[Update after publication: The original post included an error which affected a great deal of the post and its recommendations. It has now been corrected and updated. The original post stated that the “50% of wages” limitation applied to service business owners with a taxable income under $157,500 ($315,000 married. That is not the case. I apologize for the error.]
The Tax Cuts and Jobs Act of 2018 (TCJA) established a brand new deduction that professionals and business owners need to be aware of. Unfortunately, they made it quite complicated, making that task somewhat difficult. In this post, I'll boil it down to what you need to know about the deduction.
The deduction reduces the tax due for owners of pass-through businesses, which basically means any self-employed business that is not a C corporation. That means sole proprietorships, partnerships, S Corporations, and LLCs taxed as sole proprietorships, partnerships, or S Corporations. The reason for this deduction is that C corporations received a monstrous tax cut, when the maximum corporate tax rate was cut from 35% to 21%. This tilted the playing field in the business world, providing an advantage that did not previously exist to C corporations at the expense of their competitors structured as pass-through entities. This deduction is designed to help even out the playing field.
Size of the Deduction
The deduction is 20% of your Qualified Business Income (QBI). QBI is ordinary business revenue minus ordinary business expenses, i.e your profit. Remember that wages paid to you by your S Corporation are not QBI- they're an expense to the business, not business income.
How much of that 20% you get to take as a deduction may depend on as many as four factors:
- The nature of the business
- The taxable income of the business owner
- How much the business pays its employees
- How much property the business owns (in a few situations)
The Nature of the Business
Let's start with the nature of the business. There are basically two categories here: a personal service business and a non-personal service business. If the business is a personal service business, the deduction is eliminated at higher incomes. A non-personal service business does not have its deduction limited at higher incomes. What are personal service businesses? If you're reading this blog, there's a very good chance at least one of your businesses is a pass-through personal service business. In general, they're talking about high-income professionals like:
- Physicians
- Attorneys
- Veterinarians
- Podiatrists
- Optometrists
- Chiropractors
- Accountants
- Financial advisors
- Consulting firms
- Professional athletes
Interestingly, engineers and architects are specifically excluded.
The Income of the Business Owner
Assuming you own a personal service business, your income determines whether you qualify for the deduction. In 2018, the defining income is a taxable income (line 43 on the 1040) of $157,500 ($315,000 married.) The deduction phases out from $157,500 to $207,500 ($315,000 to $415,000 married). In addition, the deduction is also limited to 20% of the taxpayer's taxable income, so if all of the household's income is QBI, then any deduction you take will reduce the size of the pass-through deduction.
How Much The Business Pays Its Employees
The deduction may be reduced by how much the company pays its employees, but only for high-income business owners (i.e. taxable income over $157,500 ($315,000 married). In that case, the deduction is the lesser of 20% of QBI OR 50% of what the business pays its employees in wages. This is unlikely to be a factor in a company with a low profit margin and a lot of employees. That business owner will likely just get the 20%. However, a company with a high profit margin and few employees may be severely limited. In fact, a company with no employees at all (such as a typical physician sole proprietor paid on a 1099,) will get no deduction at all because 50% of $0 is, well, $0.
How Much Property the Business Owns
Alternatively, and again only for high earners, instead of having the deduction reduced by the 50% of wages rule, it can be reduced by 25% of wages AND 2.5% of the basis of the business's qualified property. The larger of the 50% of wages or the 25% of wage + 2.5% of basis is the maximum deduction, up to 20% of QBI. This “basis rule” would apply to a business with a great deal of property, such as a real estate investing business.
This flowchart may help you understand how to apply the various rules.
The Nitty-Gritty
Now that we've discussed the rules, let's talk about how they could apply in a few situations common among readers of this site. Then we'll talk about some strategies now available due to these new rules.
The Hospitalist
Okay, let's consider a hospitalist with a taxable income of $200,000 married to a stay at home parent. The hospitalist is an independent contractor paid on a 1099. She has no employees. How large is her deduction? $40K, 20% of the taxable income.
The Employed Physician
Consider an academic pediatrician with a taxable income of $150,000. He is an employee of the university hospital. What is his deduction? $0. He doesn't own a business and this is a deduction for business owners.
The Private Practice Internist
Now let's consider an internist who is the sole owner of his practice, structured as an LLC taxed as a sole proprietorship. He is married to a stay at home spouse and the couple has a taxable income of $200,000. Well, since the couple's taxable income is less than $315,000, he qualifies for the whole deduction. 20% of the taxable income of $200K is $40K. The other limitations do not apply since taxable income is under $315K married. Note that the QBI is likely quite a bit higher than $200K.
The Private Practice Internist with a Partner
The same internist as above takes on a partner. The LLC is now taxed as a partnership and they split hours, call, and profits 50/50. So when the internist and his wife go to do their taxes, the limiting factor is still the taxable income of $200K, so the deduction is $40K. The other partner's husband is a radiologist and their taxable income is $500K. That couple doesn't get a deduction.
