No doubt, you have heard that there is a 20% deduction for business income. But, as with anything tax, the devil is in the details. First let’s review some common definitions:
Taxable income for this purpose is defined as the net income shown on the form 1040 after all deductions, minus any long-term capital gain income. The rationale for this is that long-term capital gain come is already getting taxed at a preferred lower rate.
Flow-thru income is defined as your share of the net profit from the business, typically found in box 1 of a K-1 issued by a partnership or S Corporation, or at the bottom of the schedule C.
Specified service business are specifically listed businesses, most of which are professional services, including physicians, dentists, and other medical practitioners.
Phaseout is the reduction of the deduction when taxable income is greater than $315,000 for a joint filer, and $157,500 for all others. For specified service businesses, once taxable income reaches $415,000 for a joint filer or $207,500 for all others, the deduction is eliminated in its entirety.
Your deduction is limited to the lesser of 20% of the flow-thru income or 20% of your taxable income and phased out for those with higher taxable income. The allowable deduction for those within the phaseout range brings into the mix the W-2 wages paid by the business. The calculation is fairly complex, the mechanics of which are beyond the scope of this article. This deduction is taken on the individual tax return.
Below is a simplified example for a joint filer, showing the same practice flow-thru income and the effect different taxable income amounts has on the 20% deduction:
|Scenario I||Scenario II||Scenario III|
What about becoming a C corporation? A C corporation is a separate entity that pays taxes on its own. Prior to the new tax law, C Corporation medical practices were classified as personal service businesses and taxed at a flat rate of 35%. This was repealed under the new tax law, and instead, all C Corporations are taxed at a flat 21%.
A C corporation is great if you want to retain profit in the business for use for expansion, asset acquisition, etc. But money taken out of this type of entity will be treated as either salary (taxed at ordinary income rates to you; deducted by the corporation) or dividend (taxed at long-term capital gains rates to you; not deductible by the corporation). Thus a practitioner who routinely pulls nearly all the cash out of the practice each year would not realize any savings by changing to a C corporation, and will potentially pay more tax overall, compared to the taxation of flow-thru income.
The above presents a simplified explanation of how the new tax law on professional service businesses. Now is the time to run models to determine the optimal tax structure for your practice. For assistance with this matter or any other tax issues, please contact Laurence C. Rubin, CPA, Professional Services Industry Group lead partner, at 301.222.8212.