Originally published on Forbes.com.
My excitement about the 20% deduction for qualified business income has risen to a fever pitch. The day before yesterday, I spent going through client scenarios at a local CPA firm, where I play the role that the national office plays for the Big 4. I’m not saying I’m as good as the men and women in the national offices of the Big 4. But I’ll go there whenever they ask me to and this week I bought a dozen Dunkin Donuts for the break room. That’s nothing. Sometimes the owner of the firm gives me Red Sox tickets. Did I mention we are in New England?
Yesterday I focused on specific trades or businesses which will be locked out of the deduction once over the taxable income threshold. That is taxable income without considering the 20% deduction. The deduction phases out over $50,000 beginning at $157,500 on single returns. Double those numbers for married filing jointly.
If you are in:
any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, 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 1 or more of its employees or performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2))
it is game over. No deduction for you. As my piece yesterday indicated, there is a significantly large gray area in whether you are in or out of those fields. One of my shortcuts of planning is in the area of independent contractor versus employee. If you are asking the question, she’s an employee. I would flip that on the fields question. If you are legitimately asking whether you are included in one of the fields, there is probably a strong argument that you are not.
If you are over the threshold and not in one of the disfavored fields, you face another test. The 20% deduction is limited by a W-2 test or an alternative test that is a combination of W-2 and capital expenditure. The W-2 test is what is based on what is paid to everybody – owners and non-owners.
The Upside of S Corporations
S corporation have long had an advantage over proprietorships and partnerships in the area of flow-through income. The flow-through income of proprietorships and partnerships will generally be entirely subject to self-employment tax. The flowthrough income of S corporations is not. S corporations are required to pay their owners who work in the business a reasonable salary (That is a simplification, but let’s roll with it). When you are talking about S corporations making north of a couple of hundred thousand, there is a lot of flexibility in the mind of many practitioners and, knock on wood, it seems to be working out.
The IRS is a little schizophrenic on the issue because there is a lot of case law where the IRS was arguing that salaries paid by C corporations are too high. Most of the case law in the too low S corporation salary area is people who were violating Reilly’s Eleventh Law of Tax Planning – Pigs get fed. Hogs get slaughtered. The way Herb Cohan, my first managing partner, put it was “Don’t be a chazzer“. One rule of thumb is that anything over the social security maximum ($127,200 in 2017) is enough. Another is one third of total income.
Newt Gingrich was criticized for using this technique when he released his 2010 return during the 2012 primaries. (There used to be a quaint tradition of Presidential candidates releasing their returns. Now only losers do that ). He had salary of $252,500 from Gingrich Holdings Inc, which flowed through over two million to him. I stood up for old Newt.
Well thanks to the new 20% deduction S corporations just gained another advantage over proprietorships and there will be a new rule of thumb on the minimum salary.
The 28.57% Solution
Thinks of an S corporation with a single owner who is the sole employee. Total income is $3,000,000. The owner takes a salary of $150,000 leaving $2,850,000 to flow through. The S corporation is saving him $82,650 in medicare tax. Not exactly a fortune, but if it was laying on the sidewalk, he would bend over to pick it up.
Now we have the 20% qualified business income deduction. The nature of the business is such that depreciable assets are negligible. So we take 20% of $2,850,000 – $570,000 -and compare it to 50% of $150,000 -$75,000. We get the lower number. Well that sucks. We need more W-2. Sure it will cost us more medicare tax but when you compare 2.9% to 50% of 37%. Well I’ll let you do the math.
There is a problem, though. As we increase the W-2, the flow-through goes down lowering our result on the first test. If there is more W-2 than we need, we are wasting medicare tax.
I have often remarked that you learn all the math that you need to do tax work by fourth grade. I am now going to give you something that let’s you stay with that. Try 28.57% of the $3,000,000 as your salary. That would be $857,100 which leaves you $2,142,900 of flowthrogh. Now let’s run the test. 2o% of $2,142,900 equals is $428,580 and half of $857,100 is $428,550. It is not perfect because 28.57% is not the exact percentage. Try dividing $3,000,000 by 3.5, if you are a fanatic.
Stumbling On It
As I was running scenarios for my accounting firm client I stumbled on this as I was trying to come up with the right salary by brute force, which is not very hard with a spreadsheet program. I realized that the problem could be solved using algebra. I could tell you to give it to a bright thirteen year old, but I will share the algebra in case you don’t want to do it yourself. Or you can trust me and skip the next paragraph.
T is the total income. N is the net income after salary. W is the wages. The optimal solution is when 20% of N equals 50% of W. T is the total of N plus W. 20% of N is equal to 50% of W. If you multiply both sides of that equation by 5 you get that N is equal to 250% of W. Go to the first equation and substitute giving you T=W+2.5W which is T= 3.5 W which is W=T/3.5.
When I was a junior accountant at Joseph B Cohan and Associates, one of our tasks was preparing depreciation schedules by hand. We would do the computation for all the assets on hand at the beginning of the year and the seniors who went out in the field would finish it up with the current year acquisitions which would form the basis for a journal entry to the trial balance. We would use a declining balance method converting to straight line to bring the net book value to zero. As the asset was getting along in life we would figure it both ways to see which was higher.
I figured out that the cross over could be derived algebraically. I shared it with the fellow who sat behind me. He did not make use of it, but when explaining how we do depreciation schedules to a newbie he said “Pete has some sort of Einstein formula for when you go to straight line”. That made my day.
Regardless, now you have the source of the 28.57% solution. I would suggest that you use it as a starting point, because there can be other issues. Maybe salaries to others or substantial depreciable assets. Remember Reilly’s Sixth Law of Tax Planning – Don’t do the math in your head. Your client might have other devilish details complicating the situation, but this might help a little.
A Warning
Don’t screw around and think that qualifying for the 20% deduction will mitigate the consequences of some other shenanigans. You cannot four years later when dealing with an auditor argue that you really had more W-2 wages. This is from the Committee report.
W-2 wages are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer.51 W-2 wages do not include any amount which is not properly allocable to the qualified business income as a qualified item of deduction. In addition, W-2 wages do not include any amount which was not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return.
On CPAs
One of the themes of this blog is self-deprecatory mocking of the public accounting profession, which sometimes tends to take itself too seriously and complain about what is a pretty soft life compared to – well just about everything else I can think of other than being a trust fund beneficiary.
I spend most of my working time in the basement of my condo with another CPA, but she like me had an atypical path into the profession. Getting out of the house and spending the day with a few of my professional brothers and sisters put me back in touch with how fond I am of them.
Take somebody who has about 70% of the math ability of an engineer or actuary, 80% of the verbal reading comprehension ability of a lawyer, 60% of the leadership ability of an Army officer and maybe 70% of the charisma of a top producing life insurance salesman and you have the makings of a pretty good CPA. An above-average share of humility is required, which is why some of those other professions might not do so well as CPAs.
Their biggest professional hazard, which most of them don’t realize, is envy, because their best clients will tend to make more money and have more prestige than they do. Still, they really are a pretty good bunch and generally very loyal to their clients and the people they work closely with and the sensible ones don’t take themselves too seriously, but do take their work very seriously. I’m glad to be among them, although I will continue to mock them and expect them to mock me back.