The Tax Cuts and Jobs Act (TCJA) gave the individual taxpayer a reduction in rates, reduced the number of brackets, almost doubled the standard deduction and made all sorts of problems for individuals in high tax states, but this post is not about that side of the law. This post is specifically for the service professional businesses paying owners and employees and whether they received a reduction in taxes.
If your company is taxed as a C corporation, the rates went from graduated rates up to 35%, now to a flat 21%. This huge tax cut is working its way through the economy now as companies decide what to do with that money they were previously sending to Uncle Sam.
However, most service businesses are not taxed as corporations and instead pay taxes personally when filing their personal return. Since the corporate rate was slashed, there had to be a leveling of the playing field for these businesses as well. The IRS created code section 199A for these taxpayers.
Businesses that pass through their income to the owner are known as flow through entities because the income from the company is not taxed at the entity level but instead “flows through” to the owner (on a form K-1) and is then taxed on his/her personal return.
These individuals were given a personal deduction from their businesses because the business does not pay taxes.
Even though these companies don’t pay taxes, they will send through a deduction to the owner of potentially 20% of the Qualified Business Income (QBI). (The TCJA introduced the phrase QBI and this is most basically income less deductions. There are two ways this can be limited below 20% of QBI but generally let’s say 20% of the QBI flows through as a deduction on the owner’s return.)
Sounds good so far, what’s the catch?
There is this enormous catch that is called the Specified Service Trade or Business (SSTB). The QBI calculation and deduction is for those businesses not labeled an SSTB. An SSTB is:
“A trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.”This is being debated throughout tax nerdom as to what business qualifies as an SSTB. Obvious professions included here are optometrists, doctors, dentists, lawyers, actuaries, and accountants. Not so obvious is engineers and architects, despite being service professionals, are not included as SSTB, meaning they do get the deduction.
Now, to make it even a little more tricky, an SSTB does receive a deduction up to 20% of QBI if the taxable income of the owner is below the threshold. If the taxable income is below $315,000 married or $157,500 single the owner will receive the deduction. (The deduction is phased out as income reaches beyond $415,000 married (and half that for single).)
Let’s look at an example.
A married optometrist’s practice is going well. QBI from his business is $200,000. Add that to wages and other sources of income to arrive at taxable income of $300,000. Because the taxable income is below $315,000, he receives 20% of QBI as a deduction, or 20% * $200,000 = $40,000 deduction. This deduction will reduce his income on his personal tax return.
Consider however, all things equal, but the business income is $315,000 and taxable income is a total of $415,000, there is no deduction. Taxable income over the $415,000 threshold will not generate a deduction from the SSTB income to be used when preparing his personal taxes.
This post hardly scratches the surface of this regulation and, while the ink is not yet dry on the updated regulations from the IRS, there are many more headaches ahead. The Tax Cuts and Jobs Act granted most businesses a deduction, but several did not receive one. High earning service professionals will be some of the few businesses who do not receive a deduction.