In my last post, I covered which businesses are eligible for the deduction and how the deduction is reduced for high income taxpayers and some types of businesses. In this one, we’ll discuss the mechanics of calculating the deduction.
Congress must have designed the calculation to be as difficult as possible. You might think that you calculate the deduction by taking your business profit and multiply that by the 20% deduction rate. Then you put the deduction on page 1 of the 1040 form where it reduces your income. That is precisely how you do not calculate the deduction.
First, the deduction does not appear on page 1 of the 1040. It appears on page 2 of the 1040 right after your itemized deduction total or your standard deduction amount. Right away, note that the deduction does not reduce adjusted gross income (AGI), which means that it does not affect any deductions calculated on the basis of AGI. For instance, you don’t get to calculate deductible medical expenses on an income amount calculated after the new deduction.
The 1040 form for 2018 has not been released yet, but I suspect the deduction will appear where your personal exemption amount formerly appeared. For 2018, personal exemptions have been eliminated, but that’s a post for another day.
Second, you calculate the new business deduction by making two calculations:
- Multiply 20% by your business profit
- Multiply 20% times your adjusted gross income after deducting your itemized deductions or standard deduction. When calculating the base for the multiplication, deduct long term capital gains from AGI. Why? Because long term capital gains already get a tax break. You don’t get an additional break on them.
Your deduction is the lower of the two amounts. Isn’t that a nice simple little calculation? Let’s look at two examples.
Business income $100,000
Adjusted gross income including business income and long term capital gains $200,000
Long term capital gains $50,000
Itemized deductions $30,000
Business income of $100,000 times 20% = $20,000.
Adjusted gross income. $200,000
Less: Long term capital gains $50,000
Less: itemized deductions: $30,000
Base for calculation: $120,000
Base times 20% = $24,000
Your deduction amount in example #1 is $20,000.
Business income $70,000
Adjusted gross income including business income and long term capital gains $100,000
Long term capital gains $30,000
Itemized deductions $35,000
Business income $70,000 times 20% = $14,000
Adjusted gross income. $100,000
Less: Long term capital gains $30,000
Less: itemized deductions: $35,000
Base for calculation: $35,000
Base times 20% = $7,000
Your deduction amount in example #1 is $7,000. Please note that this is lower than 20% times business income. Your deduction, based on calculation #2, may be lower than you expect. Running real numbers on this calculation is important given the factors going into the deduction calculation.
Your taxable income becomes adjusted gross income less itemized or standard deductions less the business deduction. You apply your tax rate to that taxable income amount as you would in prior years, including the separate calculation for long term capital gains and qualified dividends.
I didn’t mention this above, but I believe that qualified dividends will be deducted from AGI in the calculation for the same reason long term capital gains are deducted.
I have no clue why the deduction had to be this complex. It didn’t start out that way in the original proposals from nearly a year ago. Am I happy that it’s complex? Damn right, I am. I see a yacht in my future.
If you have any questions, please contact me at firstname.lastname@example.org or (703) 818-8284. I will have more posts on the way. I don’t know what I’ll cover next in the new tax law. I am open to suggestions.
I am developing a model to determine if single owner LLC’s treated as S corporations should give up the S corporation status, and switch back to sole proprietor tax status, or even convert to C corporation status. So far, I can tell you that there is no clear answer. This may be my next post if anyone is interested. Let me know.
Thanks for reading!
Frank Stitely, CPA, CVA
SK CPAs & Business Advisors PLLC