The Tax Cuts and Jobs Act (TCJA), signed into law in 2017, has brought about significant changes in the US tax landscape, impacting businesses and individuals alike. One of the most notable changes introduced by the TCJA is the Qualified Business Income (QBI) deduction. This new tax provision has raised questions about the continued relevance of S-Corporation (S-Corp) elections for small businesses. In this blog post, we will examine the impact of the QBI rule changes on S-Corp elections and whether they still make sense in the current tax environment.
What is an S-Corporation?
An S-Corporation is a type of corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. This allows S-Corps to avoid double taxation on the corporate income, as shareholders report the flow-through of income and losses on their personal tax returns, and the corporation pays no federal income tax. S-Corps are popular among small businesses due to their favorable tax treatment and limited liability protection.
The QBI Deduction and its Implications
The Qualified Business Income (QBI) deduction, established by the TCJA, allows eligible taxpayers to deduct up to 20% of their qualified business income from a partnership, S-Corporation, or sole proprietorship. This deduction is in addition to the taxpayer’s regular itemized or standard deduction. The QBI deduction aims to provide tax relief for small business owners and help stimulate economic growth.
Before the introduction of the QBI deduction, S-Corp elections were a popular choice for small business owners seeking to reduce their self-employment tax liability. S-Corp shareholders could take a portion of their income as salary, subject to employment taxes, and the remaining portion as a distribution, which is not subject to self-employment taxes.
However, with the introduction of the QBI deduction, the tax benefits of an S-Corp election have diminished. The QBI deduction is calculated based on the taxpayer’s share of the business’s qualified business income, which does not include S-Corp shareholder wages. As a result, S-Corp shareholders who take a significant portion of their income as wages may see a reduced QBI deduction.
Do S-Corp Elections Still Make Sense?
The answer to this question depends on a business owner’s individual circumstances. While the QBI deduction has certainly changed the tax landscape, there are still scenarios in which an S-Corp election may be beneficial. Here are a few factors to consider when deciding if an S-Corp election makes sense for your business:
- Self-Employment Tax Savings: Although the QBI deduction may reduce the potential tax benefits of an S-Corp election, it does not eliminate them entirely. S-Corp shareholders can still save on self-employment taxes by taking a portion of their income as a distribution, which is not subject to self-employment taxes. However, it is essential to weigh this benefit against the potential reduction in the QBI deduction.
- Liability Protection: S-Corps provide limited liability protection to their shareholders, which can be an important consideration for some business owners. This protection may outweigh the potential reduction in the QBI deduction for some businesses.
- State Tax Considerations: State tax laws vary, and the QBI deduction may not be available or may be calculated differently in some states. In these cases, the tax benefits of an S-Corp election may still be significant.
Another factor to consider when deciding whether to elect S-Corp status is its potential impact on future Social Security benefits. Social Security benefits are calculated based on a worker’s average indexed monthly earnings (AIME) during their 35 highest-earning years. Self-employed individuals and business owners pay Social Security taxes through self-employment taxes.
As previously mentioned, S-Corp shareholders can save on self-employment taxes by taking a portion of their income as a distribution, which is not subject to self-employment taxes. While this strategy can lead to immediate tax savings, it may have a long-term effect on Social Security benefits. By reducing the amount of income subject to self-employment taxes, S-Corp shareholders may inadvertently lower their AIME, resulting in reduced Social Security benefits when they retire.
Conclusion
In conclusion, the QBI deduction’s introduction has indeed shifted the tax landscape and reduced the benefits of S-Corp elections for some small business owners. However, it is crucial to carefully consider your individual
Some Final Thoughts
One example I studied recently that really highlights the impact of the QBI deduction is this blog post from Gusto, posted January 2023:
https://gusto.com/resources/articles/taxes/s-corp-tax-savings-calculator
I noticed this excerpt: “For simplicity, this example does not include the 20% deduction for “Qualified Business Income” that became available to owners of pass-through businesses under the Tax Cuts and Jobs Act in 2018.“
After thinking about how “simplicity” and “tax” do not go well together, I set out to determine the actual impact of this missing piece of Gusto’s calculations.
Without QBI, the savings are obvious: “What’s the tax savings between these two scenarios? $27,874.75 (LLC) – $22,471.34 (S-Corp) = $5,403.41!“
But would an LLC with $100,000 of profit actually pay $27,875 in tax when factoring in the QBI?
I plugged this scenario into my tax software and sure enough, the estimated federal tax bill for the LLC was $24,100. So for an entity with $100,000 of profitability, the ACTUAL post-QBI tax savings are just $1,600.
Once you factor in the Social Security issues, the necessity of maintaining an accurate payroll with various state withholding licenses, the extra accounting fees, AND the challenge of taking a business use of home deduction or vehicle mileage (simplified) with an S-Corp, I really can’t see a scenario where an S-Corp makes sense!
For Those Profiting $200k Per Year
Under this circumstance, it may be worthwhile to consider S-Corps as a long-term tax strategy. This would be the case only if you are not an aggressive user of the home office deduction and vehicle mileage deduction (both are ineligible through the S-Corp tax code)
See the attached PDF here for the analysis of the tax-benefits for businesses with higher profitability:
