Xavier, Yolanda, and Zach each own a third of XYZ, LLC. XYZ is a law firm focusing on insurance defense. The firm earns $300,000 a year. By law, the three barristers cannot earn salaries from their LLC. So, to avoid commingling corporate and personal assets (e.g. making their car payments with LLC funds), they each take a $100,000 guaranteed payment. Aside from the name, a guaranteed payment is pretty much the same as a salary (subject to employment tax).
The three LLC members are quite happy with this arrangement. Since guaranteed payments are not tied to business profits, these transfers are exempt from the self-employment tax. (but subject to employment tax through W-2 salary)
But then along came the 2017 Tax Cut and Jobs Act. The TCJA contained a rather obscure provision known variously as the pass-through 20-percent deduction or Section 199A. This deduction applies to Qualified Business Income. Guaranteed payments are not QBI. So, it appears that Xavier, Yolanda, and Zach may miss the party.
Undeterred, the three lawyers amend XYZ, LLC’s operating agreement. They reclassify their $100,000 payments as profit shares. Since these transfers are W-2 wages, profit shares qualify as QBI, so the members are eligible for the Section 199A deduction.
Roughly the same result would come about if XYZ was a partnership or any other pass-through tax organization.
Some Additional Caveats
Most tax planning professionals know that very few things in the Tax Code are this straightforward. The 199A deduction is no exception. The 199A deduction is limited to the lesser of:
- 20 percent of taxable income, or
- 20 percent of QBI income less capital gains income.
So, if Margaret the investment adviser has $100,000 in QBI, $100,000 in capital gains income, and a taxable income of $170,000, she can only deduct $14,000 (20 percent of $70,000, which is the excess of her taxable income over her capital gains income).
There are income limitations as well. Most businesses are SSTBs (specified service trade or businesses). Professional organizations, like groups of lawyers, doctors, and accountants, are always SSTBs. Furthermore, according to the IRS, “any trade or business where the principal asset is the reputation or skill of one or more of its employees” is also an SSTB.
If the taxpayer belongs to one of these organizations, the taxpayer is still eligible for the 199A deduction if the taxpayer’s taxable income is less than $157,500 ($315,000 for married taxpayers filing joint returns. Most businesses that sell goods, like restaurants, grocery stores, and car dealerships, are not SSTBs. Therefore, the income limit does not matter.
So, assuming Xavier, Yolanda, and Zach are either unmarried or married to spouses who earn less than $215,000 apiece per year, the XYZ, LLC members qualify for the pass-through 20-percent deduction.
If income exceeds the ceiling, the phase-in rules may apply. So, these taxpayers may still be entitled to a limited 199A deduction. The phase-in range for joint filers is $315,000 to $415,000; the phase-in range for single filers is $157,500 to $207,500.
Contact us to learn more about the TCJA that affect your clients.