The new tax law contains a remarkable new deduction for individuals who earn "pass-thru" business income.(Yup, the law actually spells it "pass-thru".) Basically, if you are reporting business income from K-1, a Schedule C, or a Schedule F, you get a deduction for 20% of your net business income, subject to some limitations.
The NY Times and the LA Times described this a the "Gig" deduction, and the biggest loophole for the next decade. They worry that salaried employees will forgo their paycheck, benefits, and job security (whatever that is), and become independent contractors to qualify for the 20% deduction.
They're both wrong.
This new deduction is not a loophole, it's an essential feature of the new law. The purpose of this new deduction is to reduce the advantage that tax reform bestowed on corporations by reducing their top tax rates from 35% to 21%, while leaving pass-thru income to be taxed at individual rates of up to 37%. Congress adopted the 20% deduction because they didn't want to force every mom and pop business to incorporate in search of lower rates.
And while the deduction clearly benefits all those Uber drivers among us, it is not limited to the gig economy. Most of my business clients will benefit from this, from the father-son team with backhoe, to the construction contractor with over $100 million in revenues.
So, how will this work?
If you are reporting business income on your 1040, you can deduct 20% of net qualified business income. The deduction comes after adjusted gross income, and is allowed whether you itemiize or not. If you have income from more than one pass-thru business, you combine gains and losses to determine net income.
Two significant limitations apply:
1. If your taxable income (wages, interest, business income, etc) exceeds the threshold amount ($157,500, or $315,000 on a joint return), the 20% deduction is limited to 50% of wages paid by the business, or 25% of wages plus 2.5% of business capital.
2. If you are a "specified service" trade or business, your deduction phases out above the threshold. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. The definition excludes engineering and architecture services, because they had better lobbyists than the accountants and lawyers.
Once the threshold is exceeded, the W2 limitation becomes critical, and, if you fit a particular fact pattern, you can optimize your deduction by managing your payroll expense.
Suppose your business income is $500,000, and payroll is $150,000. Your deduction is the lesser of $100,000 ($500,000 x 20%) or $75,000 ($150,000 x 50%).
But what happens if you pay Christmas bonuses of $35,000? Now your deduction is the lesser of $465,000 x 20% ($93,000) or $185,000 x 50% ($92,500). It cost you $35,000 to pay those bonuses, but you just decreased taxable income by $35,000 + $17,500 = $52,500.
S-corp Only Opportunity?
Now, the really fun part. This works for S-corps, but not partnerships or sole proprietorships.
The limitation based on W-2 payroll does not distinguish between owner payroll, and rank and file payroll. So, let's try the same scenario, but you're an S-corp, with only one person on payroll, you. Before the bonus you get taxed on $500,000 company income, and $150,000 W2, minus the $75,000 deduction, or $575,000. After paying yourself a bonus, you are taxed on $465,000 company income, plus $185,000 W2, minus $92,500 deduction, or $557,500. It cost you almost nothing to pay yourself a bonus, but it increased your deduction by $17,500.
Most of us would agree that this bonus-to-yourself strategy should not work, but the law does not prevent it. Stay tuned, will Congress or the IRS address this loophole?