itemized). Again, super simplification here… made up numbers. Without any consideration to available credits, your taxable income would be the remaining $100,000. So, the IRS will apply your tax bracket to that $100,000. What if we could make the number the IRS taxes smaller? Well, they would take less, right? And, therefore, you keep more at the end of the day. I think taking more money home and paying Uncle Sam less, sounds pretty great. Do you agree? So that is what the QBI deduction does for you. You get to deduct 20% of your income that is attributed to your business (so, if your spouse adds another $100,000 to the pot, it doesn’t count towards this deduction. Savvy?) For our example, that deduction would reduce your taxable amount by an additional $40,000. Uncle Sam would have that much less to tax. Arbitrarily, if your marginal bracket is 24% at $100,000 of taxable income, this deduction could potentially move you to the next lower bracket! Would you rather pay $24,000 in taxes or $13,200? The latter, right? In this example, you still brought in $200,000 at the start, and now you have an additional $10,800 for whatever else you need to do! It’s not that linear, but you get the point, right? And if you fall into the Specified Service Business, like me (i.e. you’re a doctor, lawyer, accountant, performing artist or something) then you have more hoops to jump through. My point for any professional is that being proactive in your finances can save you money and empower you to accomplish other goals.
Sorry to say this, but obviously there are limitations. If you make too much, this deduction goes down. This deduction could be limited by the greater of a percentage of your wages paid or your investments. And if you’re a specified service business, you’re limited even further as I already alluded to. But don’t let that get you down. What can we do?
- Adjust wages paid. Some instances you may want to lower, others you may want to increase. And other times, you may want to convert your independent contractors into regular employees. Granted, you have to consider the increased cost of payroll tax, too. Ugh, more math!
- If you have more than one qualified business, you may want to aggregate them. Sometimes, like if you provide retail and services, it may make sense to segregate the businesses.
- Control depreciation of assets.
- Make deductible contributions to retirement plans or HSAs.
This list goes on, which is why this is a topic you should discuss with your planners and advisors way before next April.
ONE LAST EXAMPLE, LET’S PICK ON ATTORNEYS
Tommy is married and files a joint return, and he practices law through an LLC, a single member LLC to be precise. His taxable income for 2018 (before any QBI deduction) was $375,000, which includes $200,000 from his practice and $175,000 from his wonderful wife. Because his taxable income is over $315,000 but not over $415,000, the specified service business exception is subject to a phase out (this is that other great hoop we get to jump through, yay!) Tommy’s taxable income over the threshold is 60% into the phase-out range. Therefore, my friend only gets to count 40% or $80,000 of his income as QBI. Now, he does pay an administrative employee $50,000 annually. Here comes another limit! Tommy can only take $20,000 (which is $50,000 × 40%, wage limitation in play) of the W-2 wages into account to compute his deductible amount. In this case, Tommy could and should probably make a deductible contribution to himself and his employee to a retirement plan which would lower his taxable income, help his family in the long run (retirement planning), and potentially allow him a greater QBI deductible amount.
Saving money isn’t just about squirrelling away loot into different accounts, or forgoing that $5 latte, it’s also about taking advantage of opportunities to keep your money or getting credit for money spent properly. Insomniacs and nerds, for some light reading (term used very loosely), Google-pedia IRC 199A… Snooze! Just kidding, it was not horrific. I also found interesting and way better written than my own, the QBI article provided by Michael Kitces.