The greatest opportunity business owners received from the Trump Tax Act is the new IRC 199A pass-thru business deduction. This deduction allows certain taxpayers to deduct 20% of their Qualified Business Income.
However, not every taxpayer can receive this deduction, so estate planners have a huge opportunity to exploit the new statute by educating themselves with the details of the new statute.
For a married couple with taxable income of no more than $315,000 and for an unmarried individual with taxable income of no more than $157,500, there are minimal rules and the 20% federal income tax deduction is available. There is a phase-out of the deduction from $315,000 to $415,000 for married taxpayers and from $157,500 to $207,500 for unmarried taxpayers. These figures are for total income, not just based on Qualified Business Income.
For a Specified Service Business, unfortunately no IRC 199A deduction is available for owners whose taxable income exceeds the dollar amounts in the foregoing paragraph. A specified service trade or business means any trade or business involving the performance of services in the fields of: Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.
However, for a business that is not considered a Specified Service Business, an IRC 199A deduction is available for owners whose taxable income exceeds the dollar amounts outlined above. However, it’s limited to the greater of (a) 50% of W-2 wages or (b) 25% of W-2 wages plus 2.5% of Qualified Property (certain depreciable property such as buildings and equipment).
Non-Specified Service Business: Choice of Entity Example
Assume $1,000,000 of Qualified Business Income (QBI) for this tax year and that the business has no Qualified Property. Let’s compare three choices of business entity: Sole Proprietorship, Partnership and S Corporation.
Sole Proprietorship: $1,000,000 QBI; $0 W-2 wages. Therefore, $0 QBI deduction
Partnership: $1,000,000 QBI; $0 W-2 wages. Therefore, $0 QBI deduction
S Corporation: Assume $200,000 wages. Therefore, $800,000 QBI. Does this mean $160,000 QBI deduction (calculated as 20% of $800,000)? Unfortunately, no. If we apply the W-2 wage test which is 50% of $200,000, the QBI is limited to $100,000 which is still a better result than using a Sole Proprietorship or Partnership.
Applying the 28.57% Magical W-2 Formula
The ideal sweet spot for percentage of W-2 wages versus overall income is 28.57%. [To be more specific, 28.571428571% which is computed by dividing 3.5 into 100.]
Looking at the above Example, assuming that we increase the W-2 wages using the Magical W-2 Formula to 28.57% of the $1,000,000. Therefore, the W-2 wages are $285,700 and the Qualified Business Income is therefore reduced to $714,300.
$285,700 * 50% = $142,500
$714,300 * 20% = $142,860
Therefore, after applying the Magical W-2 Formula, by increasing W-2 wages, we have discovered the sweet spot to maximize the IRC 199A deduction at $142,500!
IRC 199A potentially gives business owners a very large new income tax deduction. However, as described in this article, the choice of entity can have a big impact over this deduction and the 28.57% Magical W-2 Formula can perfect the extent of this deduction.
The Ultimate Estate Planner has a number of educational programs related to the Tax Reform that you may be interested in.
- What Every Advisor Needs to Know About Tax Reform for 2018 Planning & Beyond
- Planning for Professional Practices & Other Business Entities Under the Tax Reform Bill
- Estate Planning After Tax Reform
- Tax Planning for Real Estate Under the Tax Reform Bill
ABOUT THE AUTHOR
Steven J. Oshins, Esq., AEP (Distinguished) is an attorney at the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada, with clients throughout the United States. He is listed in The Best Lawyers in America®. He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011 and was named one of the 24 Elite Estate Planning Attorneys in America by the Trust Advisor. He has authored many of the most valuable estate planning and asset protection laws that have been enacted in Nevada. He can be reached at 702-341-6000, ext. 2, at [email protected] or at his firm’s website, www.oshins.com.