The Internists Hire a Doc
The internists have decided to hire a doc. They're going to pay him a salary of $200K. The practice is getting busier and the doc works hard. The QBI of the business rises to $700,000. The first partner couple now has a taxable income of $250K. The second partner couple now has an income of $550K. The first partner's allocable share of QBI is $350K. 20% of $350K is $70K. However, the deduction is limited to 20% of their taxable income, or $50K. The other partner married to the radiologist still doesn't get a deduction, and of course the third doc is an employee and so doesn't qualify for the deduction.
My Practice
Let's say I make $250K at my practice, taxed as a partnership. My allocable share of QBI is $250K, my allocable share of wages is $50K and no property is owned by the practice. Unfortunately, my wife and I have this other business, which raises our taxable income to $1 Million, well above the $415K limit. So we get no deduction from the $250K of QBI from the practice. Without WCI, we would have had a deduction of $50K.
My Side Gig
Let's say the QBI for WCI, LLC (taxed as an S Corp) is $800,000. Since that is more than the $315K limit, the 50% of wages rule will apply. There are only two employees, Katie and I, and total wages are $300,000. It is NOT a service business (it sells ads and books), so the $315K-$415K limit does not apply, and owns almost nothing for which there is a significant basis, so we'll ignore the 25% of wages + basis rule. What is the deduction? 20% of $800K is $160K. 50% of wages is $150K. The deduction would be $150K.
I hope those examples are helpful to you in understanding the rules. Now let's get into some strategies you may be able to employ in order to lower your tax bill.
Strategies to Maximize Your Deduction
# 1 Change from Employee to Independent Contractor
Take a doc married to a non-earner. Let's say she makes $250K as an employee. She talks her previous employer into contracting with her new business instead of employing her as a person. Since she'll be covering the benefits and the employer share of the payroll taxes, she successfully negotiates payments of $300K per year. Perhaps their taxable income is $200K, which is the limiting factor on their pass-thru deduction, which is 20% of taxable income, or $40K. However, she does have to pay some additional payroll tax. But instead of paying 1/2 of the payroll tax on $250K ($11,604), she pays all of the payroll tax on $200K ($21,759). However, she gets a deduction for half of that, or $10,879. Overall, she pays an extra $10,155 in tax and gets an extra $40,000 as a deduction. Assuming a marginal tax rate of 29% (24% federal + 5% state) that deduction is worth $11,600. This strategy has resulted in lowering her tax bill by $1,445. PLUS, don't froget that the employer paid her more due to her savvy negotiating. If you assume the old employer covered that extra $10,155 in taxes, she really came out $21,755 ahead by becoming an independent contractor.
# 2 Hire Employees
Although this doesn't apply to service businesses if your taxable income is under $157,500 ($315K married), non-service businesses over that limit could potentially increase their deduction by hiring or paying employees more due to the 50% of wages rule. This could incentivize you to hire employees instead of bringing on partners.
# 3 Lower Your Taxable Income
Here's another strategy. Remember that the income limitation on service businesses is based on the taxpayer's taxable income. If your taxable income is anywhere close to the $157,500-$207,500 ($315-415K married) limit, reducing it can give you a significant deduction. What are good methods of reducing your taxable income? Well, you not only have deductions available that reduce your adjusted gross income (above the line deductions like contributing to tax-deferred retirement accounts and HSAs) but also below the line deductions such as contributing to charity (or a donor-advised fund) assuming you itemize. Those are always good ideas to lower your tax bill, but they're even better ideas if you are anywhere near those limitations on this deduction.
# 4 Raise Your Taxable Income
Of course, just to keep things complicated, RAISING your taxable income can also increase the size of this deduction if you are limited by the 20% of taxable income rule. So much for simplifying the tax code.
# 5 Get Rid of the Service Business
If you ever needed motivation to get out of medicine and do some other kind of non-service business, it's an even better idea now. Did you see the anticipated deduction for WCI, LLC above? A plastic surgeon making WCI kind of money doesn't get that deduction. However, realize that extra income from a side gig could eliminate the deduction from your practice if it boosts your taxable income too much.
# 6 Stay at Home Parent
The tax code has always favored a couple where one member is not working. Now, in some situations, this could be even more favorable thanks to this deduction. Many two doc couples will be phased out of the deduction where just one of them might still get it.
# 7 Pay Yourself More
If you're a non-service business S Corp, and your deduction is limited by the wages you're paying yourself, consider paying yourself more. The downside to that is you pay more Medicare tax, so you have to take that into account when making the decision. This is a big deal for Katie and I, so I thought I'd do some calculating.
Let's say WCI, LLC makes $1.5M this year. What is the ideal amount we should pay ourselves to minimize our taxes? For every dollar we pay in wages, our QBI goes down and our Medicare tax bill goes up, but our deduction goes up. Our marginal tax rate is going to be somewhere around 42%.
