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How Taxes on Business Income are Calculated Under Tax Reform

Dec 21st 2017
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As the Tax Reform bill inches closer to the President’s desk, the latest version of the bill still leaves more questions than answers, particularly in the area surrounding pass-through business deductions.

On December 15, 2017 many Americans were surprised to learn the agreed upon method of applying a lower tax rate to business income includes a flat-tax method on C Corporation income, while a deduction method is used for all LLCs, Partnerships, S corporations, and Sole Proprietorships. 

Although the Senate had passed a similar version of a deduction method in implementing tax reduction for pass-through businesses, the new version of the bill includes several new departures from the Senate’s proposal leaving many practitioners confused about the new formulas and how to calculate the applicable deduction.

For C corporations, the Republicans in House and Senate agreed upon a flat tax rate of 21% for corporations, this was slightly higher than the expected rate of 20%, and much higher than the plan released by Trump of 15%.  Also a surprise, a change of heart related to personal service corporations. Originally thought to be taxed at the highest current corporate rates, Senators and Representatives instead opted for a flat tax of 25%, which is still a significant savings over current tax rates for PSCs.

Pass-through entities, however, are not so easy to calculate. Ordinarily taxed at the individual level after separately stated items are “passed-through” via Forms K-1, current pass-through income can be taxed as high as 39.6%, the current highest tax rate.

The provision in the latest version of the bill provides for a deduction in the amount of 20% of certain pass-through company income. However, the provision calls for a phase in of a wage and capital limitation for taxpayers with taxable income over a threshold of $157,500 for individuals and $315,000 for joint filers. 

In order to apply the wage and capital limitation for taxpayers earning over the threshold, it is first necessary to calculate 20% of the qualified net business income.  Each trade or business activity income is calculated separately. 

Next, the taxpayer selects the higher of one of two factors. Factor one equals 50% of wages paid and deducted through the company. Factor two consists of the sum of 25% of company wages and 2.5% of qualified unadjusted property. Once the greater of these two factors is determined, the taxpayer uses the lesser of the wage and capital limitation or the percentage of business income factor as their deduction.

Additionally, the same threshold amounts apply to limit a personal service company’s ability to participate in the 20% deduction. For personal service pass-through entities whose owners’ taxable income exceeds the above mentioned thresholds, an exclusion of qualified business income and wages are phased in beginning at the threshold limits mentioned, and are completely phased in when taxable incomes reach $207,500 for individuals and $415,000 for joint filers. 

Further direction will be provided by the Secretary of the Treasury for instructions on how to claim the deduction, but the bill specifies the deduction is not to be used in reducing adjusted gross income.

The method comes as a shock to many voters who assumed tax breaks would not be included in the bill for passive activities like real estate; and one might assume under the wage limitation, that real estate investment companies may not benefit from the provision given they typically have few wages. However, with the ability to use the greater of the 50-percent wage factor or a 25-percent wage plus 2.5-percent capital factor, investors can also benefit from the business income deductions.

Many tax professionals are now asking similar questions such as “what is considered qualified property?” or “which wages are used in the wage limitation calculation?”

Qualified Property means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable yearThe property must be used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year.   

Wages paid by the company refers to all company wages including wages paid to employees of the business. While tax pros may have a difficult time ahead getting used to the new laws (should the law pass as stated this week) there may be one group of professionals who have a more difficult challenge ahead. 

The Treasury has not only be tasked with determining the compliance reporting for this and all other provisions of the tax reform package, but they also need to provide procedures and interpretations, as well as anticipate potential hole in the new methodology to ensure there are counter measures enacted to prevent abuse. 

All of this, and still launch tax season timely, release the 2017 compliance forms and act as enforcement and collection? We can all take comfort in knowing we’re not the only ones on the planet struggling with the new policy.

Editor’s Note: As with all of our content, this above all right now could use your feedback and insights. 

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Replies (10)

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Elite Business CPA's
By EliteCPA
Dec 21st 2017 15:46 EST

Wow!! Busy Season will surely be a very, very busy season!

Thanks (1)
By lisagibs
Dec 21st 2017 17:11 EST

Does it apply to Sch E filers with passive rental activity? or do they now need to form LLC

Thanks (1)
Replying to lisagibs:
Dominic Molina
By Dominique Molina
Dec 22nd 2017 14:16 EST

Yes it also applies to Schedule E. Passive activities are not an issue in this area.

Thanks (2)
By beckkl
Dec 22nd 2017 11:50 EST

A couple of things still aren't clear to me. I'm a 1099 IT contractor with earnings of 200K. Would I be able to deduct 40K? I pay no salary. Its not clear to me if the salary calculation/limitation is phased in at 315K for everyone, or just the service-based business?

Thanks (1)
Replying to beckkl:
Dominic Molina
By Dominique Molina
Dec 22nd 2017 14:23 EST

It can be confusing because both the personal service issue as well as the wage limitation for high income earners use the same thresholds. To simplify the concept visualize 5 scenarios. First, for anyone under the bottom threshold (157,500 and 315,000)- just take 20% of qualified business income. 2. For personal service businesses who are between 157,500-207,500 single or 315,000-415,000 joint) you will apply a phaseout formula to reduce the 20% deduction. 3. For non personal service businesses who are between 157,500-207,500 single or 315,000-415,000 joint) you will phase IN the wage and capital limitations. 4. For personal service businesses over 207,500 and 415,000 no deduction is permitted. 5. For non personal service businesses over 207,500 and 415,000, apply the wage/capital limitation.

Thanks (1)
Replying to Dominique Molina:
By johngoing
Dec 22nd 2017 15:34 EST

Above, in scenario 4, you reference personal service businesses. Is that the same thing as a "specified service trade or business" (e.g. lawyers, doctors, accountants, etc.)? If so, it seems you are saying lawyers, doctors, accountants (e.g. specified service trade or businesses) can take the deduction as long as their income is less than the phase out amount. Is my understanding correct?

Thanks (1)
Replying to johngoing:
Dominic Molina
By Dominique Molina
Dec 22nd 2017 16:48 EST

Yes it is the same definition, however they have modified it to exclude engineers and architects.

Thanks (2)
By Jkallenbach
Dec 23rd 2017 00:21 EST

Will a shareholder/taxpayer's wages be included or excluded from the total wages paid by the company for purposes of calculating the limitation on the pass-through deduction?

Thanks (1)
Replying to Jkallenbach:
Dominic Molina
By Dominique Molina
Dec 23rd 2017 00:24 EST

The wages paid will be included. You would probably be able to take your 940 totals I assume.

Thanks (2)
By Youssef Kubis
Feb 16th 2018 01:09 EST

Hi, I have a question regarding the income definition that determines the bottom threshold, is it the total income from all resources (AGI), or the income from W2, or just the net income from the passthru business? For example, if I have an S Corp and I am taking an annual salary of $300k, then my Scorp’s net income at the end of the year is $200k, and assuming I am in a personal service business, and I file MFJ, would I qualify for the 20% tax deduction? Thanks

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