CHAPTER 15 - TAXING BUSINESS INCOME

Art, an executive with Azure Corporation, plans to start a part-time business selling products on the internet. He will devote about 15 hours each week to running the business. Art's salary from Azure places him in the 35% income tax bracket. He projects substantial losses from the new business in each of the first three years and expects sizable profits thereafter. Art plans to leave the profits in the business for several years, sell the business, and then retire. What type of entity Art's business should be?

From a tax standpoint, Art should initially consider operating as a sole proprietorship or as a single-member LLC. This would allow him to deduct the losses against other income.

Marco and Ruby, married taxpayers who file a joint return, have taxable income of $370,000, of which $300,000 is attributable to an accounting sole proprietorship that pays wages of $40,000 to employees. The taxpayer has an applicable percentage of:

45% Applicable percentage = 100% - Taxable income before QBI deduction - Threshold amount $100,000 (married filing jointly); $50,000 (others) Applicable percentage = 100% - $370,000 - $315,000 $100,000 Applicable percentage = 45%

The Federal income tax treatment of business income usually follows the legal form of the taxpayer (i.e., an individual's sole proprietorship is reported on the Form 1040); a C corporation's taxable income is computed on Form 1120. The check-the-box Regulations are used if the unincorporated taxpayer wants to use a different tax regime. Under these rules, a disregarded entity is taxed as an individual or a corporate division; other tax regimes are not available. For instance, a one-member limited liability company is a disregarded entity.

Disregarded entity

A sole proprietorship pays tax at the same rate as a corporation.

False. Income from a sole proprietorship is taxed at the owner's personal income tax rates which range from 10 percent to 37 percent. A corporation pays tax at a flat rate of 21 percent.

The maximum deduction for qualified business income is 25 percent.

False. The maximum deduction is 20%.

Eliza is a 50 percent partner in Peak Partnership. During the year, Peak earned net profit of $100,000 ($210,000 gross income - $110,000 operating expenses) and distributed $20,000 to each partner. Eliza must report Peak Partnership profit of $20,000 on her Federal income tax return.

False. The partnership must file Form 1065, an information return on which the partnership net profit or loss is reported. Peak's net income of $100,000 is allocated to Eliza according to her partnership interest and Eliza reports the resulting $50,000 of income on her Federal income tax return, regardless of how much of the income was withdrawn from the partnership.

The reasonableness approach included in the House bill would have required all businesses to pay a minimum wage to their owners.

False. Under the House bill, all entities would have been required to pay reasonable compensation to their owner/employees. If followed, this approach would ensure that a portion of business income is taxed at income tax rates (and also ensures that this income is subject to employment taxes, like other employees).

Vegetable Company has taxable income of $60,000 in 2018. It distributes all of its after-tax income as a dividend to its sole shareholder, Chen, who is 28 years old, and single. Chen has no income sources other than Vegetable Company. Based on these facts: a. Vegetable Company will pay tax of $12,600. b. Chen will have no Federal tax liability. c. Chen will receive a dividend of $47,400. d. Chen will have taxable income of $35,400. e. All of these choices are correct.

e. All of these choices are correct. Vegetable pays tax of $12,600 ($60,000 × 21%). It then distributes its after-tax income of $47,400 ($60,000 - $12,600) as a dividend to Chen. Chen has taxable income of $35,400 ($47,400 - $12,000 standard deduction). Chen's tax liability is zero since the dividend is subject to the favorable tax rates and Chen's taxable income is under $38,600.

A legal entity in which all owners are protected from the entity's debts but which may lack other characteristics of a corporation (i.e., centralized management, unlimited life, free transferability of interests). LLCs are treated as partnerships (or disregarded entities if they have only one owner) for tax purposes.

Limited liability company (LLC)

For purposes of the deduction for qualified business income, a specified service trade or business includes those involving the performance of services in certain fields, including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; services consisting of investing and investment management, trading or dealing in securities, partnership interests, or commodities; and any trade or business where the business's principal asset is the reputation of one or more of its employees or owners. § 199A(d)(2).

Specified service trade or business

Who can claim the qualified business income (QBI) deduction?

The QBI deduction is available to any noncorporate taxpayer.

Congress provided a means of reducing the taxes on businesses that operate in different noncorporate business forms by creating the deduction for qualified business income.

True. With the reduction in the corporate income tax rate to 21 percent in 2018, Congress needed to provide a means of reducing the taxes on businesses that operate in different business forms (e.g., sole proprietors, partnerships, and S corporations). Congress accomplished this with the creation of the deduction for qualified business income, which applies to noncorporate taxpayers.

