One of the most hotly discussed parts of the Tax Cuts & Jobs Act (TCJA) is the Qualified Business Income Deduction (QBID), otherwise known as the Section 199A deduction. In general, the deduction provides certain pass-through businesses (sole proprietorships, partnerships, S Corporations) with the ability to deduct 20% of their qualified business income (QBI) on the owner’s personal income tax return, subject to some phase outs and limitations. The deduction effectively lowers their top individual tax rate from 37% to 29.6% (37% x 80% = 29.6%). Section 199A was included in the TCJA to provide relief to small businesses that do not operate as C Corporations, because C Corporations tax rates were significantly reduced from a top rate of 35% to a flat rate of 21%.
The deduction is limited to the greater of 50% of the W-2 wages paid by the business, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property owned by the business. These limitations do not apply to taxpayers with taxable income at or below a certain threshold. For 2019, the threshold amount is $321,400 for joint filers and $160,700 for all other taxpayers. For taxpayers above these thresholds, good tax planning becomes essential.
The deduction starts to phase out for specified service trades or businesses (SSTBs) once taxable income reaches the above referenced thresholds. Most construction businesses do not fall under any of the SSTB categories.
The amount of W-2 wages paid by a business plays a significant role in calculating the deduction. S Corporations have an advantage over sole proprietors and partnerships in that they can pay the owner W-2 wages. The more wages a business pays, the bigger potential deduction they can take, but at the same time, wages are an expense of the business so they lower the QBI. So it is a balancing act to determine the optimum wages for a business to pay. Take note in the following example:
|Net income (pre-wages)||1,000,000||1,000,000||1,000,000|
|W-2 Wages (including owners)||900,000||100,000||300,000|
|Qualified Business Income (QBI)||100,000||900,000||700,000|
|(a) 20% of QBI||20,000||180,000||140,000|
|(b) 50% wages||450,000||50,000||150,000|
|199A deduction (lesser of lines (a) & (b))||20,000||50,000||140,000|
|Tax savings (assumed 37% rate)||7,400||18,500||51,800|
In Scenario (1) the owner opts to take a large salary in the form of bonus in December. This enables them to defer making any tax payments until the end of year and avoid paying quarterly estimates. This has always been a common planning strategy for business owners, but should be reconsidered in light of Section 199A. As you can see this option wipes out most of the business’s QBI, and limits the deduction to only $20,000.
In Scenario (2) the owner opts to only take a “reasonable salary” from the company, as required by the IRS. This allows them to limit the amount of exposure to FICA taxes. While this scenario results in the highest QBI, with minimal wages, the deduction is limited to only $50,000.
Scenario (3) provides the maximum tax savings because the business paid out close to the optimum amount of wages. You want to have enough wages to get the deduction, but not too much wages where it starts to reduce your deduction.
Note that in all scenarios, the same amount of income is being reported on the owner’s personal tax return, but with proper planning, there can be significant tax savings.
Hiring subcontractors is very common in the construction industry. Payments to subcontractors do not count as W-2 wages for purposes of Section 199A. Businesses should consider whether hiring employees would be more beneficial. It’s not as simple as just changing their classification, as the IRS has very specific guidelines for determining employees vs. subcontractors. You need to consider the additional costs of having employees, such as payroll taxes, workers compensation, benefits, etc.
Because of an S Corporation’s ability to pay the owner W-2 wages, LLC’s that have previously elected to be treated as a partnership or sole proprietorship for tax purposes may want to consider converting to an S Corporation if they have insufficient W-2 wages. All factors should be considered before making the change as S Corporations are not alwaysthe best option in all cases.
Aggregation of Activities
Another common practice in the construction industry is having business operations broken up into various entities. This may result in some businesses having disproportionate payroll and/or assets, limiting the overall Section 199A deduction. The aggregation election may allow you to group together similar and commonly controlled activities, treating them as one activity. This election can be very beneficial if one business shows significant income, but lacks W-2 wages, while another business shows less income, but has plenty of W-2 wages and/or assets. Without the election, each business is treated separately when calculating the allowable deduction. The election is irrevocable, unless circumstances change, so careful consideration is required before making the election.
The Section 199A deduction can be greatly beneficial to pass-through businesses. There is no one-size-fits-all for all business types and it’s important to consult with your business advisor and/or accountant to make sure you do what is best for your particular circumstances and leave no opportunities on the table.
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