[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:
- 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.
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.
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.
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!