Many of our clients are self-employed consultants who perform their consulting services both in and outside the United States. Many of these clients have asked us how the new tax reform law might affect them. Specifically, they are inquiring about whether they qualify for the new 20% Qualified Business Income (“QBI”) deduction. In this article, I will address common questions and concerns about the QBI deduction for consultants.
The Tax Cuts and Jobs Act, passed on December 22, 2017, reduced corporate income tax rates from graduated rates up to 35% to a flat 21% rate. Since small business owners, including consultants, often do business using passthrough entities (the income from which flows through to their individual returns and is taxed at individual tax rates) instead of C corporations, they also requested a tax reduction related to their business income. Congress obliged by adding Internal Revenue Code Section 199A, which generally allows a 20% deduction on certain Qualified Business Income (QBI).
The top individual tax rate in the United States is 37%, and a 20% deduction related to passthrough business income effectively lowers the top rate to 29.6%. The 20% QBI deduction is effective for taxable years beginning on January 1, 2018, and expires on December 31, 2025.
Generally, QBI is the ordinary business income less ordinary business deductions you earn through a passthrough entity. QBI does not include wages you may earn as an employee.
The 20% QBI deduction is generally equal to the sum of the LESSER OF:
- The “qualified business income” of the taxpayer, or
- 20% of the excess of taxable income over the sum of any net capital gain
Limitations for Consultants
Congress and the Administration believed that not all non-corporate businesses should get this tax break. At certain income thresholds, the law limits and ultimately eliminates the 20% QBI deduction if the taxpayer is in a “Specified Service Trade or Business.” A Specified Service Trade or Business means any trade or business involving the performance of services in the fields of:
Health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities. However, a trade or business that involves the performance of engineering or architectural services is not a specified service business.
Therefore, since the profession of consulting is a Specified Service Trade or Business, consultants need to understand when or if they will be able to avail of the QBI deduction. Here are answers to some common questions we are receiving in this regard:
How can I easily estimate my QBI deduction?
If your family’s total income is composed almost entirely of consulting income from a passthrough entity and your taxable income is less than $157,500 a year or $315,000 married filing a joint income tax return, then then your QBI deduction is generally 20% of your taxable income.
For example, if your consulting taxable income is $150,000 then your QBI deduction is $30,000.
I am a consultant and file a married filing a joint income tax return. My taxable income is slightly higher than $315,000; am I allowed a 20% QBI deduction?
A consultant and other person in a specified service trade or business loses his/her ability to use the 20% QBI deduction if his/her taxable income exceeds $157,500, if single, and $315,000 if married filing jointly. The 20% QBI deduction phases-out as taxable income increases over a range from $157,501 to $207,500 (single) and $315,001 to $415,000 (married filing jointly).
I am a sole proprietor, below the income thresholds and reporting consulting income on Schedule C of my Form 1040 tax return. Do I have to form a Limited Liability Company (LLC) to take the QBI deduction?
No, you do not need to form an LLC or any other entity to take advantage of the QBI deduction. All passthrough entities and Schedule C businesses are eligible.
I perform some of my consulting work outside the United States. How will this affect my QBI deduction?
The 20% QBI deduction is limited to work that is “effectively connected with a U.S. Trade or Business.” Generally, this means that only the consulting work (reduced by associated expenses) performed within the United States will qualify for the 20% QBI deduction. Careful records should therefore be kept regarding the earnings derived for services performed in the United States and those outside the United States. Detailed records should also be kept related to expenses and whether the expense is associated with work performed in or outside the U.S.
I am a G-4 dependent visa holder and a nonresident for income tax purposes. Is my consulting income allowed a 20% QBI deduction?
A nonresident, whether you are a G-4 visa holder or other nonresident, should be entitled to a 20% QBI deduction on your consulting income provided you earn Qualified Business Income within the United States and your taxable income is less than $157,500 (nonresidents generally must file a nonresident income tax return). The consulting income you earn outside the United States should not be taxable, since nonresidents are only subject to tax on income earned within the United States.
What else should I keep in mind?
Please note that currently we only have the law to rely on, and the law provides sparse details with regard to the QBI calculation and nuances. The Treasury and IRS are expected to release further regulations and guidance in this area.
We are closely monitoring developments and will publish updates as they occur. In the meantime, should you have urgent needs or questions on the QBI, feel free to contact Tracy Barnett at Tbarnett@thewolfgroup.com or 703-502-9500 x154 to set up an appointment with one of our Tax Directors.