The Tax Cuts and Jobs Act of 2017 permanently reduced the top corporate tax rate to 21%. To try and make the playing field somewhat even for other businesses, this law also gave taxpayers with noncorporate businesses a new deduction for tax years 2018 through 2025. For example, beginning in 2018, a C corporation would pay the top corporate federal income tax rate of 21%, but a business taxed as a Subchapter S corporation could be taxed to an individual owner at a rate as high as 37%. If this Subchapter S corporation were to take full use of the new Qualified Business Income deduction (QBI Deduction) the effective tax rate would drop to 29.6%. While better than 37%, it’s still better to leave earnings in a C corporation with a top rate of 21% than in an S corporation. However, if the shareholders want to pull earnings out of the corporation, earnings distributions from a Subchapter S corporation don’t trigger any additional tax, whereas earnings distributed to owners by the now-lower-taxed C corporation results in additional tax on the dividends.
To make matters more complicated, the full 20% of business income QBI Deduction is only available after meeting a series of tests. The deduction is taken on the returns of the business owners and they do not have to itemize to claim this deduction. Among the limitations are the following:
First, the income has to be from a “trade or business”. Fortunately, this definition is very broad, but effectively excludes interest, dividend, and wages from any business.
The deduction cannot exceed 20% of the taxpayer’s ordinary income. If the qualified business income is negative, then the losses can carry forward to the next year.
There are also rules to prevent high income taxpayers from converting their wages to business income and taking advantage of the deduction. For qualified business income from the health, legal, consulting, athletic, financial, brokerage, or other high-skill service fields the deduction is phased out. The deduction phase-out for this type of income begins when taxable income exceeds $315,000 for joint filers and is completely eliminated when taxable income exceeds $415,000 for joint filers.
For businesses that otherwise qualify for the deduction without the phase-out for certain service income described above, if the owner income exceeds $415,000 on joint return, then the QB I deduction is limited to the greater of 50% of the owner share of W-2 wages paid in the business, or 25% of the wages and 2 ½% of the unadjusted basis immediately after acquisition of tangible depreciable property.