So if we paid ourselves $300K, we'd have a QBI of $1.2M and a Medicare tax bill of $8,700. Our deduction would be the lesser of $240K or $150K. After applying our marginal tax rate, the deduction would be worth $63,000, for a savings of $56,127 (remember part of the Medicare tax is a deduction).
What would happen if we paid ourselves $500K instead? The QBI would drop to $1M and the Medicare tax bill would rise to $14,500. So the deduction would be the lesser of $200K or $250K. Our wages are now clearly too high, since we're limited by the 20% of QBI rule and paid those extra Medicare taxes for nothing. The optimal answer is somewhere between $300K and $500K.
I'm sure a better mathematician than I could write an equation to sort this out. But let's try $400K. At $400K, 20% of QBI would be $220K and 50% of wages would be $200K and the Medicare taxes would be $11,600. Total tax savings would be $74,836. That's going to be pretty close to optimal for us, especially since we're going to have to choose what we'll pay in wages before knowing exactly what the QBI will be for the year.
Bottom line, by paying ourselves $100K more, we reduced our tax bill by about $19K.
I hope that explanation of the pass-through deduction is helpful for you. I'm sure there are lot of strategies out there that I haven't even thought of. For example, some are wondering if doctors will now form co-ops, which are not technically personal service businesses. It will be interesting over the next few years to see all the ways people come up with to increase this deduction.
What do you think? What other strategies have you thought of to maximize this deduction in order to lower your tax bill? Comment below!
Helpul post, Jim.
My main side hustle income for now is actually through medical expert witness consulting, which (unfortunately) also looks like will be categorized as a “personal service business.” Is this your understanding, too?
Second question, do you think there is a number where incorporating to an S Corp from an LLC starts to make more sense in the setting of this new tax code?
Not that I needed it, but this does give me more ambition to keep my website going as well to get that income up as it would not be categorized this way and the tax benefits seem much greater from your post. I’ll stick to being an LLC until that point, though, just to keep it simple.
TPP
1) Yes.
2) Highly dependent on everything else. I mean, if you’re married to a radiologist then what’s the point of incorporating your hospitalist practice?
Fair enough. I am not married to a radiologist. Part-time teachers don’t make quite as much 🙂
What if the doc with the radiologist spouse files married filing separately?
You need to run the numbers. You may be losing money on the MFS but gaining it on the pass-thru deduction. Hard to say which one would be larger, very individual. But it’s easy with software to hit the “MFS” button and see if you come out ahead.
Great post about a confusing topic.
Is it your understanding that W2 income and LLC 1099 income (minus expenses and applicable deductions) are combined as far as the phase out is concerned for the side hustle ?
Yes, it’s based on taxable income on the 1040.
Thank you.
Darn it.
That is NOT my understanding. I believe W-2 income is specifically excluded.
Based on other posts on this page, this distinction appears to be something that many are trying to understand as well.
Particularly applicable given that many of us are employed as W2 earners in larger groups but also have our own solo-owned-and-operated S-corps for side hustle consulting or medicolegal.
If the phase out is based not only on wages/distributions from the S-corp but ALSO the W2 income from the primary job then many of us will not see as high a benefit, if any.
For the purpose of figuring out whether the “specified service business” or the W2/basis phaseouts apply, it is taxable income that matters. This means W2, spousal income, 1099’s, K1’s, farm income, dividends, etc, minus deductions.
I made an assumption that 1099 income was also from a specified service business (i.e. phyisician income). If not, then the answer may be different. That’s what I get for making assumptions.
Best,
-PoF
POF-
Thank you. I should have been more clear. I agree that if both W2 and 1099 income are both physician services, that would make since. As stated by Pathbrat, many are W2 earners and have a side hustle that’s not specifically clinical care (e.g. legal work). In that case the W2 income may be excluded.
Just now circling back to this article post-the updates WCI made. I’m now totally confused about whether W2 income counts toward one’s total taxable income. In my case, I’m a professor, paid around 155K from my university (W2 income). I also have a professional speaking and consulting business (side hustle) that has generated 160K this year. My wife also makes some money (but not much – she’s mostly a stay at home parent), and I believe that after my SEP IRA contributions and business expenses we’ll come in under 315K. But are you saying that my W2 income may be excluded. This is so confusing! Thanks to you and WCI for helping me (try to) make sense of this complicated issue.
The applicable deduction for QBI is based on each business individually, although the phaseouts are determined by TOTAL taxable income for the filing unit (individual or MFJ). This includes W2 income, 1099 income, K1 income, dividends, etc.
An individual who owns multiple businesses can have an applicable deduction for none, one some or all of them depending on the details. See WCI’s example about himself. No QBI deduction for being a doctor (total taxable income too high, service business) but large QBI deduction for WCI, LLC (not a service business, has W2 employees).
One of the upshots of this is that physicians who own medical-related businesses that can credibly be categorized as non-service (owning physician offices, imaging centers etc) keep more money from their side hustle than their main job due to this change in the tax code.
If I understood the post and the examples, my moonlighting business (sole proprietorship reported on Schedule C) earns NO deduction.
