The Tax Cuts and Jobs Act (TCJA) is significant tax legislation signed into law. This act has interesting provisions that could benefit all taxpayers except C corporations. One such provision allows for a 20-percent qualified business interest income deduction. Shareholders, partners, and sole proprietors can benefit from registering their businesses as S corporations. The provision will expire in 2025.
Some tax planning considerations arise because the benefits of this program are temporary. One concern is maximizing fixed asset expenditures and then accelerating deductions for capital expenditures (see Section 179, which expires after five years). Whether or not you itemize your deductions, this benefit can be taken advantage of. It will reduce the business person’s income tax but not self-employment tax.
Tax Deduction for Qualifying Businesses
The tax law allows for a deduction if the business can qualify. The difference between being an individual or corporate owner will determine what rate of taxes are owed.
Shareholders of S corporations can enjoy the benefits of being eligible business owners. Shareholder wages at this level would not reduce income eligible for tax deductions, but dividends may still be subject to taxes if they have been in existence as C-corporation.
When we talk about who qualifies, there are a few rules. The deduction is typically 20% of business income or less than adjusted taxable income – so an individual may have a type of business that qualifies but won’t get any credit because they don’t earn enough to qualify.
Whether or not wage income qualifies is dependent on the type of service provider. For example, attorneys will typically only receive fees from their clients and not salary because it’s considered self-employment rather than regular work for a company (See IRS guidelines about whether contractors should get wages).
To qualify as a touchstone, one must have business income. This means that the individual and/or their partners need to be reporting any revenue associated with the business’s operations.
Who is Ineligible for This Deduction?
The IRS has guided what types of services are within the definition “non-qualifying” in Regs 1.199A-5. Generally, the following businesses or trades cannot be considered as specified services: law, accounting, health, athletics, trading, financial services, performing arts, etc. This list is not all-inclusive.
“Consulting” is not limited to those who provide training or educational courses, nor includes architecture and engineering. Athletic services include those provided only by performers and coaches for various sports. This can be a tricky area of the law, as it’s not always clear whether consulting services are “ancillary” to an otherwise sale or performance.
Financial services can be an umbrella term for many different things. They include managing wealth, developing a plan to transfer funds into retirement accounts, or afterthought plans like healthcare. It doesn’t, however, cover anything explicitly related to making loans.
The restaurant owner/chef may take a 20% deduction for business income, but they will have non-qualifying service fees that amount to $500K or more.
There are many subtle distinctions when one works through the basic categories of non-qualifying services. The IRS has some regulations that allow non-qualifying services to be treated as qualified. This applies if the income is less than 10% of gross receipts from a trade or business activity. If an organization has more than $25 million worth, then only 5% will apply.
Even non-qualified income can qualify at a lower level with the right strategy. Mid-range earners may obtain some degree of qualification for their work in these areas if they’re willing to put forth an effort and take advantage where possible.