Two short weeks ago, we dissected perhaps the most widely-anticipated but least-understood aspect of the Tax Cuts and Jobs Act: the new deduction available to business owners. As a reminder, under the new law, after January 1, 2018, the owner of a:
- sole proprietorship reported directly on Schedule C
- rental activity reported directly on Schedule E
- S corporation, or
…is entitled to take a deduction equal to 20% of the “qualified business income” earned from the business.
Qualified business income is best thought of as the ordinary, non-investment income of the business. Stated in another way, this is the revenue the business was designed to generate, less the applicable expenses. So we ignore things like interest or dividend income or capital gains from the sale of property.
The deduction, however, is limited to the LESSER OF:
- 20% of qualified business income, or
- 50% of the total W-2 wages paid by the business.
There is also an alternative limitation based on the owner’s allocable share of 2.5% of the unadjusted basis of certain business assets, but let’s cast that aside for today.
This “50% of W-2 wage limitation,” however, does not apply, if the total TAXABLE INCOME of the business owner is less than $315,000 for the year (if married, $157,500 if single). There is a short range of income in excess of these thresholds where the W-2 limitation is phased in, but by the time taxable income reaches $415,000 (if married, $207,500 if single), the “50% of W-2 wage limitation” applies in full.
Example: A, a married taxpayer, operates a business as a sole proprietor. The business has one employee, who is paid $50,000 during 2018. The business has no significant assets. During 2018, the business generates $200,000 of income to A, and A’s total taxable income, after deductions, is $215,000. A is entitled to a deduction of $40,000 ($200,000 * 20%). The “W-2 wage limitation” — which would normally be $25,000 ($50,000 * 50%) does not apply because A’s taxable income is less than $315,000.
Assume instead that all facts remain the same, except the business generates $400,000 of income to A, and after deductions, his taxable income if $450,000. In this case, A’s deduction is limited to $25,000, the LESSER OF:
- 20% of $400,000, or $80,000, or
- 50% of W-2 wages of $50,000, or $25,000.
With the basics established, let’s move on. In this post, we spent 10,000 words breaking down the new law, but something has been bothering me of late. In that article, we spent the majority of time discussing how the new deduction allows owners of sole proprietorships, S corporations and partnerships to retain their competitive tax advantage over C corporations, while providing them with a new competitive advantage over employees.
But in those 10,000 words, I may well have buried – or even worse, flat-out ignored, the lede: kick-started by some insightful emails from readers, I started to think about Section 199A differently: how does the new deduction position owners of sole proprietorships, S corporations and partnerships against each other.
The results may surprise you. If we are to interpret Section 199A based on its most obvious reading, the new law will provide anomalous results, rewarding some business types over the other at one level of income, and then reversing those results at a different income level.
Let’s take a look…
Case Study 1: High Income Business With No Outside Employees
Consider the following fact pattern:
- A is the sole owner of a business. In the scenario where the business is held in a partnership, A owns 99% of the partnership with his wife owning the remaining 1%.
- A builds and sells a product.
- A has no employees; rather, he gets by with the help of a few independent contractors.
- The business has no substantial fixed assets.
Assume that in 2018, the business generates $500,000 of ordinary income. Assume further that this is also A’s taxable income on his 2018 return. Let’s look at how A’s deduction varies depending on how he chooses to operate his business:
With income of $500,000 reported on Schedule C, A would begin the process of computing his deduction by simply multiplying his qualified business income (QBI) of $500,000 by 20%, yielding a tentative deduction of $100,000.
The deduction, however, is limited to 50% of the W-2 wages paid by the business. As a sole proprietorship, A cannot pay himself wages, and because there are no other employees, the business has no W-2 wages; as a result, the “50% of W-2 Wages” limitation is $0. In addition, because A’s taxable income is above the top threshold of $415,000, the limitation applies in full.
Thus, A gets no deduction in 2018.
Assume instead, that A operates as a wholly-owned S corporation during 2018. As an owner of an S corporation, there is tremendous motivation for A to forego wages in exchange for distributions, because Rev. Ruling 59-221 provides that S corporation income is not subject to self-employment tax. As a result, every dollar of wages A DOESN’T pay himself saves him 15.3% in payroll tax (up to the Social Security wage base; 2.9% after that).
The IRS is wise to this game, however, so A knows he must pay himself “reasonable compensation” or else end up staring down the barrel of a painful audit. As a result, he pays himself $125,000 in wages during 2018. This reduces his flow-through income from $500,000 to $375,000.
In computing qualified business income, Section 199A(c)(4) provides that QBI does not include “reasonable compensation paid to the taxpayer.” This has been widely interpreted — and I have shared the same view — to mean that the $125,000 of wages A receives and reports on his Form 1040 are not included in his calculation of QBI and are thus not eligible for the 20% deduction.
As a result, the popular view is that A’s QBI is $375,000, and his tentative deduction is $75,000.
The deduction is limited, however, to 50% of the W-2 wages paid by the S corporation. In this case, to comply with the reasonable compensation requirement, A was paid a salary of $125,000. As the sole owner, A’s share of the wage deduction is the full $125,000, and his 50% limit is set at $62,500.
Thus, A is entitled to claim a deduction of $62,500, equal to the LESSER OF:
- his QBI deduction of $75,000 ($375,000 * 20%), or
- his W-2 limitation of $62,500 ($125,000 *50%).
Assume instead, that A operates as a partnership, in which he owns 99% and his wife owns the remaining 1%. Because all partnership income is generally subject to self-employment tax (except for limited partners under Section 1402(a)(13)), there is not the same motivation for A to forego wages in exchange for distributions, as he will pay the full payroll tax on all of his income, regardless of how it gets to his hands. Furthermore, as a partner in a partnership, A generally CAN’T pay himself wages in accordance with Revenue Ruling 69-184, and instead, is compensated for his services by means of a “guaranteed payment” under Section 707(a) or Section 707(c).
Assume A pays himself a guaranteed payment of $125,000 in 2018, the same salary he drew in the S corporation scenario. This reduces his flow-through income from $500,000 to $375,000.
In computing qualified business income, Section 199A(c)(4) similarly provides that QBI does not include “any guaranteed payment…paid to a partner for services.” As with the S corporation wages, this has been widely interpreted to mean that the $125,000 of guaranteed payments A receives and reports on his Form 1040 are not included in his calculation of QBI and are thus not eligible for the 20% deduction.