“However, a company with a high profit margin and few employees may be severely limited. In fact, a company with no employees at all (such as a typical physician sole proprietor paid on a 1099,) will get no deduction at all because 50% of $0 is, well, $0.”
I am the only “employee”. How do I not count as an employee? It seems I would need to become an S Corp and pay myself a salary to be an employee? Looks like I have some reading to do on S Corp.
I have a W2 job that pays $300,000. I have moonlighting that earns another $160,000 (on <$10,000 of expenses as the hospital pays my malpractice) giving the side business a profit of about $150,000…no deduction? I guess I could hire my wife as the book keeper and then she would gain access to a backdoor Roth. Wouldn't the IRS look askance at paying a salary to a spouse "all of a sudden" based on new tax law?
Can my W2 employer make me an independent contractor? Maybe. He has offered it to me in the past. For example, he paid me $250,000 in 2011, but offered me $275,000 as an independent contractor. I figured with the family health insurance, paid malpractice (with a tail which cost him $10,000 when I left) and the self employment tax hit, these outweighed the extra money.
Looks like my situation does NOT improve with the new tax law, unless I get out of the "service business" and start a new business type altogether. Depressing post, but well written and helpful. Docs on SERMO think their 1099 income will get the break if their taxable income is lower than $315,000 (or above this with the phaseout).
Good job helping simplify a complex topic! One point I noticed… It’s my understanding that the wages limitation only applies to high income taxpayers above a threshold similar to the service Business phaseout. Believe i read it here – https://www.kitces.com/blog/pass-through-business-deduction-rules-qualified-business-income-qbi-limits/
Insightful, thanks. I’m left wondering about how the deduction applies strictly to rental property. For example, consider if your hospitality or employed physician went down PIMD’s path and bought an apartment building. From the initial description and flow chart it appears as though the “non personal services” business rules apply, where QBI would be the after expenses distribution of rental profits and the deduction limited by 2.5% of the property basis. Right?
Good question. I think it depends on whether the money from the real estate business is earned income (i.e. are you a real estate professional) or is it rental income (i.e. you’re a doc who happens to own an apartment building you spend 50 hours a year on.)
There is disagreement among tax professionals whether you need to be a real estate professional to take the deduction or not. No guidance from the IRS so far. My interpretation at this point is that yes, you could take the deduction if applicable, however that is just my opinion.
I tried putting this article off for a while so things like that could be clarified, but few were. It will probably be worth hitting the subject again this Fall when the IRS comes out with its clarifications.
I asked this months ago, but things were still hazy, can someone please confirm my understanding?
Non working Spouse. My group is an S Corp. I am a partner. we get 100k in distributions from the s Corp. we get another $200k in W-2 income from the company as Salary.
If I understand correctly I will see about a 5% deduction on the distributions but NOT on the salary the company pays, so about a $5000 deduction?
Thanks!
To me, that looks like $100,00 in QBI with $200,000 in wages, assuming you’re an equal partner.
I would expect you to receive the smaller of [20% of $100,000 = $20,000] or [50% of200,000 = $100,000]. So a deduction of $20,000. This assumes that all partners have equal pay scales and there are no other employees. It’s probably a bit more complicated than that, but “The Private Practice Internist with a Partner” example above is a good outline.
Best,
-PoF
Thanks.
Unfortunately we have 6 office employees that make 30-90k. We also have half time partners and partners that work extra. 50 total partners and employees.
Getting too complicated? Was 2017 my last year with TurboTax?
Todd
Maybe, maybe not. I don’t see why Turbotax couldn’t handle this deduction.
Sounds about right to me.
Your taxable income will fall below the $315k MFJ threshold (assuming no significant other sources of income you haven’t mentioned). You would then be eligible for the full 20% deduction. The number of other partners, employee W2 income doesn’t apply to you if you are under the $315k MFJ threshold. Therefore, your deduction is 20k. Accordingly, it’s in your financial interest to lobby the other partners to reduce partner W2 income and increase distributions accordingly, since it gives you a bigger deduction.
Gotcha, and thank you. I will lobby for more distributions.
If I went over the 315k taxable due to unanticipated income, I thought the impact is proportional as described in the phase out? Why would our employees and half timers matter in that calculation?
PULMDOC, you sound pretty savvy about this topic, so I’ll ask my question again of you (in the hopes that someone can help me determine whether I’ll get the deduction!).
Just now circling back to this article post-the updates WCI made. I’m now totally confused about whether W2 income counts toward one’s total taxable income. I’m a professor, paid around 155K from my university (W2 income). I also have a professional speaking and consulting business (side hustle) that has generated 160K this year. My wife also makes some money (but not much), and I believe that after SEP IRA contributions and business expenses we’ll come in under 315K. But are you saying that my W2 income may be excluded. This is so confusing! Thanks to you and WCI for helping me (try to) make sense of this complicated issue.
Yes, W-2 counts toward total taxable income.
