Portrait of small business owner
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The tax overhaul unveiled a new 20% tax deduction for small business owners in 2018 — and just over 1 in 10 filers so far have claimed it.
The qualified business income deduction is one of the new features of the Tax Cuts and Jobs Act, which went into effect last year.
This new tax break allows owners of “pass-through” entities, including S-corporations, partnerships and sole proprietorships, to deduct up to 20% of their qualified business income.
Filers eagerly grabbed the deduction for the 2018 tax year. More than 14 million income tax returns claimed this break as of May 23, according to data from the Internal Revenue Service.
Up to that date, the IRS received more than 134 million returns.
In all, filers claimed roughly $74 billion in so-called QBI deductions taken as of that date, the IRS found.
“With it being the first year, I think everyone is still trying to figure it out,” said Tim Steffen, CPA and director of advanced planning at Robert W. Baird & Co. in Milwaukee.
“You’ll see that number go up as returns start coming in this fall,” he said.
How it works
As tempting as the deduction sounds, figuring out if you qualify is no easy feat.
Here’s a breakdown of who can take it.
First, business owners in any industry may take the 20% deduction if they have taxable income that’s under $157,500 if single or $315,000 if married and filing jointly in 2018.
The IRS applies limitations over those thresholds.
For starters, taxpayers in a “specified service trade or business,” including doctors, lawyers and accountants, can’t take the deduction at all if their taxable income exceeds $207,500 if single or $415,000 if married.
With it being the first year, I think everyone is still trying to figure it out. You’ll see that number go up as returns start coming in this fall.
CPA and director of advanced planning at Robert W. Baird & Co.
The rules are a little different for business owners who aren’t in a “specified service trade or business.”
In that case, you get a reduced deduction if your taxable income exceeds the $157,500/$315,000 threshold but is still under the $207,500/$415,000 threshold.
If your business isn’t in a specified service trade or business, and your taxable income exceeds the $207,500/$415,000 threshold, then your deduction is generally capped as a percentage of W-2 wages paid to your employees.
Here’s another consideration: The QBI deduction is only around until the end of 2025.
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Some accountants decided to proceed with caution on the deduction this spring, as the IRS proposed new guidelines for the rules in January 2019.
Those updates included proposed guidance on the tax break for rental real estate owners — a safe harbor they can follow to be sure they qualify for the 20% deduction.
Other new regulations detailed the conditions in which a business owner can aggregate multiple trades and businesses to get the tax break.
Even tax software providers were caught by surprise by these rule changes and accountants had to override the programs to calculate the deduction.
This prompted some tax professionals to have their clients ask for more time.
“I would say that of the clients on extension — even those who had all of their information — we probably could have filed 75% of them [by April 15] if we had wanted to,” said Jeffrey Levine, CPA and director of financial planning at BluePrint Wealth Alliance in Garden City, New York.
“We chose not to because we weren’t confident in the software and we weren’t confident in the guidance,” he said.
Prepping for next year
“What’s more interesting to me is what will people do going forward now that they’ve had a taste of this deduction,” said Levine.
To trim their tax bills, some entrepreneurs are asking about boosting their savings in retirement plans, while others are more inclined to give their money to charity, he said. Others are weighing whether they should bring on additional employees, even on a part-time basis, to help the business owner qualify for the new deduction.
“It may be that, over time, as the rules are more clear and accountants become more familiar with it, you could see the number of returns claiming the deduction shift more in future years,” Steffen said.