Small business owners continue to seek clarity on the new tax deduction introduced by the Tax Cuts and Jobs Act.
The 20% deduction on business income introduced with the tax reform law is available for small businesses that are taxed as “pass through” entities. This means that the net business or partnership income is taxed at rates and brackets applicable to individual taxpayers.
While the deduction is available to both non-service and service businesses, there is a limit on the deduction for “specified service businesses” with a phaseout triggered depending on the amount of household taxable income. For these businesses, the 20% deduction on qualified business income (QBI) begins to be phased out as household taxable income exceeds $315,000 (married filing jointly) or $157,500 (single).
According to the Joint Explanatory Statement of the Conference Committee: “A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, 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 one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.” (For more details on the new deduction, see the Tax Policy Center’s report.)
Planning strategies for service businesses
There are some planning considerations to consider for those businesses that fit the definition of specified service businesses.
1. Planning for the income threshold
- Consider the timing of income. Investors should focus on transactions that could increase overall income such as the sale of a stock or property, or managing the timing of business expenses and receipts.
Use strategies to reduce taxable income such as funding retirement plan or a health savings account.
Consider the following example, in which the owner of a specified service business establishes a retirement plan and avoids the phase-out on the new 20% business deduction.
2. Separating non-professional services from the core business
- Some larger-scale professional service businesses (law and CPA firms) may consider separating non-professional services (administration, information technology, property management, etc.) from the core business into a separate entity such as an LLC.
- This may allow the pass-through income derived from the newly created, non-professional LLC to benefit from the deduction for qualified business income.
The majority of U.S. companies are pass-through firms, structured as S-Corps, Limited Liability Companies, partnerships, or sole proprietorships. For these companies, the tax deduction effectively lowers the maximum tax rate to 29.6% from 37%.
Many businesses are seeking additional detail from the Internal Revenue Service about what types of businesses are defined as specified services businesses. In fact, the Association of International Certified Public Accountants (AICPA) sent a request to the IRS in February seeking guidance on this issue.
It is important for business owners to work with a qualified tax or legal professional to understand the impact of the income restrictions and if they could benefit from these planning strategies around the deduction limitations. In addition, the new deduction expires in 2025. Unless Congress acts, the tax deduction will not be extended or made permanent. Investors may want to consider taking advantage of the deduction, and maximizing its potential tax benefit, in the near term.