You say sole proprietorships are included and then you say they are excluded because they have no wages. Conflicting, no? The wage limit is not for those under the service business inclusion (under $350k MFJ).
See: https://www.physicianonfire.com/tax-reform-physicians/
“50% of your nonservice S Corp W2. This does not apply to those with only doctor income. Those below the taxable income limit are exempted from this wages calculation and those above the taxable income are excluded from this deduction.”
Yes, this has been my understanding as well. If in a specified service business (such as medicine), if taxable income is below the wage limit (phases out between 315-415K Married Filing Joint), then the 20% deduction is available. It is NOT limited by the wage and/or property basis restrictions.
The flow sheet is not correct (unless something has changed in interpretation of the new law).
From the site linked by another poster:
Phase-in of Wages and Wages & Capital Limitation
The wages or wages plus capital limitation does not apply to taxpayers with taxable income not exceeding $315,000 (joint filers) or $157,500 (other filers). The limitation is phased-in for taxpayers with taxable income exceeding these amounts over ranges of $100,000 and $50,000, respectively. For example, H and W file a joint return on which they report taxable income of $375,000. W has a qualified trade or business that is not a specified service business, such that 20 percent of the QBI with respect to the business is $15,000. W’s share of wages paid by the business is $20,000, such that 50 percent of the W-2 Wages with respect to the business is $10,000. The business has nominal amounts of qualified property such that 50 percent is W-2 Wages is greater than 25 percent of W-2 Wages plus 2.5 percent of qualified property. The $15,000 amount is reduced by 60 percent (($375,000 – $315,000) / $100,000) of the difference between $15,000 and $10,000, or $3,000. H and W take a deduction for $12,000.
Will research again and correct if wrong.
I’m glad I’m not the only one that was thinking this might be incorrect. From everything I had read up until this point it would seem sole proprietors would be eligible for the deduction. Any accountants out there that can chime in?
My understanding was that sole proprietors WERE eligible but that the wage limitation still applied. But I could be wrong (certainly several people think I am.) Will research and correct prn.
Okay, looks like you guys are right. The 50% of wages rule doesn’t apply under the $157,500/$315,000 limit. Correcting the post (and chart now).
Great news. Thank you for your hard work on all of this. In doing my own research it is definitely a very complicated subject even just trying to figure it out for my own personal situation. I commend you for trying to figure out all the various situations. Now I just gotta make sure I stay under $315k 🙂
Thanks for changing this! Love your blog! I know many docs follow you religiously like I do so I wanted to share the good news. Hence the post with POF.
Just gotta update the chart. Man, that one little error affected 3/4 of the paragraphs in this post.
*315k (not sure how 350k was typed)
Good question. Certainly I wouldn’t be surprised if I were wrong on some aspect of this complicated topic. Certainly Dr. Elseroad disagrees with me. I’ll try to do more research to confirm this point.
Jim,
As usual, excellent post. Here’s my specific situation,
Both wife and I are physicians, we employed part-time Hospitalist’s and also have a 1099 income on the side as Hospitalists moonlighting at another hospital.
Combined w2 income- taxable ~$250k
Combined 1099 income- taxable $150k roughly
Any way to use this deduction? We don’t have any business entity set up, we are sole proprietors I guess…..
All the 1099 income is from a specified service business, so you’ll be subject to the phaseout between a taxable income of $315,000 and $415,000.
My understanding is that if you can get taxable income (after standard or itemized deductions and tax-deferred retirement contributions, etc…) down close to $315,000 while having $150,000 in 1099 income, you could have a deduction of up to $30,000, worth about $7,200 in the federal 24% bracket (with additional savings on applicable state income tax).
You do not need any formal business entity. As you stated, you are sole proprietors.
Best,
-PoF
Since you’re approaching a taxable $415K you would be almost completely phased out anyway, but I think the issue you’ll run into is a lack of W-2 wages being paid from your business.
I had emailed PIMD just this weekend after attending a lecture by a CPA discussing QBI and the new tax law. Another accountant/friend send me two interesting links on this topic:
https://www.bdo.com/insights/tax/federal-tax/tax-reform-and-section-199a-deduction
and
https://www.irsmedic.com/blog/2018/01/tax-reform-what-is-qbi.html
I appreciate all the examples given on application of QBI.
My understanding of the articles is that we can still use Schedule A and C to itemize to arrive at the taxable income (line 43) and then apply the rules of QBI.
Keep up the detailed posts.
It also my understanding that the wage limit (for the nonservice businesses with >315k MFJ that it applies to) does not include wages you pay yourself to prevent the scheme you mention at the end.
Really? That would be a bummer. I don’t have an S-corp for my side gig this year, but am considering it for 2019. I would guess that would also exclude wages paid to a spouse on an MFJ tax return. Do you have a reference?
Best,
-PoF
Not 100% sure but the definition of W2 wages is on the bottom of page 27 and top of 28 but refers to the old tax code. But is the language of including only employees. I am not sure you can call yourself employer and employee of same business (despite your W2).
