Like most business owners, you have probably followed the news closely as Congress passed major tax legislation and the president signed it into law. The Tax Cuts and Jobs Act (TCJA) contains a variety of significant provisions affecting contractors. Near the top of the list is a potentially substantial (though temporary) deduction for owners of “pass-through” entities.
Pass-through entities are businesses whose earned income “passes through” to owners’ personal returns, where federal income tax liability is then assessed. Examples include partnerships, S corporations, single-member limited liability companies (LLCs) and some multimember LLCs as well. A sole proprietorship also receives the benefit of this deduction.
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.
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 qualified business income (QBI). For purposes of this tax break, QBI can generally be defined as the net amount of qualified items of income and deductions from any qualified business of the non-corporate owner. Investment income or capital gains from the business generally do not qualify for the deduction.
The deduction is available to individuals (as well as estates and trusts) that own interests in pass-through business entities. It generally equals 20% of the owner’s share of net QBI income or loss from all of their qualified businesses, subject to certain restrictions.
Recognizing the limits
For higher income taxpayers, payment of relatively low employee wages may limit this tax break. The maximum amount of the new tax deduction generally cannot be more than 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.
“Qualified property” is depreciable tangible property purchased in the last 10 years or any older property including real estate with a depreciable life of more than 10 years that is not yet fully depreciated, was owned by a qualified business as of year end and used by the business at any point during the tax year for the production of qualified business income.
The W-2 wage limit doesn’t apply, however, if your personal taxable income is less than $315,000 (married filing a joint return) or $157,500 (single filer).
This new tax 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 can’t pay themselves 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 too high for the W-2 wage limit exception to apply, now may be a good time to look at your choice of entity structure and start paying yourself W-2 wages. Otherwise, you won’t be able to claim this valuable new deduction.
Getting the whole story
The tax deduction for QBI now available to owners of pass-through entities is a notable reform. If your construction company operates under a qualifying business structure, be sure to discuss the full ramifications of this break with your CPA.
And don’t stop there. The TCJA contains many other provisions of interest to construction company owners — particularly the more generous depreciation-related tax breaks, which could benefit your business when acquiring equipment or other assets. Not all of the news is good, of course, as the law does introduce new limitations to many other deductions. Again, your VonLehman advisor can provide all of the details.