By Payroll and Entitlements Editorial Staff
If your company operates as a sole proprietorship, S corporation, or partnership, the company owners may be entitled to a new income tax deduction for a portion of the income that they receive from the business. In some cases, the amount of that deduction may be limited by the amount of W-2 wages paid by the business. What’s more, applying that limit may involve special W-2 calculations by your payroll department. The IRS has just released voluminous final regulations dealing with the new income tax deduction for owners of pass-through businesses—that is, businesses whose income is reported by and taxed to the business owners on their personal returns. In addition, a new Revenue Procedure lays down the ground rules for calculating W-2 wages for purposes of the new deduction.
Background. Starting with 2018, a provision added by the 2017 Tax Cuts and Jobs Act allows eligible business owners to claim a deduction for up to 20% of qualified business income received from a domestic business operated as a sole proprietorship or through a partnership, S corporation, or a trust or estate.
The deduction is subject to special rules for business owners with taxable incomes above certain limits ($315,000 for joint filers or $157,500 for other filers for 2018; $321,400 for joint filers or $160,725 for other filers for 2019). The deduction will be phased out if the qualified business income comes from a specified service, trade, or business (e.g., health, law, accounting, actuarial science, performing arts, consulting, athletics, or investing). What’s more, regardless of the source of income, the deduction will be limited to the greater of 50% of the W-2 wages attributable to the trade or business or 25% of those W-2 wages plus 2.5% of the basis of certain property used in the business.
And that’s where payroll professionals enter the picture. Computing the W-2 wage limitation is not necessarily a simple matter of toting up some figures plucked from the W-2 forms that you prepare for your company’s employees each year. In many cases, W-2 wages will have to be specially computed to maximize the deduction for company owners. So, if your company is eligible for the deduction, higher-ups may be calling on you to develop new W-2 wage data.
W-2 calculations. The final regulations specifically provide that, if a sole proprietor or pass-through entity conducts more than one trade or business, W-2 wages must be determined separately for each trade or business. If W-2 wages apply to more than one trade or business, the total is apportioned among the businesses in the same manner that deductions for the wages are allocated to the separate businesses. Once the W-2 wages for each separate trade or business are determined, only those wages that relate to qualified business income are taken into account in figuring a business owner’s deduction.
For purposes of these calculations, W-2 wages include the total amount of wages subject to withholding (I.R.C. Sec. 3401(a)), as well as 401(k) and other retirement plan contributions (I.R.C.Secs. 402(g)(3), 457, and 402A). In determining W-2 wages, a sole proprietor or pass-through entity can take into account W-2 wages paid and reported by a professional employer organization or other third party, provided that the wages were paid to common law employees or officers for employment by the sole proprietor or pass-through entity.
The final regulations do not specify rules for calculating W-2 wages for purposes of the deduction; instead, they authorize the IRS to spell out the rules. Thus, the new IRS Revenue Procedure provides three alternative methods for calculating W-2 wages:
- Unmodified Box Method. Under this method, W-2 wages are deemed to be the lesser of the total entries in Box 1 (Wages, tips, other compensation) or Box 5 (Medicare wages and tips) of all Forms W-2 filed with the Social Security Administration (SSA) for all employees.
- Modified Box 1 Method. Under this method, W-2 wages are calculated by subtracting from the total Box 1 entries any amounts that are not wages for withholding purposes and any amounts that are treated as wages only for withholding (for example, supplemental unemployment compensation benefits) and then adding elective deferrals to 401(k) and similar retirement plans that are reported in Box 12 of Form W-2 (coded as D, E, F, G, and S).
- Tracking Wages Method. Under the third method, W-2 wages are figured by tracking the actual amount of wages subject to federal income tax withholding and then adding retirement plan contributions in Box 12 as above.
Although the unmodified box method is clearly the simplest option, if your company sponsors a 401(k) or similar retirement plan it will likely result in a far lower W-2 amount—and a lower deduction limit for company owners—than either of the other two methods. Therefore, you may want to review your systems to make sure that you can crunch the additional numbers if and when company officials ask for them. (T.D. 9847, February 4, 2019; TDNR SM-0589, March 4, 2019; NPRM REG-134652-18, August 16, 2018; IRS News Release IR-2019-4, January 21, 2019; IRS Rev. Proc. 2019-11, January 18, 2019; IRS Notice 2019-7, January 18, 2019.).
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