Either way WCI has declared sole proprietorship basically excluded. The point of the article written with you was “don’t do anything”. WCI seems to indicate: “oops should have told you to form s corps as soon as this law passed”.
Sure, you can be both employer and employee. I am. S Corps do that all the time
I have NOT declared sole proprietors excluded. I’ve declared sole proprietors without employees excluded, and even that may be wrong. Give me a few minutes to do more research.
From page 28: ‘‘(B) LIMITATION TO WAGES ATTRIB-
6 UTABLE TO QUALIFIED BUSINESS INCOME.—
7 Such term shall not include any amount which
8 is not properly allocable to qualified business
9 income for purposes of subsection (c)(1).
Page 32: ‘‘(4) TREATMENT OF REASONABLE COMPENSA-
20 TION AND GUARANTEED PAYMENTS.—Qualified busi-
21 ness income shall not include—
22 ‘‘(A) reasonable compensation paid to the
23 taxpayer by any qualified trade or business of
24 the taxpayer for services rendered with respect
25 to the trade or business,
So since your reasonable compensation (w2) can’t count as QBI it doesn’t count as part of the W2 for the QBI deduction calculation.
W2 isn’t included as QBI because it is a business expense and thus lowers QBI. Any given dollar can be a wage or a QBI but never both. S-corps have long been used for an owner to also treat themselves as an employee as there have been benefits before this new 199 deduction.
Excellent post. As Larry mentioned, how does the pass-through deduction apply to rental properties? Is it better to place your rentals in an LLC to qualify for the deduction?
I don’t think the LLC makes a difference. Same rules apply to a real estate sole proprietorship. Here is a post from Stephen Nelson that might help.
https://evergreensmallbusiness.com/real-estate-investor-sec-199a-deduction/
Thanks for the information Larry.
I am semiretired doing only locum tenens as an independent contractor through recruiting agencies. I am not incorporated. Isn’t the income I make considered wages to myself?
No, but hold on….I may be wrong on this point that you need wages.
I may have missed your final answer in this dizzying list of comments. Can you take the 20% deduction off of a 1099 (Sole Proprietor with no wages) of say $50k and all income ( W2 + 1099) is less than $313k?
Married? Yes. Cool huh?
Great stuff. I am GP dentist with sole prop status (LLC). Have plenty of staff wages. So I am assuming at this point I should not switch to corporate status as as a sole prop my QBI will be much higher?
I don’t think the incorporation decision should affect this decision. Have you read the post since I updated it?
If I began taking a reasonable W2 salary vs all income as pass through wouldn’t this drastically reduce my QBI? For example operating profit of 300 K results in 60K deduction but @ 200K W2 salary deduction would be 20K .
I can’t tell from your comment if you’ve read the updated version of the article or not.
Increasing wages does decrease QBI. Bear in mind, this only applies to non-service business owners with a taxable income over $157,500 ($315,000 married).
I posted a question about this on another site and it seems this issue of whether you are out of the deduction if you are a sole proprietor on the side with 1099 income is the question that applies to my situation: W2 income main job, and 1099 moonlighting income as sole proprietor,and whether I must be an S corp to avoid the “wages to employee” issue.
I hope I get to deduct 20% of my TBI. I put a bunch of scenarios through with a Trump Tax calculator online and it seems that if my taxes are lower, it will be due to the “children under 17 tax credit”.
No. My original article was mistaken. For a service business and a taxable income under $157,500 ($315K married), the 50% of wages rule doesn’t apply.
It is not the wages but the actual QBI. If i pay myself as a W2 employee a reasonable salary wouldn’t this drastically reduce the profit that counts as QBI?
Yes, and in fact there could exist a situation where it makes sense to dissolve a corporation and go back to being a sole proprietor if this deduction is larger than what you’re saving on Medicare taxes.
Really appreciate this post, thank you. In response to this comment about dissolving a corporation: this is exactly what was occurring to me reading your post. I’ve currently got an S-corp but would clearly save more by becoming a solo proprietor and increasing my QBI by getting rid of my W2 to myself. I will make sure I have less than $315K in AGI (MFJ). So my question is: does it matter when I do this or am I covered as long as I get rid of the business by end of the year? Currently my 1099s are going to my S-corp business and I’m being paid on a W2 from my S-corp.
Also, how does one go about the logistics of this? Do I just call up the groups I work for (that my one person business works for) and have them start issuing 1099s to me with my personal SSN and then tell my state that my business no longer exists? This is so confusing but I don’t want to miss out on having less taxes taken from me because I waited to long to do this.
You don’t have to get under $315K in AGI, just in taxable income.
It might get kind of complicated calculating this deduction if you had an S Corp for part of the year. Might be easier to dissolve it on 12/31.
But yes, you can have them start paying you as a sole proprietor right away if you like, and you can dissolve the S Corp whenever you like.
Ok got it, thank you. So I guess that means the sooner I dissolve the business the better since it seems like as as long as the 1099s are going to the business that money that I’m paying myself as a W2 wouldn’t be QBI and I’m missing out on 20% tax deduction. I was hoping I could somehow make it retroactive for the calendar year but I guess not.
