I have seen a lot of chatter online lately between SEOs about how the new U.S. tax laws will affect them. I have been having an ongoing conversation about this issue with our long-time accountant, Ed Borine, and I figured it might be of interest to share what he has been advising us. It’s all about optimization right?
Warning, this post should not be construed as actual tax advice. This is purely clickbait entertainment. If you want actual tax advice, consult with a tax professional.
TL;DR How To Maximize Your Pass Through Income Tax Deduction
- LLCs should consider shifting to a subchapter S corporation, sole proprietorship or partnership
- If you have employees, shift as much expenses to W2 wages as possible
- Reduce your salary to minimize salary income and maximize profits
- Sole proprietors should consider setting up a tax shelter vehicle
- Hire a good accountant
The focus on my discussion with Ed has been how to take advantage of the tax credits for Qualified Business Income. I am going to start with some exposition and then move on to how we can milk this thing for all it’s worth.
- There are no clear regulations yet
Once the tax bill became law, it then is sent to the IRS/Treasury, which writes the “regs” that interpret the law and explain how to apply it step-by-step. The IRS has not published the new regs yet. Until it does, all we have to go on is the bill itself, which is rife with ambiguity.
- What is Qualified Business Income?
Qualified Business Income is income earned by certain types of business entities that is then “passed through” to its owners’ and reported as income on their personal income tax returns. The pass-through deduction applies to your “Taxable Income”. Think of the first page of your 1040 which has all your different types of income and then adjustments to that income. For example, if you are self-employed you can deduct health insurance premiums. You end up with Adjusted Gross Income (AGI). Then you can add itemized personal deductions. Subtract these from your AGI and you get your taxable income. Section 199A (the pass through deduction) is then applied to amount of “pass-through income” that is included in your taxable income, which in theory will reduce the taxes you owe.
- Who is eligible for the pass-through tax deduction?
Stockholders of subchapter S corporations, partners in partnerships, and sole-proprietorships are eligible for the pass-through tax credit.
- Is Limited Liability Company (LLC) income that is passed through eligible for the pass-through tax deduction?
Managing members of LLCs must treat pass-through income as self-employment income/wages. LLCs are a relatively cheap way to shelter personal assets; however, if you are a one-person LLC, spend a few hundred bucks on a general liability policy and change to a sole proprietorship to take advantage of this new rule. There are probably good reasons to be an LLC, but that’s for you and your accountant to decide. For the record, Local SEO Guide, Inc. is a subchapter S corporation.
- What are the income thresholds for using the pass-through tax deduction?
You must have either “pass-through business income” or “self-employment income” in order to be eligible for the deduction. However, once you hit a certain amount of “taxable” income, the amount of the deduction starts to diminish. The thresholds for this “diminishment” depend on your marital/filing status:
Filing StatusDeduction Dimishes AfterDeduction Credit Ends At
To put it in English, a single person having at least $157,000 in taxable income will begin to lose the deduction at the rate of 2% for every dollar that their taxable income exceeds $157,500. Once they make over $207,500 in taxable income, the deduction is gone. If you are married, you lose the deduction at the rate of 1% for every dollar that your taxable income exceeds $315,000. The main concept you should get is that you are in effect penalized for having too much taxable income, so if you make over the top threshold, you will want to engineer your taxable income to max out the credit.
Please note that the Sec. 199A deduction is applied to the lesser of your qualified business income or your taxable income.
- Here’s an example for married, self-employed filers:
Let’s say you are a married, self-employed person and you have no employees (so no W2 wages paid to employees) and no depreciable assets (these are key concepts I’ll get to shortly). If you had $400,000 in “qualified pass-through” income, which is the bottom line of your Schedule C, and $300,000 in taxable income, you are able to take a deduction against your income of 20% of your taxable income. So you can deduct $60,000. Not bad. This assumes that your taxable income is less than the bottom line of your Schedule C.
- How does this work for partnerships?
If you are a partner or if you own a sub S corp, the calculation would be the same as above, but instead of Schedule C, it would be the amount on your corporation’s K1 form that is passed through to you as ordinary income. Usually that’s the first monetary line on the K1 form.
- Paying W2 Wages & Having Depreciable Assets Complicate Things
Here’s the kicker on this – If you have qualified income and have exceeded the thresholds, you are still eligible for the deduction as long as you had either W2 wages that were paid or depreciable property in your business or a combination of both.Let’s say that you have the situation where you are married, you had qualified pass-through income, your taxable income is over $415K, and you had W2 wages paid of $400K, you would take a % of those W2 wages and multiply it by the 20% and they get the deduction. The calculation is either 50% of the W2 wages or 25% of the W2 wages plus 2.5% of the original amount of depreciable property.Let’s restate that in equation form to make it easy:– You have $600K in total income, you have $450K in taxable income, paid $400K in wages and have no depreciable property– Your deduction is now calculated using the W-2 wages that you paid– 50% of $400K = $200K*20% = $40K (this is your deduction)Once you are over the income threshold, the only way you can get the maximum deduction is to increase the amount of taxable W2 wages.
This being the case, here are some options you’ll want to talk over with your accountant. If your qualified income is going to exceed the top threshold:
- Shift as much expense to W2 wages as possible. For example, if you pay health insurance premiums for your employees that are not taken out of their salaries, start paying the premiums via their salaries (hopefully pre-tax so they don’t have to pay taxes on the benefit).
- If you are paying yourself a salary, reduce your salary to increase the pass-through amount by increasing the net profit of the company.
- If you are a sole proprietor and think you are going to go over the maximum income threshold, consider setting up a defined benefit plan or another tax shelter vehicle so you can engineer your income to stay within the range that benefits you most. However, remember that doing this postpones the tax on the income; it does not shelter the income from tax.
- If your company is an LLC, consider shifting to a subchapter S or sole Proprietorship as early in 2018 as possible.
If you’ve made it this far, you see why Ed calls this bill the “Full Employment for Accountants Act of 2017”. So do yourself a favor and get on your accountant’s calendar asap. He or she is going to be pretty busy.
And if you need a great accountant, I’d be remiss if I did not recommend Ed. Here’s his info:
Ed Borine, MS Taxation
E.R. Borine Financial Management
628 Tenth St., Santa Monica, CA 90402
And if you have any questions, pop them in the comments and maybe I can get Ed to answer a few. Happy tax optimizing!