Do the Right Thing & Save 20%
By Ben Kinsey
For all active business entities in the US that are not rental properties or hobbies, there is a new 20% business deduction that applies to your overflow income. (This is your income minus your salary) Salary, in this case, is important since the only way you can take the 20% deduction is if you take a salary, or in the case of a partnership, a guaranteed payment. The term the IRS uses to describe this is Qualified Business Income.
The Shape of Things to Come
The way things used to work is you were taxed on 100% of your income with no deduction other than what was referred to as the production deduction. This deduction was only available to manufacturers and businesses that built new construction. Whether you were the engineer, the planner or the manufacturer of new materials, you were able to take a production deduction of up to 9%. All other types of businesses were ineligible for this deduction.
Starting on January 1, 2018, there is an opportunity for all business owners to take advantage of a 20% savings on their qualified business income.
Let’s say your S Corp brings in a million dollars and expenses are 80%. This would produce a $200,000 net profit in 2018 before the owners get paid. If the owners got paid $80,000 in salary, this would leave $120,000 in net profit. This would mean when the business files its taxes at the end of the year; it would qualify for 20% of the $120,000, which is a $24,000 deduction. The kicker is, in order to take the deduction, the owners would have to take either 50% of the $80,000, which is $40,000 or 20% of the $120,000, whichever is less. In this case, the business would only qualify for a $24,000 deduction. On top of that, the new deduction only applies if the owners take a salary.
The trick to maximizing your savings under the new rule is to make sure you take enough in salary. If this same business only paid out $40,000 to the owners in salary, then the deduction that would apply would only amount to $20,000, since 50% of the owner’s salary would be less than 20% of the qualified business income, which in this case would be $32,000. ($200,000-$40,000=$160,000 x 20%=$32,000) The trick is to choose the salary that works best within the formula, which in this, for instance, would be in the neighborhood of $60,000. ($200,000-60,000=$140,000 x 20%=$28,000 & 50% of 60,000=$30,000)
The Rules of Engagement
They say the only thing sure in life is death and taxes. Yet the new deduction was born because of an insecurity in the amount of taxes collected. The reason the federal government decided to provide the 20% deduction was to get business owners to contribute their fair share into FICA and Medicare. That’s why you are required to take an adequate salary in order to take full advantage of the deduction. This is why planning is vital to maximizing your results when it comes to the new rules. Never before has there been a straight deduction for paying the owner just for performing services for a corporation.
There have long been rules for S Corps and partnerships when it comes to taking “reasonable” salaries. When the owners or partners don’t take a reasonable salary, they don’t contribute their fair share to FICA and Medicare. This, in turn, starves FICA and Medicare of the 15% taxation due to these entities. The IRS decided instead of having to go through the time and trouble of hunting down all the companies in this country that are taking unfair advantage of the system; the federal government instead decided to give every business owner an incentive by offering a 20% deduction to everybody who plays by the rules. Better still is the fact that these new rules are in effect until 2025 to qualified businesses.
(FYI: If you don’t want to take a $60,000 salary, there is a way for you to look like you are taking a salary by channeling the payment to your 401K and still qualify for the deduction.)
All business owners with certain limitations described below. A qualified business is defined as any trade or business other than businesses or professionals engaged in providing services to clients. Those limited by income from taking this deduction include accountants, lawyers, doctors, actors, consultants, brokers, engineers, financial advisors, actuaries, and stock or commodities traders. If you are unsure if your business is excluded, talk to your CPA. On the other hand, if you do qualify for the deduction, there is no limit on the use of this deduction.
For instance, let’s say you own a retail business that does $5 million in revenue with a 10% margin. This would net you $500,000 before salaries for the business owners. With this big of a net profit, if you want to maximize the benefits, you would need to pay out $140,000 in salaries to the owners, since 50% of $140,000 is $70,000 and 20% of $360,000=$72,000
Since you can’t make these calculations retroactively, the bottom line is if you want to maximize your tax deductions, you need to plan your strategy by talking to a CPA right away. If your business qualifies and you play by the rules, you’ll have the satisfaction of doing the right thing while saving 20% at the same time.
Ben Kinsey, CPA of Small Business Group works with owners of closely held corporations in the Northeast Florida region. If you work in the North Florida area we offer a FREE initial Consultation at our office, please contact Small Business Group if you would like to know more about strategies for your business.