My solo 401K contributions are t effected are they? I contributed $18,500 as an individual and $36,500 as a business in Jan. Can I still count that $36,500 business contribution as part of my now solo proprietor business?
I know you can make the S Corp declaration retroactive a few months, but I don’t think you can do that on the dissolving side. Could be wrong though. You should double check that.
Yes, sole proprietorships can still use an individual 401(k). New business new individual 401(k) though. Of course you’ll need a new EIN.
Thanks for the breakdown of this complicated subject. I’m an anesthesiologist earning 350k and my husband is a surgeon earning 400k, both W2 employees. We live in NY and are heavily taxed on our income. I have the opportunity to be paid as independent contractor (as in your example), but given our high incomes would we benefit from converting my income to 1099 and taxed as an S corp? How would the numbers look? How much income would i need as 1099 to have any benefit over W2 wages? (my employer covers my malpractice at about 30k, gives me 12K (pretax) for health, has a non-matching 401K set up, an HSA, and gives me about 25K in profit sharing benefits that go into a non-prototype retirement account with Fidelity.) Thanks for your input WCI.
I don’t think you’re going to benefit from doing anything to try to get this deduction because it is unlikely you’ll get your taxable income below the limit for service businesses.
Also, re-read the post since I updated it. No point in incorporating just to get this deduction.
That doesn’t mean incorporating isn’t worth it to reduce your Medicare taxes though. Basically, the calculation to determine whether to incorporate is whether the saved Medicare taxes are more than the hassle and costs of incorporating.
The calculation to determine how much more you need to be paid as an IC instead of employee is IC pay must be equal or greater than your wages, plus extra payroll taxes paid (be sure to include deduction for half of it), plus the cost of buying your own benefits.
YES – been waiting for this – very very helpful!!
As always – JustSayin’
Are we sure that for the sole proprietor/ LLC / S Corp individual physician that his/her wages don’t count as “employees’ wages” for the purposes of providing a deduction floor above $0?
For instance the solo S Corp physician may generate a W-2 and has “wages.”
I’m referring to your paragraph: “However, a company with a high profit margin and few employees may be severely limited. In fact, a company with no employees at all (such as a typical physician sole proprietor paid on a 1099,) will get no deduction at all because 50% of $0 is, well, $0.”
In this case, it would be possible to make a calculator to figure out the ideal income to pay the employees and to have as leftover QBI to maximize the deduction. Was looking for just such a calculator on PoF website a while back.
Did you read the updated version? Be aware the 50% of wages issue only applies to high earners, and not service companies.
Confused by this:
“What would happen if we paid ourselves $500K instead? The QBI would drop to $1M and the Medicare tax bill would rise to $14,500. So the deduction would be the lesser of $200K or $250K. Our wages are now clearly too high, since we’re limited by the 20% of QBI rule and paid those extra Medicare taxes for nothing. The optimal answer is somewhere between $300K and $500K.”
Wait, so the limitation is 20% of taxable in this example (1M = 200K). So marginal rate *.42 = 84,000 which is better than the 63K deduction previously. How is this a upward max/border case? I’m sure I’m missing something…
Those wages don’t count toward QBI, so as your wages go up (minimizing the 50% of wages rule effect) your QBI goes down (decreasing what 20% of QBI is.)
Understood, but did I calculate it right based on flow chart? You’d be getting 84K deduction (minus whatever medicare you could deduct)?
It’s not clear to me what you’re trying to do or say. Are you saying there is an error in the post? If so, what do you think the error is?
No error. I was just trynig to understand what you were saying. Read it more and it makes sense. If you have time would you mind laying out how you went in first scenario paying yourself 300K where deductions were 63K -> 56,127 as the final figure (sorry I’m not that great at what you can deduct from medicare and what you can’t). Thanks!
Oh, sounds like you’re just not following the math.
SS tax is 12.4% and Medicare tax is 2.9%. But half is deductible to a business owner. A doc typically has already maxed out their SS tax, so incorporating just saves on Medicare taxes.
So paying yourself an extra $100K in salary means you owe another $2,900 in Medicare tax. But that comes with a $1,450 deduction. Multiplying that deduction by your marginal tax rate (mine is around 42%) would save you $609 on your taxes. So total after-tax cost for calling that $100K salary instead of distribution is $2900-$609 = $2,291. If it increases your pass-thru income deduction by more than that, then you come out ahead.
Thanks WCI. Yea I’m getting upto speed on valid deductions beyond W2 and business world like this year.
Very clear explanation. Thank you.
One more advantage of doctors owning their business instead of being an employee.
Thanks for the summary,
Dr. Cory S. Fawcett
Prescription for Financial Success
My side hustle is in rental property. I currently have 29 units owned through two LLCs. If I’m reading this correctly, my plan to employee my family in some form will actually be detrimental?
