The following discussion is not intended to be tax advice. In this complex area of the tax law it is important to consider individual facts and the tax law and existing regulations and the application to specific circumstances in order to understand options and possible results.
The first step in maximizing the QBID is to carefully analyze one’s current income producing activities. Using the definitions and limitations of the tax law, determine how much of your income is Qualified Business Income. For taxpayers with less than the phase in levels of limitations ($157,500 single and $315,000 married), the primary goal will be to define as much of one’s income as qualified business income as possible.
Current W-2 Employees
For taxpayers whose primary source of income is reported on a W-2, the first thought will be to convert W-2 income into business income. Who wouldn’t like to pay tax on 80% of their income instead of 100%! This idea will meet with some pretty stiff resistance on several levels. First, existing tax law and regulations do provide guidance on who is an employee and who is an independent contractor. The IRS has a very successful history of challenging those who do not follow that guidance. If you want to convert from working for someone else to running your own business, you need to do more than change your paycheck to a business check. Furthermore, independent contractors do not qualify for fringe benefits, so one needs to carefully consider how they will pay for tools and equipment, vehicles, incidental job costs and obtain insurance for life, health, and job injuries. However, the QBID could be significant enough to investigate this option further if you regularly see some people in your industry classified as employees and some classified as independent contractors.
Real estate rental
For those who invest in rental real estate, it will be important to qualify any rental income as trade or business. This may mean changing the terms of leases or providing some services to tenants. Since there are currently no definitions in tax law for when a rental is considered a trade or business, this is an area we will need to watch for further IRS guidance.
Higher income taxpayers
For taxpayers in the phase out limitations range or slightly above, deductions will have an enhanced effect. For every dollar of deduction, you also increase the QBID at the same time, resulting in $1.20 of tax deduction. Consideration of employee bonuses, retirement plan contributions, bonus depreciation and expensing, donations, and other deductions become more attractive. Of course it is always important to remember that tax savings cannot rescue a bad business plan, so be careful when chasing tax deductions.
Entity type selection
Another area of potential savings is choosing the best type of tax entity, or combination of entities. This area of planning will be quite complex and cannot easily be described in a short article, but holds a myriad of possibilities. As an example, service professionals not ordinarily qualifying for the QBID may want to consider splitting their business into qualifying and non-qualifying activities and choosing different types of entities to take advantage of the lowest overall tax burden.
For entities where working owners are below the phase-in levels, determining the type of entity requiring the least amount of non-qualifying compensation allocation may be a significant planning consideration. Current tax law does not require a partnership to pay guaranteed payments, potentially providing a significant loophole for those choosing to take advantage. However, your partnership income could be subject to self-employment tax, which would help to offset your enhanced QBID versus S corporation income that is not subject to self-employment tax.
Entity choice could also be used in combination with the reduction of tax rates for C Corporations in the right circumstances. Income earned and retained in a C Corporation is not included in the taxable income of the owner. A taxpayer with multiple businesses may consider electing to operate one as a C Corporation with a 21% tax rate while operating others as pass through entities thereby reducing overall income to below the phase-out limits.
As you can see from this short discussion, the ideas for tax savings from the QBID are significant and numerous. Due to the complexity of the law, it will be important for taxpayers to work with their tax advisors to consider each situation on an individual basis. The good news is that until regulations and technical corrections are made, any reasonable tax plan could result in a generous tax deduction with minimal risk of penalties. As IRS guidance is issued and technical corrections are made to the bill, we will publish updates in our blog and monthly newsletter.