The qualified business income deduction for pass-through entities is one of the most significant and potentially confusing components of the recent tax reform legislation. Pass-through entities accounts for about 95% of all US businesses and include sole proprietorships, partnerships, LLCs and S-corporations – So the impact of this legislation is profound.
Under the prior legislation, taxable income from pass-through entities was assessed at the individual taxpayer’s rate. While this is still true for the taxpayer’s own wages, business owners’ pass-through income may receive a deduction to help lower that rate. Many business owners are wondering if they will receive this deduction and what limitations may exist. This provides financial advisors the opportunity to help educate clients about these changes and how business life insurance may be impacted.
High Level Change in Pass-Through Business Taxation
At its simplest level, this tax legislation provides up to a 20% deduction for qualified business income (QBI) for tax years 2018 to 2026. In general, QBI is ordinary income earned by a business within the United States, but does not include investment income such as interest, dividend, and capital gains – And it does not include wages earned as an employee or retirement income. The implementation of strategies to optimize this deduction will be a critical aspect of tax planning going forward. Two initial considerations for any discussion will be the income level of the taxpayer and the type of business generating the income.
Threshold Question – What is the Taxpayer’s Taxable Income?
How much a taxpayer makes determines whether they can take a deduction. For taxpayers with taxable income below the threshold amount, the deduction is the lesser of:
- 20% of QBI from pass-throughs; or
- 20% of taxable income less net capital gains
The threshold amount is $315,000 of taxable income for married joint filing and $157,500 for all other filers. Bear in mind that taxable income is calculated after above-the-line deductions, and either the standard or itemized deduction and is specific to the taxpayer.
Therefore, it is possible for one partner in a partnership to qualify for the deduction, while the other may not.
If taxable income is between $315,000 and $415,000 for married filing jointly, or between $157,500 and $207,500 for other filers, the taxpayer gets a portion of the 20% pass-through deduction. Once over $415,000/$207,500, the deduction can be lost depending on the type of business.
Is the Business a Specified Service Business?
The QBI deduction is completely phased-out for specified service businesses over the $415,00/$207,500 taxable income threshold. In general, a specified service business is any trade or business where the principal asset is the reputation or skill of its owners/employees. This includes health, law, accounting, consulting, financial services, athletics, and the arts, but does not include engineering and architecture. There is often much confusion surrounding what may or may not qualify as a specified service business.
If the business is not a specified service business, the business must pay wages or own property once it exceeds the above threshold, because the amount of the deduction is based on the lesser of the following two calculations:
- 20% of QBI; or
- The greater of (1) 50% of w-2 wages or (2) 25% of w-2 wages plus 2.5% of your qualified property cost
Impact on Life Insurance Arrangements
For successful pass-through businesses that are not specified service businesses, the availability of the deduction could be dependent on wages paid to employees. This may increase the opportunity for bonus and restricted bonus arrangements. Highly compensated owners of specified service businesses will have a hard time qualifying for the QBI deduction, which may cause them to split their business into multiple entities. For example: A dentist could split the business into real estate, equipment and operating entities, where the real estate and equipment businesses could qualify for the deduction. Multiple business entities will likely increase the use of cross-purchase arrangements or the use of LLC buy-sell structure to avoid multiple policies. Multiple business entities increase the complexity of the case, and often require a cover letter for underwriters to formulate a clear understanding of the arrangement.
How DBS Can Help
In 2018, your business clients will be trying to sort out the details of the tax reform legislation. You will have the opportunity not just to educate them about the tax law changes, but to also make them aware of how they can utilize the changes to help achieve their planning needs. For a copy of the DBS tax guide which compares last year tax to 2018 contact Laura Thompson at 800-869-1327 extension 283.