Where the heck was the AMA when they were including physicians n the list? The financial impact of physicians on communities is well documented.
I’m not following your argument in the first paragraph, nor can I connect your first paragraph with your second.
Crazy specific question for anyone willing to take a stab at it:
Partners in our group are paid employee salary through a C corp parent company and then distributions are paid through a S corp subsidiary group. This is done for contract negotiation purposes. If all done under one S corp, given employee salaries and distribution amounts, partners would otherwise qualify for 20% QBI deduction. Would partners qualify for the QBI 20% deduction in this parent-subsidiary scenario? The employee salary for the S corp would be $0, but there’s obviously much higher salaries for the parent C corp. Does this depend on how the parent and subsidiary file their taxes?
Interesting set-up. Not sure I understand the benefits of setting it up that way, nor do I know the answer to your question. Better get a pro on that one.
That’s probably what we’ll have to do. It’s set up that way because our practice has several different services, so insurance companies/hospitals can’t leverage one service against another in contract negotiations. From talking around with the group, it sounds like the pay structure had to be set up this way, but I can’t think of why (salary thru c Corp).
My guess is yes the S Corp will be eligible for the pass through deduction as long as you’re under the phaseout limits for specified service corporation. I don’t claim to understand why they don’t just pay you salary from the C corp and then dividends as an owner. C Corp dividends are taxed at more favorable capital gains rates while S corps are taxed at ordinary rates.
The last part of this post explains why it’s more favorable to run your medical practice as a S corp rather than C corp. To make a long story short unless you plan to go public or have over 100 shareholders, or need to retain corporate earnings to buy capital, it makes more sense to be taxed as a S Corp: https://solobuildingblogs.com/2017/12/31/how-the-new-tax-law-affects-solo-practice-doctors/
This is an absolute boon to the independent physician with a non-working spouse:
Income: $375k
Deductions for HSA(6.9K), 401(k)(55K), health insurance premiums for family(17.5K), half of self-employment tax(13K), standard deduction(24K) get me down to 258K
So that lops off another $51K in deductions. That $12,240 at the 24%. Throw in 2 kids so a $4000 credit that I didn’t get last year and the fact that the rates are lower(by as much as 9% where the old 33 overlaps the new 24) and I am saving over $20K in taxes.
Sounds excellent. The child credit will help me also.
I am planning to make ~$50k net (after expenses) on consultant 1099 income this year and am under the $315k married filing jointly, while maxing a W2 401k for $18.5k.
How can I best use an additional 401k/retirement account and the pass through deduction to pay the least tax possible on this income?
For 2018, If you have maxed out the employee elective contribution amount on a W2 workplace 401K, you can either set up a solo 401 on the 1099 and make an employer profit sharing contribution of 25% of gross income in a corporate structure or 20% of net income on a sole proprietorship.
I have been using a SEP-IRA for years on my side income and max it out every year while maxing out the 401K contribution in my W2 income. WCI favors the solo 401 over the SEP. I’ll be opening a solo 401 for the first time in 2018.
Well, you get the pass-thru deduction no matter what you do, but you can lower taxes further by putting about $10K into an individual 401(k).
Which factors in first? 20% of net income into a solo 401 and then 20% pass through on the remainder or the other way around or is it 20% of net income for each?
Yeah. That’s my question, too. In this example of the poster netting $50K in 1099 consulting work, will putting $10K into a SEP-IRA or solo 401K reduce his credit from $12.5K to $10K? If so, and he’s at a 24% marginal federal tax rate under the 2018 tax code, there may not be much benefit to putting that $10K into a retirement account. I’m still very confused about this. On the other hand, if he’s bumping up on $315K (married) income, then an extra $10K in retirement account contribution could keep him from the phaseout zone of $315K – $415K, so it might be a real benefit. Someone told me that the $315-$415 was actually gross income, and wasn’t MAGI. I don’t know whether he is correct, or even whether this is truly known at this point.
It’s not even MAGI, it’s taxable income.
The former. Any amount added to 401k lowers taxable income so it will lower your pass thru deduction, though your taxes will be lower overall.
So the 20% pass through deduction would only be on the $50K 1099 taxable income. Is that correct? The deduction would only be $10K.
it’s 20% of the 50K MINUS 1/2 SE and retirement/health insurance contributions
All of the nonsense surrounding this new tax law makes my head spin.
I am the sole owner of two S corps and one single member LLC. They all could be classified as service businesses, although that is open to some degree of interpretation, in particular for one of the businesses. I also own investment properties as a sole proprietor.
The income taxes are an unfathomable amount, a large multiple of our entire annual spend. I cannot wrap my head around what my next best move is. My longstanding good friend who was my CPA recently retired and my new CPA and I just don’t seem to click. I am not confident in the advice I am getting. I guess what I really need is better advisors. I am busy running things which I enjoy, but this new tax law is such a painful distraction.
Think of how much getting good advice could be worth to you and hopefully that will provide the motivation to spend some of that time you’re spending running these companies shopping around for a competent CPA that you click with.