The Qualified Business Income Deduction Made Simple

When the Tax Cuts and Jobs Act was signed into law by President Trump on December 22, 2017 the tax landscape for practice owners changed dramatically. Not only did the personal tax brackets change significantly, the bill also introduced a brand-new provision to reduce tax on passthrough income; the Qualified Business Income Deduction. As with most things tax related, the provision and eligibility requirements are not simple. But fear not, we have waded through the deep waters of the law and have boiled down the provision to the most basic concepts that will affect you, the practice owner.

The Basics

In its most simple form the Qualified Business Income Deduction is a deduction of 20% of your practice’s net income. Whether you operate your practice as an S-Corporation, a partnership, or a schedule C sole proprietor the deduction may be available. Barring any limitations (to be discussed later) the 20% deduction is applied directly to your practice’s net income. if your practice reports taxable income for the year of $250,000 the deduction would be $50,000 and the result would be that your taxable income from the practice would be only $200,000 (250,000 – (250,000*20%). This essentially means that you would be collecting 20% of your practice income tax-free! While this is great news there are several limitations that you need to be aware of before you can go out and spend the extra money that you just calculated in your head.

Specified Service Business limitation

There are several limitations written into the bill but, for practice owners, we can simplify by focusing on one provision that will impact you before all the others. The IRS considers your practice to be a “Specified Service Business”, one that provides services to clients based on personal expertise. Other business that fall into this category are those performing services in the fields of law, health, accounting, and consulting. According to the bill income from Specified Service Businesses is not eligible for the 20% Qualified Business Income Deduction. The unfortunate reality is that this limitation will prohibit many doctors from being able to take advantage of the deduction. However, there is a glimmer of hope to be had for some practice owners. There is an exception to the Specified Service Business limitation. To quickly identify your benefit from the new deduction there are only a few key numbers that you need to keep in mind. If your filing status is single you need to remember the numbers $157,500 and $207,500. If your filing status is married filing jointly you need to remember the numbers $315,000 and $415,000. If you are single the Specified Service Business limitation does not apply, and the 20% QBI deduction is available to you, if your taxable income is less than $157,500. Once your taxable income reaches $207,500 the deduction phases out completely. Similarly, if you are married and your taxable income is less than $315,000 the Specified Service Business limitation does not apply, and the 20% QBI deduction is available. Once your taxable income reaches $415,000 the deduction will phase out completely. In both cases the deduction phases out ratably between the two limitations. I know, that is still kind of confusing. Here are some examples to help. First, it is important to note that the Specified Service Business limitation is tied to “taxable income” on your personal tax return. So, while the 20% deduction is always calculated based on the net income from your practice, the limitation itself is based on your total personal taxable income, which includes your practice income, wages, spouse’s wages and any other sources of income or deductions.

Examples

Example 1 – Married Filing Joint with taxable income under $315,000

Assume your practice produces net taxable income of $250,000. You operate an S-Corporation which provides you a W2 of $80,000 and your spouse receives a W2 from your practice of $25,000. Assume also you have itemized deductions of $10,000 property taxes, $25,000 mortgage interest, and $10,000 in charitable donations for total deductions of $45,000. In this case your taxable income will be $310,000 (250K + 80K + 25K – 45K = 310K). Since your taxable income is less than $315,000 the 20% deduction will apply to your practice income and will create a deduction of $50,000 (20% * 250K). Now you will be taxed on $260,000 (310K – 50K) instead of the original $310,000.

Example 2 – Married Filing Joint with taxable income over $415,000

Assume your practice produces net taxable income of $350,000. You operate an S-Corporation which provides you a W2 of $115,000 and your spouse receives a W2 from your practice of $25,000. Assume also you have itemized deductions of $10,000 property taxes, $25,000 mortgage interest, and $10,000 in charitable donations for total deductions of $45,000. In this case your taxable income will be $445,000 (350K + 115K + 25K – 45K = 445K). Since your taxable income is greater than $415,000 the 20% phases out completely.

Example 3 – Married Filing Joint with taxable income between $315,000 and $415,000

Assume your practice produces net taxable income of $275,000. You operate an S-Corporation which provides you a W2 of $100,000 and your spouse receives a W2 from your practice of $25,000. Assume also you have itemized deductions of $10,000 property taxes, $25,000 mortgage interest, and $10,000 in charitable donations for total deductions of $45,000. In this case your taxable income will be $355,000 (275K + 100K + 25K – 45K = 355K). Since your taxable income is in between $315,000 and $415,000 a portion of the 20% deduction will apply. Since taxable income of $355,000 is $40,000 over the $315,000 limit 40% of the benefit of the deduction will be reduced. The original deduction, without regards to the limitation would have been $55,000 (20% * 275K). To arrive at the limited deduction, we will remove $22,000 (40% * $55,000) from the original deduction for a reduced deduction of $33,000. Now you will be taxed on $322,000 ($355K - $33K) instead of $355,000. Of course, there are other subtleties of the tax provision and there are many questions left unanswered at this point as we wait for the IRS provides further guidance. But, by understanding the basics discussed above you will have a good idea of how the 20% deduction will apply to your taxes. David Knittel | Director of Tax | PracticeCFO
WordPress Image Lightbox