The Tax Cuts and Jobs Act not only reduced the tax rate on C corporations, it includes a significant tax break for certain “pass through” entities such as sole proprietors, partnerships, S Corps, LLCs, and self-employed individuals. Business owners who report business income on their personal tax returns will now be able to deduct 20% of “qualified business income,” which is defined as the net amount of qualified income, gains, deductions and losses for the business. On average, the deduction may result in about a 20% reduction in taxes.

That’s the good news. Now for the bad news.

The deduction is limited to the lesser of 20% of business income or 50% of total W-2 wages paid by the business. So a high-income business with few employees is likely to be limited to a deduction of 50% of wages.

There are also restrictions on what type of work will be considered qualified business income. There are limitations on the deduction available for high earning individuals in certain service fields. People working in these fields who have taxable income over $315,000 for joint filers, or $157,500 for all others, will see the 20% deduction phased out over the next $100,000 and $50,000 of income, respectively.

These service areas include consulting, law, accounting, health care, veterinary services, financial services, brokerage services, performing arts, professional athletics, trading in securities… the list is long and not quite finalized at this writing. Essentially the limitations apply to work in which the principal asset of the business is the reputation or skill of its owner or principal.

There are exceptions. For example, while architects and engineers may be considered consultants and often are hired based on their reputation, they are exempted from the phase out of the deduction. Manufacturers of health care products, while operating in the health care field, are exempted from the phase out because they produce tangible goods.

Tax professionals are still waiting for definitive guidance from the Internal Revenue Service (IRS) on this and many other provisions of the new tax law. It is important that you consult with a qualified tax advisor before making any decisions related to your taxes under the new law.

For additional information, please contact Gray, Gray & Gray’s Tax Department at (781) 407-0300.