Deconstructing the TCJA’s deduction for business income

by Dave Wolfenden, CPA, CVA, MS, Managing Director

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We’re fast approaching the one-year anniversary of the passage of the Tax Cuts and Jobs Act (TCJA). All these months later, the law continues to challenge tax experts and business owners alike as they try to implement strategies to maximize the tax savings from the act.

One example is the new tax deduction for qualified business income (QBI) that’s available to eligible owners of “pass-through” entities, including many construction companies. It’s a potentially valuable break, but you’ll need a CPA’s guidance to properly claim it. Let’s deconstruct it a bit to lay the groundwork.

A new twist
Pass-through entities are businesses whose earned income “passes through” to owners’ personal returns, where federal income tax liability is then assessed. Examples include sole proprietorships, partnerships, S corporations and, typically, limited liability companies (LLCs).

If you operate your construction company under one of these entity types, you’re probably aware that there’s never been any special tax treatment applied to business income that passes through to your personal return. You just pay taxes on it as you do on your other ordinary income. But, with the introduction of the QBI deduction, also referred to as the “pass-through deduction” or the “Section 199A deduction,” that has changed.

Qualified business income
For tax years beginning on or after January 1, 2018, and before January 1, 2026, the TCJA establishes a new deduction based on a noncorporate owner’s QBI. For purposes of this tax break, QBI can generally be defined as the net amount of qualified items  of income, gain, deduction and loss from any qualified business of the noncorporate owner.

The deduction is available to individuals (as well as estates and trusts) that own interests in qualifying business entities. It isn’t allowed in calculating an owner’s adjusted gross income, but it reduces taxable income. In effect, it works like an itemized deduction — though you don’t have to itemize to claim it.

It generally equals 20% of QBI, subject to certain restrictions. The restrictions begin to phase in when an owner’s taxable income (before the QBI deduction) exceeds $157,500 — or $315,000 for married couples filing jointly. They fully apply when income reaches $207,500 and $415,000, respectively.

Boundaries to beware of
Payment of relatively low employee wages may limit this tax break. If an owner’s taxable income is high enough that the income-based restrictions fully apply, the maximum amount of the QBI deduction can’t exceed 50% of the total W-2 wages paid to all employees of the business (including wages paid to owners) or the sum of 25% of W-2 wages plus 2.5% of the cost of qualified property — whichever is greater.

“Qualified property” is depreciable tangible property (including real estate) owned by a qualified business as of year-end and used by the business at any point during the tax year to produce QBI.

A change to consider
This QBI deduction could signal to some contractors that it’s time for a change. Some owners of sole proprietorships or single-member LLCs with no employees don’t pay themselves (or anyone else) W-2 wages. Instead, they take the net income of the business for themselves once they’ve paid all other business expenses in cash.

If you’ve run your company in this manner and your income is high enough that the W-2 wage limit applies, now may be a good time to start paying yourself W-2 wages. Otherwise, you won’t be able to claim this valuable new deduction.

Worth the effort
Note that, if your construction company is a C corporation, you aren’t eligible for the QBI deduction. But the TCJA likely provides tax savings to you, too. It replaces graduated C corporation income tax rates that topped out at 35% with a flat rate of only 21%.

Navigating the complexities of the TCJA may not be easy, but doing so is worth the effort. As mentioned, work with your CPA to identify and implement the right strategies.

We welcome the opportunity to put our construction industry expertise to work for you. To learn more about how our firm can help advance your success, please contact Dave Wolfenden at (302) 254-8240.

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