Qualified Business Income Deduction Results in Tax Savings for Certain A&E Firms
The Tax Cuts and Job Act of 2017 (TCJA) lowered the C Corporation tax rate for architects and engineers who are treated as qualified personal service corporations from 35% to 21%. On the surface, S Corporations did not make out as well with the top individual income tax rate dropping from 39.6% to 37%, along with some other advantageous changes to tax brackets. To partially compensate for this discrepancy, the TCJA added the Qualified Business Income (QBI) deduction, which allows owners of pass-through entities a deduction of up to 20% of qualified business income. If able to take full advantage of the QBI deduction, an individual subject to tax at the highest rate of 37% may be able to reduce their effective federal tax rate on pass-through income down to 29.6% (80% of 37%).
While every business has its own unique tax planning issues, one common approach many firms take is to pay out a significant amount of their year-end profit as bonuses to employees and owners. Prior to the TCJA, payment of year-end bonuses to an S Corporation shareholder often had no significant federal income tax impact since the income was simply moved from one bucket (S Corporation pass-through income) to a different bucket (shareholder compensation), both of which were taxed in a similar manner. Keep in mind, however, that any payment of compensation would be subject to payroll taxes, so there would be an additional cost.
DGC (DiCicco, Gulman & Company LLP), an accounting and business advisory firm headquartered in Massachusetts with a robust Architectural and Engineering practice, worked with an A&E firm on their year-end 2018 tax return, an S Corporation with year-end taxable income of $2.7 million (before any year-end shareholder bonuses). The company shareholders had already been paid $3.5 million in compensation in 2018. As a cash basis taxpayer, the S Corporation had enough cash available (without borrowing on their line of credit) to bring taxable income down to $300,000 and retain enough cash for immediate working capital needs. Before the changes resulting from tax reform, this probably would have been the optimal approach. However, because of the new QBI deduction, they considered other options.
Rather than paying additional compensation (which is not eligible for the QBI deduction), it was decided that any excess cash would be paid out as a non-taxable S Corporation distribution. It should be noted that this is not a deductible expense to the S Corporation. Therefore, the S Corporation will report taxable income of $2.7 million. However, the firm was able to pass-through the full 20% QBI deduction of $540,000.
If the excess cash had been paid out as a bonus, the S Corporation’s taxable income of $300,000 would have yielded a QBI deduction of only $60,000. Because the shareholder wages, S Corporation pass-through income and QBI deduction all impact the taxable income of the individual shareholders, this results in $480,000 less taxable income. At a federal tax rate of 37%, this results in federal income tax savings of just under $178,000.
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In addition to the federal income tax savings discussed above, there will be some payroll tax savings. DGC's planning approach saved this firm close to $200,000 in federal income tax and payroll tax.
However, there are two items beyond the scope of this article that should not be ignored. First, the additional S Corporation income will likely impact their state tax returns and reduce their savings. Also, the new tax law requires that S Corporations pay a “reasonable compensation” to its shareholders, so compensation cannot be reduced to an unreasonably low level in order to increase the QBI deduction. Be sure to consult with your tax professional to discuss whether these strategies would work for you and your firm.
DiCicco, Gulman & Company's A&E practice is tailored to meet the needs of today’s A&E firms. They have a distinguished list of A&E clients who rely on our expertise to improve profitability and firm value. To learn more about how DGC’s tax experts can help you, contact Stephen Minson, CPA, MST at 781-937-5120 | firstname.lastname@example.org or Patrick Trask, CPA, MST at 781-937-5139 | email@example.com.
Stephen and Patrick recently joined Deltek for a webinar entitled, “Top 2019 Tax Planning Updates for A&E Firms.” Ensure your firm is well-positioned for the future by learning about the latest A&E-specific tax strategies in this one-hour webinar. DGC has also released its 2019 Architectural Study and Engineering Report which include detailed analysis of key financial benchmarks that can help A&E firms assess their strengths and weaknesses. Click here to learn more.
About the Author
Steve is a Partner in the Commercial Business group, and has a focus on the A&E industry. With over 30 years of experience, he works with closely-held business owners and their companies to find tax-efficient solutions to the issues they face. Steve specializes in providing tax consulting, planning and compliance services. His expertise includes consulting on tax incentives and multi-state tax matters for corporations, partnerships and individuals.
About the Author
Patrick has over 14 years of public accounting experience providing tax consulting, planning and compliance services to a variety of small, mid-size and large companies, including their owners. He advises clients in the architectural, engineering, professional services, distribution, retail, and manufacturing industries. Patrick's experience includes working on federal and mutti-state tax matters for C and S corps, partnerships and LLCs.
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