By Matt Spencer, Peterson Sullivan LLP
This article provides information on the new 20% pass-thru deduction as it applies to professional services businesses, including the fields of law, architecture, engineering, insurance, financial services, consulting, health, etc.
Effective January 1, 2018 the new tax legislation, called the Tax Cut and Jobs Act, creates a deduction equal to 20% of “qualified business income” earned from pass-thru entities. For those eligible, the deduction will be claimed on individual owners’ tax return Form 1040.
The new deduction is codified into federal law as Internal Revenue Code Section 199A. You may see the following terms used to describe the deduction, each meaning the same thing:
- 20% qualified business income (QBI) deduction
- 20% pass-thru deduction
- Section 199A deduction
The deduction is subject to a host of caveats and limitations. Please continue reading to learn more, and give your tax advisor a call to discuss your specific situation.
We note that because of the complexity and lack of existing authoritative guidance on this new law, what follows is subject to change.
If I am eligible, will I see the 20% deduction on my 2017 tax return?
No. The 20% deduction is effective January 1, 2018. Those who claim the deduction will first see it on their 2018 tax returns, filed in 2019.
What is “qualified business income” (QBI)?
Generally, QBI is business net income (not revenue) from ownership in pass-thru entities, including partnerships and S-corporations, as well as sole proprietorships.
Other restrictions aside, your business income is eligible if the company is structured as a:
- Partnership (files tax return Form 1065)
- S-corporation (Form 1120S)
- Sole proprietorship (Form 1040 Schedule C)
Other entity types may qualify as well. These are the main three.
Business income from C-corporations (Form 1120) is not eligible for the 20% deduction.
Can you provide a brief example of how the 20% deduction generally works?
Ignoring other limitations, if QBI equals $100,000, a $20,000 (20% x $100,000) deduction may be claimed on the owner’s personal tax return. Assuming the highest 2018 individual tax rate of 37%, a $20,000 deduction results in $7,400 tax savings (37% x $20,000).
The deduction reduces personal taxable income, which is your adjusted gross income MINUS deductions (standard or itemized). It does not directly reduce adjusted gross income.
It is not necessary to itemize to claim the deduction. That is, eligible taxpayers may claim the 20% deduction even if they also take the standard deduction.
What are the 2018 taxable income thresholds?
Because we are going to reference “applicable taxable income thresholds” frequently in this article, it is good to review them up front.
How do I know what my taxable income is?
Your taxable income can be found on your Form 1040. For example, on your 2016 Form 1040 it is page 2 line 43. Taxable income includes all income and deductions, including wages, capital gains, interest, dividends, retirement income, income and losses from all businesses, spouse’s income, itemized deductions, etc. It does not include tax credits.
Some professional service income is eligible for the 20% deduction regardless of taxable income, and some is only eligible under the taxable income thresholds. Can you explain?
In short, architects and engineers are eligible regardless of personal taxable income amount. Most other professional services income is ineligible when the owner’s taxable income is above the applicable thresholds (for 2018 $415,000 married / $207,500 single).
The new law is less generous to professional service trades or businesses than to other industries. Many professional service activities are excluded from the definition of businesses that generate qualified business income. Those excluded will not be eligible to claim the 20% deduction unless personal taxable income is below applicable thresholds.
These ineligible businesses are defined in the new law as specified service trades or businesses:
“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, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners; or any trade or business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.”
Is there any type of professional services income that is eligible for the 20% deduction when taxable income is above applicable thresholds?
Yes. Architects and engineers.
The new legislation explicitly exempts architects and engineers from the definition of a specified service trade or business. Architectural and engineering income is therefore eligible for the 20% deduction regardless of personal taxable income level, but still subject to other limitations.
What is the W-2 wage limit?
When taxable income is above the applicable thresholds, your 20% deduction is subject to a W-2 wage limit, which is the GREATER of:
(i) 50% of your allocable share of the firm’s W-2 wages, OR
(ii) 25% of your share of the firm’s W-2 wages PLUS 2.5% of your share of the firm’s unadjusted basis (i.e. cost) of all qualified property.
For most professional services, W-2 wages far exceed qualified property (building, furniture, equipment, etc.). Therefore, for most professionals we expect (i) the 50% W-2 wage limit to apply, not (ii) above.
For example, if you own half of a firm that pays $200,000 in total W-2 wages, your 20% deduction is limited to $50,000 (1/2 firm x 50% x $200,000 wages). This assumes the business has insufficient qualified property, and therefore limit (i) above applies.
How does the W-2 wage limit apply when personal taxable income is BELOW $315,000 married ($157,500 single) for 2018?
When 2018 personal taxable income is below $315,000 married ($157,500 single), no taxpayer is subject to the W-2 limit. This includes the specified service businesses like doctors, lawyers, etc., in addition to architects and engineers. Therefore, below these taxable income thresholds, professional services pass-thru income is generally eligible for the 20% deduction regardless of industry.
