3 Ways to Maximize the New 20 Percent Business Tax Deduction
Who qualifies and what are the key considerations to take into account?
Most businesses owners are eager to minimize costs, and the Tax Cuts and Jobs Act has prompted many to consider whether to set up pass-through entities to capitalize on the new rules. The law includes relief for up to 20 percent of “qualified business income,” in the form of a special deduction for individuals, trusts and estates.
But who qualifies and what are the key considerations to take into account?
Here are three considerations to maximize the value of the new deduction. Of course, circumstances vary and a trusted advisor should be consulted before making a move.
- SPIN OFF THE SERVICES PORTION OF YOUR BUSINESS
High-income taxpayers who receive income from a service business may not be able to take full advantage of the 20 percent deduction and some may not be eligible for the deduction at all. The new tax rules say if the taxpayer earns income from a “service business” and has taxable income over $207,500 (single / married filing separately) or $415,000 (married filing jointly), adjusted for inflation, then he or she does not get the 20 percent deduction. If the taxpayer’s taxable income is between $157,500 and $207,500 (single / married filing separately) or $315,000 and $415,000 (married filing jointly), adjusted for inflation, then he or she can take a partial deduction, but not the full 20 percent deduction.
A services business may be a doctor’s office, a law office, a stock broker … the list goes on. It’s defined as “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.”
So, what is a service professional to do?
Divide and conquer may be one option. The existing service business could create two entities: One to employ the service professionals and one entity for all other activities.
For example, imagine a racquet and tennis shop that is structured as a partnership. The shop not only sells tennis equipment, but also offers lessons through its owner, an accomplished pro. The shop could consider keeping its retail business inside the existing partnership and forming a second partnership through which the tennis pro could offer his lessons. Any profits distributed out of the existing partnership should be eligible for the 20 percent deduction, on the theory that the retail shop is not a services business. So, for high-income service professionals who want to take advantage of the 20 percent deduction, restructuring is one option to explore.
2. BUY (DEBT-FINANCED) PROPERTY
The service business hurdle is not the only issue for business owners who want to take the 20 percent deduction. If the owner of a non-services business has taxable income over $207,500 (single / married filing separately) or $415,000 (married filing jointly), adjusted for inflation, then the 20 percent deduction is capped. Specifically, the deduction cannot be greater than 50 percent of the wages that the business paid in the taxable year or 25 percent of the wages that the business paid in the taxable year plus 2.5 percent of the unadjusted basis of business property.
So what is Congress’ incentive for providing business owners with the deduction cap?
Job creation and encouraging investments domestically top the list. Many businesses are considering expanding through investments in property in order to be eligible for the full deduction. Property that increases the deduction cap is property that is held by, and available for use in, the trade or business at the close of the taxable year; is used at any point during the taxable year in the production of “qualified business income”; and is not fully depreciated as of the end of the tax year. This could include a myriad of business property, ranging from machinery to livestock. With the expansion of business property comes the need for more employees to assist with operating the business. Investment in business property not only can increase the deduction, but also carries two other tax benefits, including the depreciation deduction from the business property and the ability to lock in low interest rates and take a tax deduction for interest paid if the property is debt-financed.
First, the business property can give rise to a depreciation deduction. The deduction can be as high as 100 percent of the property’s adjusted basis, thanks to the “immediate expensing” provisions in the new tax law. Alternatively, the property may be eligible for bonus depreciation. Second, if the property purchase is debt-financed, the business potentially could lock in a low interest rate and also take a tax deduction for interest paid.
3. CONSIDER “MARRIED FILING SEPARATELY” STATUS
As highlighted above, two limitations on the 20 percent deduction (the service business limitation and the wage/property cap) apply to high income earners. But, in a dual income household, a spouse who would be eligible for the 20 percent deduction, but for the fact that his or her spouse makes too much money, might consider filing separately, rather than jointly.
For example, assume a couple where one spouse makes $150,000 per year as a partner in an accounting firm and the other makes $270,000 as an executive at a chemical company. (Assume also that the couple has negligible investment income or other deductions.) If they choose joint filing status, their taxable income will exceed the $415,000 threshold, even with deductions, and the $150,000 spouse would not be eligible for the 20 percent deduction on services income. However, if the couple elects married filing separately status, the lower-income spouse would not exceed the $157,500 threshold and potentially would qualify for the full 20 percent deduction.
In sum, the Tax Cuts and Jobs Act has created both opportunities and complexities for business owners. Until the scheduled expiration of the 20 percent deduction in 2026, they will have a lot to think about. Business owners may want to consider possible restructuring options, strategic business property investments, and their marriage filing status, to help maximize the new deduction. To explore these possibilities and more it is important that they speak with their advisor to best position their business under the new tax law.
Suzanne L. Shier, J.D., LL.M., CFP® is the Wealth Planning Practice Executive and Chief Tax Strategist/Tax Counsel at Northern Trust. She provides insight and guidance on wealth planning and tax issues of interest to clients, their businesses, and their advisors.
Diana R. Myers, J.D., CFP® is Associate Tax Counsel at Northern Trust.