Perhaps you have heard bits and pieces about how the new tax reform will help your business save money. Recent headlines have highlighted major changes with announcements such as “C-corporations to Receive a 21% Flat Tax” or “Pass-through Entities Receive a 20% Tax Reduction on Qualified Business Income.” But what does all of this really mean, and how will your business be able to maximize those savings?
The changes to C-corporation tax laws are fairly straight-forward. For tax years beginning after December 31, 2017, C-corporations will pay a flat tax of 21% compared to a progressive tax of up to 35% in previous years. Many owners of pass-through entities including S-corporations, Limited Liability Companies, Partnerships, and Sole Proprietors (“Pass-Through Entities”) are wondering if they are better off structuring as a C-corporation instead. Although the tax rate of a C-corporation has been reduced to the 21%, business owners must consider the double taxation on the income of C-corporations. Income earned by a C-corporation is first taxed at the corporate level (at a flat 21%) and taxed again when it is distributed as a dividend to shareholders, at a rate of up to 37% on the shareholder’s individual tax return.
In an attempt to equalize the reduction of the C-corporation tax rate, the new tax reform provides a 20% Qualified Business Income (“QBI”) deduction on income from a Pass-Through Entity. In its simplest form, the new tax law states you will get a 20% deduction on your QBI. The QBI deduction calculation, however, is anything but simple.
In order to simplify the calculation, the first thing a business owner should ask is: “Am I a service business?”
A service business is one in which the principal asset of the business is the reputation or skill of one or more of its owners or employees, such as doctors, attorneys, or accountants (excludes engineers and architects). The QBI deduction for a service business is dependent on your taxable income. The table below breaks down the QBI deduction brackets for a service business:
If your business is classified as a service business and exceeds the taxable income limitations, there are some additional tax strategies available where a deduction can be extracted by separating the service and non-service aspect of your business.
For non-service businesses there is no limitation on your taxable income. This means that no matter how high your taxable income, there may be some amount of deduction that will be available to you, assuming your business has W2 wages or qualified property.
Once you have exceeded the thresholds noted above for a non-service business, there is a three-step calculation which is based on the lesser of 20% of QBI or the greater of 50% of W2 wages or 25% of W2 wages and 2.5% of unadjusted basis in qualified property.
Did I mention this was anything but simple? The key to maximizing the amount of the deduction you’re entitled to is proper tax planning. Even with a non-service business, it’s important to partner with a CPA early in the tax year to discuss your specific tax situation. Contact one of our tax professionals to see how to best navigate the complexities of these changes.