The New Qualified Business Deduction

I spent a fair amount last week looking over the new IRS Regulations on the qualified business deduction. It was a breezy and compact 184 pages, although it reads longer than that.

I debated blogging on this topic. While one of the most significant tax changes in decades, the deduction is difficult to discuss without tear-invoking side riffs. 

But – if you are in business and you are not a “C” corporation (that is, the type that pays its own taxes) - you need to know about this new deduction.

Let’s swing the bat:

1.    This is a business deduction. It is 20% of something. We will get back to what that something is.

2.    There historically has been a spread between C-corporation tax rates and non-C-corporation tax rates. It is baked into the system, and tax advisors have gotten comfortable understanding its implications. The new tax law rattled the cage by reducing the C-corporation tax rate to 21%. Without some relief for non-C-corporation entities, lawyers and accountants would have had their clients folding their S corporation, partnership and LLC tents and moving them to C-corporation campgrounds.

3.    It is sometimes called a “passthrough” deduction, but that is a misnomer. It is more like a non-C-corporation deduction. A sole proprietorship can qualify, as well as rentals, farms and traditional passthroughs like S corporations, LLCs and partnerships. Heck even estates and trusts are in on the act.

4.    But not all businesses will qualify. There are two types of businesses that will not qualify:

a.     Believe it or not, in the tax world your W-2 job is considered a trade or business. It is the reason that you are allowed to deduct your business mileage (at least, before 2018 you were). Your W-2 however will not qualify for purposes of this deduction.

b.    Certain types of businesses are not invited to the party: think doctors, dentists, lawyers, accountants and similar. Think of them as the “not too cool” crowd.

                                                   i.There is however a HUGE exception.

5.   Congress wanted you to have skin in the game in order to get this 20% deduction. Skin initially meant employees, so to claim this deduction you needed Payroll. At the last moment Congress also allowed somebody with substantial Depreciable Property to qualify, as some businesses are simply not set-up with a substantial workforce in mind. If you do not have Payroll or Depreciable Property, however, you do not get to play.

a.     But just like (4)(b) above, there is a HUGE exception.

6.   Let’s set up the HUGE exception:

a.     If you do not have Payroll or Depreciable Property, you do not get to play.

b.    If you are one of “those businesses” - doctors, dentists, lawyers, accountants and similar - you do not get to play.

c.     Except …

                                                   i. … if your income is below certain limits, you still get to play.

                                                 ii. The limit is $157,500 for non-marrieds and $315,000 for marrieds.

                                              iii. Hit the limit and you provoke math:

1.    If you are non-married, there is a phase-out range of $50 grand. Get to $207,500 and you are asked to leave.

2.    If you are married, double the range to $100 grand; at $415,000 you too have to leave.

                                               iv. Let’s consider an easy example: A married dentist with household taxable income of less than $315,000 can claim the passthrough deduction, as long as the income is not from a W-2.

1.    At $415,000 that dentist cannot claim anything and has to leave.

                                                 v. Depending on the fact pattern, the mathematics are like time-travelling to a Led Zeppelin concert. The environment is familiar, but everything has a disorienting fog about it.

1.    Why?

a.     The not-too-cool crowd has to leave the party once they get to $207,500/$415,000.

b.    Simultaneously, the too-cool crowd has to ante-up either Payroll and/or Depreciable Property as they get to $207,500/$415,000. There is no more automatic invitation just because their income is below a certain level.

c.     And both (a) and (b) are going on at the same time.

                                                                                                               i.     While not Stairway to Heaven, the mathematics are … interesting.

7.    The $207,500/$415,000 entertainment finally shows up: Payroll and Depreciable Property. Queue the music.

a.     The deduction starts at 20% of the specific trade or business’s net profit.

b.    It can go down. Here is how:

                                                   i. You calculate half of your Payroll.

                                                 ii. You calculate one-quarter of your Payroll and add 2.5% of your Depreciable Assets.

                                              iii. You take the bigger number.

                                               iv. You are not done. You next take that number and compare it to the 20% number from (a).

                                                 v. Take the smaller number.

c.     You are not done yet.

                                                   i. Take your taxable income without the passthrough deduction, whatever that deduction may someday be. May we live long enough.

                                                 ii. If you have capital gains included in your taxable income, there is math. In short, take out the capital gain. Bad capital gain.

                                              iii. Take what’s left and multiply by 20%.

                                               iv. Compare that number to (7)(b)(v).

1.    Take the smaller number.

8.    Initially one was to do this calculation business by business.

a.     Tax advisors were not looking forward to this.

b.    The IRS last week issued Regulations allowing one to combine trades or businesses (within limits, of course).

                                                   i. And tax advisors breathed a collective sigh of relief.

c.     But not unsurprisingly, the IRS simultaneously took away some early planning ideas that tax advisors had come up with.

                                                   i. Like “cracking” a business between the too-cool and not-too-cool crowds.  

And there is a high-altitude look at the new qualified business deduction.

If you have a non-C-corporation business, hopefully you have heard from your tax advisor. If you have not, please call him/her. This new deduction really is a big deal.