Tax Reform’s Impact On Businesses
Prior to tax reform, the C-corporation tax rates ranged from 15 to 35 percent. Under the new law, there is a 21% flat rate. Also under the new law, there is this new deduction known as the Qualified Business Income deduction that is available for Pass-Through Businesses.
The Tax Cuts and Jobs Act of 2017, otherwise known as the GOP tax reform bill, largely went into effect on January 1, 2018. If utilized properly, the new law can be significantly beneficial for business owners. To understand how the new laws can be beneficial for business owners, it’s important to be familiar with the two types of businesses that can have an impact on the taxation of a business entity.
Taxation of a Business Entity
One way is for the entity to be structured as a C-corporation, in which case the income generated from the business may be taxed twice. For example, the corporation gets taxed at the corporate level upon earning a profit, then after the corporation makes a distribution to the shareholders, the shareholders also pay taxes on their individual tax returns. This concept is known as double-taxation. Under the new law, all the C-corporations will pay a 21% tax on their corporate profits.
The second way businesses are taxed is that instead of the tax being paid at the business level and then again at the individual level, the profits and losses pass through and get taxed at the individual level only. This is especially significant now since the individual rates are set to expire on December 31, 2025, but the 21% rate for C-corporations is permanent.
“Qualified Business Income” Deduction for Pass-Through Businesses
Under the new code, there is a special provision which allows the owners of pass-through entities to benefit from additional tax breaks that are afforded to pass-through entities.
For purposes of the tax law, the following entities qualify as pass-through businesses: sole proprietorships, partnerships, S-corporations, LLCs, trusts, and estates. However, there are different tax consequences for disregarded entities. For these types of business owners, all of their income may be considered as qualified business income.
In essence, what the new law says is that if you have a pass-through entity, you may generally receive a 20% deduction on the Qualified Business Income (QBI). For pass-through entities, the portion of the profits that the business owner is entitled to after he receives a reasonable compensation for his services is deemed as qualified business income. For example, you may consider the portion of the income that comes in the form of W-2s, meaning wages, and the portion of the profits that qualify as business income, such as in the form of K-1. The portion of the income that represents the wages does not fall within the realm of QBI; whereas the portion of the business income that is in the form of K-1 may fall within the realm of the QBI.
In order to qualify for the QBI discount and to determine the extent to which the QBI deduction will save the taxpayer on the discount, we must first determine the nature of the underlying business. There are two categories of businesses that qualify for this discount: specified service businesses and all other businesses that are not classified as specified service businesses.
What is a Specified Service Businesses?
For purposes of this tax code, a specified service business is any business – involving performance of the services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services – or any trade or service where the main asset of the business is the reputation or skill of one or more of its employees. Note, however, that architects and engineers are exempt from this category.
The Three-Tier System
For married couples who file their taxes jointly, to fall within the first Tier, the threshold for the married couple’s total taxable income may not exceed $315,000; Tier 2 is between $315,001 and $415,000; Tier 3 is any amount that is in excess of $415,000.
For single filers to fall within the first Tier, the threshold for the single filer’s total taxable income may not exceed $157,500; Tier 2 is between $157,501 and $207,500; Tier 3 is any amount that is in excess of $207,500.
How Do You Qualify for the QBI Deduction?
If your total taxable income falls in Tier 1, regardless of whether you’re a specified service business or not, you may receive a deduction. If your business falls in Tier 2, the amount of the deduction you get is generally reduced. If you are in Tier 3, depending on whether you are a specified service business or not, your deduction is either limited or you don’t get a deduction at all.
How Does the QBI Deduction Apply?
Assuming that the taxpayer qualifies for the discount and he falls within Tier 1, then the 20% discount would apply on the portion of the business income. This means that the taxpayer who earns $100,000 on his business income may pay tax only on the $80,000 of such profits. If we assume that the taxpayer falls within the 24% tax bracket, then the taxpayer would pay the 24% rate on the $80,000, not the $100,000. As such, instead of paying $24,000, the taxpayer would now pay $19,200 on the portion of the business income.
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