New law likely to be a bonanza for tax planners

One of the big tax breaks in the new tax law is the deduction for “qualified business income.” This is often called the “pass-through entity” deduction, which implies it is for partnerships and S corporations.

This deduction will actually apply to any non-corporate taxpayer regardless of the form of business. This includes selfemployed “schedule C” filers and even trusts and estates.

The theory of the deduction is this: The 2017 legislation significantly cut corporate income taxes. Most businesses are not run in corporations, so to cut business taxes, there must be some benefit for noncorporate businesses.

This deduction is generally equal to 20 percent of qualified business income.

“High”-income taxpayers may not get the full benefit, or may get no benefit at all for service-related business income. A married filing jointly taxpayer’s income is high if it exceeds $315,000. Others filers are affected if taxable income exceeds $157,500.

This income limit is taxable income, which is after all deductions (other than this qualified business deduction). Since married filers get a standard deduction of $24,000, they can actually have gross income of at least $339,000 with no reduction in benefit.

Single filers can have gross income of at least $169,500 with no reduction ($157,500 plus the $12,000 standard deduction). If taxable income exceeds the threshold amount, the deduction is scaled back, and may even disappear for a service business.

The deduction may be limited in two situations. First, for a business other than a “specified service business,” if the taxpayer’s taxable income exceeds the threshold amount, the deduction may be reduced to a separate limitation based on either business W-2 wages or a combination of W-2 wages and business capital.

This wage or wage/capital limitation is the greater of (1) 50 percent of the W-2 wages attributable to the business, or (2) the sum of 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of tangible assets used in the business.

If the wage or wage/capital limitation exceeds the 20 percent of qualified business income limit, there is no reduction even for high-income taxpayers. This is so because the overall deduction may never be less than the wage or wage/capital limitation.

As taxable income exceeds the threshold (e.g., $315,000 married filing jointly), the otherwise allowed 20 percent of qualified business income deduction is reduced until it hits the wage or wage/capital limit. This occurs when taxable income is $415,000 or more (again, married filing jointly).

Specified service businesses have a similar reduction, except the deduction becomes zero when income hits the end of the phase-out range ($415,000 married filing jointly, $207,500 otherwise).

I know this is a mess at this point, so let’s review some examples. First, you have a restaurant business that produces $200,000 of net business income. Your total taxable income for 2018 is $300,000, and you are married filing jointly.

You get a deduction of $40,000, which is 20 percent of the business income. This deduction is claimed after your “adjusted gross income”. Because New Mexico starts with federal AGI, you do not get an equivalent deduction for New Mexico.

Same facts, but your taxable income is $415,000. Now your deduction is limited to the greater of (1) 50 percent of W-2 wages paid by the business or (2) 25 percent of wages plus 2.5 percent of tangible property

Without regard to income, your deduction is limited only if the wage or wage/capital limit is less than 20 percent of business income.

If W-2 wages are $60,000, your deduction may then be $30,000 (50 percent of W-2 wages) rather than $40,000. If W-2 wages are $100,000, the deduction remains at $40,000. This is so even if your income is $20 million.

Now let’s say you are an attorney with $200,000 of (service) business income and $300,000 of taxable income. Your deduction is $40,000, just like the restaurant owner.

But an attorney with $415,000 or more of taxable income gets zero deduction because the income is from a “specified” service business. The otherwise allowed deduction is ratably reduced from $40,000 to zero as taxable income goes from $315,000 to $415,000.

The high-income attorney may even consider establishing a “regular” corporation to take advantage of the new 21 percent corporate tax rate. The new law will be a bonanza for tax planners.