When considering becoming self-employed to take advantage of the QBI deduction, one consideration is the effect of self-employment taxes.

True. Items to consider include the effect of self-employment taxes and the need to provide health insurance and other benefits, as well as potentially incurring additional business expenses.

A limitation on the deduction for qualified business income that caps the deduction at the greater of (1) 50 percent of the wages paid by a qualified trade or business or (2) 25 percent of the wages paid by the qualified trade or business plus 2.5 percent of the taxpayer's share of the unadjusted basis of property used in the business that has not been fully depreciated prior to the close of the taxable year. § 199A(b)(2)(B).

W-2 Wages/Capital Investment Limit

Complete the statement below in response to the question, "Can a sole proprietor form as a single member limited liability company (LLC)?"

Yes . Most states allow for single-member LLCs. Under the default rules of the check-the-box Regulations, a single-member LLC is taxed as a sole proprietor and by filing Form 8832 a single-member LLC is taxed as a corporation.

When calculating the QBI deduction: a. The QBI is a deduction from AGI. b. There is a limitation that applies to high-income taxpayers. c. The QBI deduction is available whether a taxpayer uses the standard deduction or itemized deductions. d. There is a limitation that applies to certain types of services businesses. e. All of these choices are correct.

e. All of these choices are correct.

Charlotte is a partner in, and sales manager for, CD Partners, a domestic business that is not a specified services trade or business. During the tax year, she receives guaranteed payments of $209,400 from CD Partners for her services to the partnership as its sales manager. In addition, her distributive share of CD Partners' ordinary income (its only item of income or loss) was $125,640. What is Charlotte's qualified business income?

$125,640.

Luis, a married taxpayer, operates an ice cream store as a sole proprietor. The business has two employees, who are paid $40,000 during 2018. The business has no significant assets. During 2018, Luis reports net income on his Schedule C of $245,000 and modified taxable income of $285,000 (this is also the taxable income before the QBI deduction). Luis's QBI deduction is:

$49,000 Since Luis's taxable income before the QBI deduction is below the income threshold for married taxpayers filing a joint return ($315,000), the W-2/Capital investment limitation does not apply. As a result, Luis's QBI deduction is $49,000, the lesser of: 1. 20% of qualified business income ($245,000 × 20%) = $49,000 2. 20% of modified taxable income ($285,000 × 20%) = $57,000

A separate taxable entity subject to the rules of Subchapter C of the Code. This business form may create a double taxation effect relative to its shareholders. The entity is subject to the regular corporate tax and a number of penalty taxes at the Federal level.

C corporations

By using the check-the-box rules prudently, an entity can select the most attractive tax results offered by the Code, without being bound by legal forms. By default, an unincorporated entity with more than one owner is taxed as a partnership; an unincorporated entity with one owner is a disregarded entity, taxed as a sole proprietorship or corporate division. No action is necessary by the taxpayer if the legal form or default status is desired. Form 8832 is used to "check a box" and change the tax status. Not available if the entity is incorporated under state law.

Check-the-box Regulations

A deduction allowed for noncorporate taxpayers based on the qualified business income of a qualified trade or business. In general, the deduction is limited to the lesser of 20 percent of qualified business income, or 20 percent of taxable income before the qualified business income deduction less any net capital gain. There are three limitations on the deduction—an overall limitation (based on modified taxable income), another that applies to high-income taxpayers, and a third that applies to certain types of services businesses. § 199A.

Deduction for qualified business income

For purposes of the qualified business income deduction, it is the ordinary income less ordinary deductions a taxpayer earns from a qualified trade or business conducted in the United States by the taxpayer. It also includes the distributive share of these amounts from each partnership or S corporation interest held by the taxpayer. It does not include certain types of investment income (e.g., capital gains or losses and dividends), "reasonable compensation" paid to a taxpayer with respect to any qualified trade or business, or guaranteed payments made to a partner for services rendered. § 199A(c).

QBI deduction

Why did the TCJA of 2017 include a deduction for qualified business income?

To provide a tax cut for owners of pass-through entities.

The decision on what form of business organization to use can change as a business grows.

True. For example, in the early years of a business (when it is more likely to generate losses), a pass-through entity is usually desired so that individual owners can utilize the losses generated by the business.

In 2018, if an individual taxpayer chooses to operate a business in the corporate form and then distributes all net profits as a dividend, the maximum combined rate is about 37 percent.

True. In 2018, if an individual taxpayer chooses to operate a business in the corporate form and then distributes all net profits as a dividend, the maximum combined tax rate is about 37 percent.