April 4, 2018
The new qualified business income (QBI) deduction provides a new reason for small business owners to reconsider how they distribute profits to themselves. Additionally, entrepreneurial-minded employees may find this tax incentive compelling enough to form their own company and serve as an independent contractor.
Generally, this deduction created by the Tax Cuts and Jobs Act can be as much as 20% of the net income reported by the owners of a qualified business. Keeping in mind that the greater the reported net income, the larger the tax benefit, owners of profitable businesses will want to maximize this deduction.
Maximizing the value of the QBI deduction comes down to two questions: What structure is your business? And how are you compensated?
Historically, C corporations have been the default limited liability choice for businesses with multiple owners. A chief downside with this structure, however, has been that income is taxed twice — first the business is taxed on its net income, then the shareholders are taxed when those profits are paid out as dividends. A new downside is that the QBI deduction is not even available to C corporation owners.
Business Entity QBI Comparison
|Form of Entity
|Income Eligible for QBI Deduction
|Single-owner disregarded entity
To address both problems, C corporation owners should consider making an election to be treated as an S corporation, which is essentially a flow-through vehicle with partnership-like characteristics. This election will eliminate the dual-tax nature of the business and allow its owners to benefit from the QBI deduction.
Be aware that, unlike partnerships and disregarded entities, S corporation shareholders are not subject to self-employment taxes on their share of business income. Therefore, the IRS has the ability to recharacterize S corporation distributions as “reasonable compensation” for an owner’s services to the business, which does not qualify for the QBI deduction.
Compensation reported on a W-2 is already the most severely taxed form of income a taxpayer can report. A business owner who receives this type of compensation, or guaranteed payments for services rendered to a partnership, suffers further cost as it is not eligible for the QBI deduction.
Additionally, each dollar of an owner’s W-2 compensation reduces the net QBI of the business by the same amount. Since the QBI deduction is 20% of net QBI, the higher your marginal tax bracket, the costlier the impact of a reduced QBI deduction.
Thus, it will be less expensive for an owner to withdraw cash from non-C corporation businesses as distributions, rather than as taxable compensation.
Tax Cost of Owner Compensation
|Marginal Tax Bracket
|Tax Cost of Reduced QBI Deduction
Because of these specific tax savings for pass-through income, if you’re an employee, you may want to explore starting your own company and contracting your services to your current employer in order to convert W-2 earnings into partnership or sole-proprietorship income. But keep in mind that if you make above $157,000 a year as an individual or $315,000 married filing jointly, the QBI deduction is limited, and may be eliminated completely, for certain service trades such as accounting, consulting and legal services. See my earlier fathom article, Understanding the New Qualified Business Income Deduction, for more information.
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