Qualified Business Income Deduction: What it Means for Flow-Through Entities

There is certainly a lot of hype surrounding the new C Corp 21% flat tax. It’s powerful, easy to understand, and will no doubt promote growth in C Corps of all sizes. What’s also getting a lot of attention, but is much more difficult to understand, is the new qualified business income deduction available to those with income from flow-through entities.

Eligible Entities

Under the new law, effective January 1, 2018, owners of certain entities are entitled to take a deduction equal to 20% of the “qualified business income” earned from the business. Eligible entities include:

  • Sole proprietorships reported directly on Schedule C
  • Rental activity reported directly on Schedule E
  • S Corporations
  • Partnerships

For taxpayers with taxable income of $315,000 (married filing jointly) or more, the deduction is limited to the lessor of:

  • 20% of qualified business income, or

The greater of:

  • 50% of total allocable W-2 wages paid by the business, or
  • 25% of total allocable W-2 wages paid by the business plus 2.5% of allocable unadjusted basis of income producing property

It’s important to note that when income is from a service business, the allowable deduction is phased out between taxable income levels of $315,000 – $415,000 (MFJ).  Service businesses include health, law, consulting, athletics, financial services and brokerage services – but architects and engineers will be allowed the deduction.

Converting to a C Corp

After digesting that, the question that comes to mind for many is – Does it make sense to remain a flow through entity or should I consider converting to a C Corp? The answer, of course, is: It depends. Below are a few situational examples.

Example 1:

  • Taxable income of $300,000 (MFJ) and Non-service business
  • Allocable share of taxable business income of $100
  • Allocable share of W-2 wages = $20
  • Allocable share of unadjusted depreciable income producing property = $15
  • Deduction is equal to 20% of QBI – $20

 

Example 2:

  • Taxable income of $650,000 (MFJ) and non-service business
  • Allocable share of taxable business income of $100
  • Allocable share of W-2 wages = $0
  • Allocable share of unadjusted depreciable income producing property = $500
  • Lesser of: 20% of QBI = $20 or greater of: 50% of W-2 wages = $0 or 25% W-2 wages plus 2.5% assets = 0 + 12.5 = 5
  • Deduction is limited to $12.5. The $12.5 capital intensive calculation is greater than the $0 wage calculation above. In addition, the $12.5 is lesser than 20% of QBI

 

 

Example 3:

  • Taxable income of $650,000 (MFJ) and service business
  • Allocable share of taxable business income of $100
  • Allocable share of W-2 wages = $20
  • Allocable share of unadjusted depreciable income producing property = $15
  • Deduction is $0 due to phase-out rules for service businesses

 

Observations

  • C Corps are attractive for growth companies who pay minimal dividends (all examples above assume C Corp dividends equal to 100% of after tax income)
  • If all profits are distributed annually, flow-through taxation is preferential
  • The flow through deduction for professional service income is greatly reduced
  • Converting from a flow-through to a C Corp or vice-versa could have additional tax and accounting consequences
  • Detailed analysis should be performed on a case by case basis

Our next newsletter will focus how the new tax law impacts the various types of flow through businesses differently despite nearly identical fact patterns. If you have any questions on how the new tax laws will affect your business, contact an Anders advisor.