The U.S. Treasury Department made an announcement on January 18, 2019 that has important implications for the financial health of independent insurance agencies and brokerages. The department confirmed that a law providing a new tax deduction applies to them.
The provision is in the Tax Cuts and Jobs Act, which Congress enacted and President Donald Trump signed in late 2017. It permits certain types of businesses to deduct up to 20% of their income from the taxable amount. Specifically, it applies to:
- Sole proprietorships
- S corporations
Income earned through wages or through a C corporation is not eligible for the deduction.
The law limits how widely the deduction applies. Specifically, certain businesses (labeled in the law as “specified service trades or businesses” or SSTBs) cannot take the deduction if their taxable income exceeds specific levels. The law defines SSTBs as businesses involving the performance of services in several sectors, including financial services and brokerage services.
The law is unclear as to whether this definition of SSTBs includes insurance agencies. It was therefore up to the Treasury Department and the Internal Revenue Service to make this determination. In the final version of regulations implementing the deduction published on January 18, the department ruled that the term “brokerage services” in the law does not include “services provided by … insurance agents and brokers.” Consequently, insurance agencies that are sole proprietorships, partnerships or S corporations may take the deduction without limits on their income. It applies to tax years from 2018 to 2025.
The deduction is calculated using “qualified business income,” which is “items of gross income, gain, deduction, and loss” connected with business operations in the U.S. It does not include:
- Short- or long-term capital gains or losses
- Interest income that cannot be allocated to the business
- Annuity income unrelated to the business
- Non-deductible compensation an S corporation pays to a shareholder
- Certain non-deductible payments to partners
- Other items unrelated to insurance agencies
The deduction equals:
- 20% of the total qualified business income, or
- 20% of the amount by which taxable income exceeds the excess of net long-term capital gains over net short-term capital losses during the tax year
Whichever is less.
To illustrate, suppose an agency that is an S corporation has taxable income of $80,000 and qualified business income of $100,000 (the two numbers are calculated differently.) The agency has no capital gains or losses. Taxable income multiplied by 20% equals $16,000, while qualified business income multiplied by 20% equals $20,000. This agency can deduct $16,000, the lesser of the two numbers. The tax rate for an S corporation is 29.6%, so the deduction saves this agency $4,736 ($16,000 times 29.6%.)
Suppose another agency is a sole proprietorship, and the owner files her taxes jointly with her spouse. The agency again has qualified business income of $100,000. However, the owner and her spouse have a joint taxable income of $150,000, including long-term capital gains of $10,000 and no short-term capital losses. Subtracting the $10,000 from taxable income leaves $140,000. Multiplying this figure by 20% equals $28,000. Multiplying qualified business income ($100,000) by 20% equals $20,000. This couple can deduct $20,000 from their taxable income. At the 22% tax rate, their tax bill is reduced by $4,400.
As these examples show, agencies and their owners stand to realize significant savings from this deduction. Agencies may want to discuss it with qualified tax accountants. All agency owners will want to take advantage of this new law.