How does the W-2 wage limit apply when personal taxable income is BETWEEN $315,000-$415,000 married ($157,500-$207,500 single) for 2018?
When in these taxable income ranges, the limitations are different whether you are or are not in a specified service business.
For those who are NOT in a specified service business (e.g. architects and engineers):
- Your 20% deduction is subject to a phase-in of the W-2 limit when personal taxable income is in the above range. However, if your firm allocates to you sufficient W-2 wages, generally you will still be eligible for the full 20% deduction.
For specified service businesses (e.g. lawyers, accountants, financial service providers, etc.):
- Your 20% deduction is subject to two limitations when personal taxable income is in the above range:
- First, your 20% deduction is subject to an income based phase-out. This means the closer your income is to the top of the range ($415,000 married / $207,500 single), the less your 20% deduction will be. At the top of the range, your 20% deduction will be $0 regardless of W-2 wages the firm allocates to you.
- Second, your 20% deduction is also subject to a phased-in limit based on W-2 wages allocated to you.
Are there other limitations to be aware of?
Yes. The 20% deduction cannot exceed 20% of the net of personal taxable income MINUS net capital gains. This applies to all taxpayers regardless of industry.
For example, if your personal taxable income is $200,000 and your net capital gain is $150,000, then your 20% deduction is limited to $10,000 [20% x ($200,000-$150,000)] regardless of your QBI amount.
This limit has the effect of reducing the deduction for taxpayers who claim significant itemized deductions, losses from other activities, or for whom taxable income is made up largely of capital gains.
What income is NOT eligible for the 20% deduction?
- Specified service trade or business income in which the owner reports 2018 taxable income MORE than $415,000 married ($207,500 single). See the above definition of specified service trades or businesses. Again, architects and engineers are excluded.
- All W-2 employee compensation. Includes S-corporation shareholder W-2 compensation.
- Partner guaranteed payments from a partnership
- Capital gains, interest, and dividends
- Retirement account withdrawals
What pass-thru income IS eligible for the 20% deduction?
- Architectural and engineering
- Specified service trade or business income in which the individual owner reports 2018 taxable income LESS than $415,000 married ($207,500 single). Includes lawyers, accountants, doctors, investment managers, etc.
If I am unable to claim the new 20% deduction in 2018, will my taxes go up?
While every situation must be reviewed separately, we expect many professional service providers nonetheless to see a reduced tax bill—assuming equivalent income, etc.—despite not benefiting from the pass-thru deduction. The main reason is that individual tax rates generally are pushed down starting in 2018.
However, some may see a tax increase, potentially those who rely on itemized deductions that have been removed or limited by the new tax legislation. For example, the deduction for state and local taxes is limited to $10,000 starting in 2018. Also, personal exemptions will no longer be allowed.
Is the 20% deduction permanent?
No. As the law is currently written, every change discussed here is set to expire December 31, 2025. Of course it is impossible to predict how future congressional action may alter this outlook. The permanent provisions of the new law mostly apply to C-corporations, which are not eligible entities.
I am a partner in a partnership, and I am paid a guaranteed payment. Are guaranteed payments eligible for the 20% deduction?
No. Guaranteed payments (as well as S-corporation wages) are not considered qualified business income eligible for the 20% deduction. Professionals otherwise in a position to claim the deduction who receive substantial guaranteed payments (or S-corporation wages) should consider re-evaluating their compensation plan. However, other factors must be considered when deciding on changes to compensation structure.
If you are not sure if you receive guaranteed payments, check your partnership 2016 K-1 (from Form 1065) box 4.
I am eligible for the 20% deduction, but my pass-thru company will report a loss. Can I still benefit from the deduction?
No. Unfortunately, not only will you be ineligible for the 20% deduction in the loss year, the loss will carry forward to reduce your 20% deduction in future years.
I am an owner of a partnership or S-corporation. How will the information needed to calculate my 20% deduction be reported to me?
Starting with the 2018 tax year, your K-1s will include the necessary information. It will include your qualified business income, as well as your allocable share of your firm’s W-2 wages and qualified property.
Any other aspects of the new 20% deduction to be aware of?
The following types of income are also relevant with respect to the 20% deduction. For simplification, this article disregards these items.
- REIT dividends
- Co-op dividends
- Publicly traded partnership income
I expect to receive no benefit from the 20% deduction under my current business structure. Are there other strategies I can consider?
Depending on your situation, certain tax planning strategies may be available.
Please call your tax advisor to discuss your situation.
CPA, Tax Senior
Matt has three years experience as a tax professional in public accounting, all with Peterson Sullivan, and two years in private accounting with a Seattle law firm. He serves a broad client base, specializing in tax compliance and planning for high-net-worth individuals, professional services firms, and real estate investments. Matt has a BA in Philosophy from Santa Clara University and an MBA from Seattle University. He is a member of the American Institute of Certified Public Accountants and Washington Society of Certified Public Accountants.