Today, we’ll continue our exploration of tax-related questions, this time looking at the intersection of several important, but confusing, topics: how to best take advantage of the Qualified Business Income tax break, and how to leverage S corporation election status to minimize your tax bill.
Qualified Business Income
Qualified Business Income, or QBI, is a new tax designation that applies to many self-employed filers, and allows for an individual to deduct a whopping 20% of annual self-employed net income from his or her tax return. For example, if a tax payer made $100,000 self-employed net income and filed as an individual, they would be able to deduct 20% of their profits — in this instance $20,000 — thereby lowering the payer’s taxable income to $80,000.
To put this terms of actual dollars shaved off the tax bill, we multiply the savings ($20,000) by the marginal tax rate of an individual filer (24% in this instance) to find the tax savings:
$20,000 saved * .24 marginal tax rate = $4,800 Savings
Who can take advantage of QBI?
The IRS specifies that partnerships, sole proprietors, trusts, and S-corps owners can all take advantage of the 20% QBI savings. However, there are a few exceptions to this rule, having to do with how your business is classified.
Specified Service Trade or Business Exception
It is important to note that for those working in trades or businesses classified as “Specified Service Trade or Business” (SSTB) have different rules governing whether or not they may take advantage of QBI. An SSTB is any trade or business activity involving the performance of a service in any of the following fields: health, law, accounting, actuarial science, performing arts, consulting, athletic, financial services, brokerage services, or business or trade where an employee’s skill or renown is the direct cause of the generation of revenue, which also includes trades and businesses involved with investing or investment management, trading or dealing in securities.
If you fall under the SSTB umbrella, you can still take advantage of the QBI, so long as your adjusted gross income (AGI) is below $315,000 for joint filings, $207,500 for heads of household, or $157,500 for single filers. This means that if you work in a service area designated as SSTB, you are only able to take advantage of QBI if your income falls below these thresholds.
Do I need an S corporation to take advantage of QBI?
No, you do not! As mentioned previously, partnerships, sole proprietors, trusts, and S-corps owners can all take advantage of the savings, but you aren’t required to have an S-Corps designation to do so. However, to maximize your tax benefit, you may want to consider combining the QBI with the S corp election, so make sure to talk with your accountant about what is right for you.
Taking advantage of S corporation tax benefits
As you probably already know, an S corporation is a pass-through entity for state and federal tax purposes, which means that business income, tax deductions, credits, and losses are all passed on to the owners or partners of the corporation.
The biggest benefit of an S corporation is that shareholders do not have to pay self-employment tax on certain types of the business’s profits, earnings and distributions. Shareholders are taxed for any salary they pay themselves, and the IRS holds an expectation that shareholders pay themselves “reasonable” compensation, which is subject to self-employment tax.
The IRS offers general, but somewhat vague, guidance on “reasonable” wages, which can be found in Publication 535, which covers business expenses. According to the IRS, reasonable “depends on the circumstances that existed when you contracted for the services,” and if the pay is later found to be excessive, it is disallowed as a deduction. Generally speaking, the IRS considers payment reasonable if it is an amount equivalent to what a similar business would charge for the same service.
S corporations are able to designate profits into two separate categories: as so-called “shareholder wages” or as a “distributive share.” Only shareholder wages are subject to the 15.3% Medicare and Social Security and self-employment tax, while the distributive share is not subject to this tax.
For example, if you make $100K in profit and pay yourself a $60k salary as a wage, you would need to pay said taxes on this shareholder wage; however, the other $40K can be labeled as a distributive share, which is a form of business profit not necessarily subject to the same taxes.
Claiming S corporation losses
Additionally, if an S corporation loses money, that loss can sometimes be deducted from the shareholder’s individual tax return, though there are specific rules you need to follow to deduct these sorts of losses—for instance, the money lost must be your own, and you need to be working in the S-corp to do so.
What makes financial sense for you?
The most important thing you can do to set yourself up for financial success is to act now, and speak with an experienced tax advisor. With major changes made to 2018 tax code, it is essential that you consult with your trusted advisor to make sure that you are taking full advantage of the revamped tax law to minimize your bill and maximize savings.