CFP - Tax Planning (14% of the exam) - Section E.38

Characteristics and income taxation of business entities

Sole proprietorships, partnerships, LLCs, S corporations and C corporations: pass-through versus entity-level taxation, self-employment tax, reasonable compensation, the qualified business income deduction, and choosing an entity for a described owner's tax and liability goals.

Internal Revenue Code Section 199ASubchapter S

Practice question for this objective

Free sampleTax Planninghard

Dr Ola Bennett owns a dental practice through a single-member limited liability company treated as a sole proprietorship for tax purposes. Dentistry is a specified service trade or business. This year the practice produced 300,000 dollars of qualified business income and paid 100,000 dollars of W-2 wages to its staff. Ola files jointly with her husband and their taxable income before any qualified business income deduction is 560,000 dollars. Assume the taxable income threshold for a married couple filing jointly is 400,000 dollars and that the phase-in range above it is 100,000 dollars. What is the qualified business income deduction?

A50,000 dollars
B0 dollars Correct
C60,000 dollars
D112,000 dollars

Above the fully phased-out threshold, a specified service trade or business generates no qualified business income deduction regardless of its wages. The qualified business income deduction runs 20 percent of qualified business income, but two separate restrictions bite above the taxable income threshold. For a business that is not a specified service trade or business, a wage and property limitation phases in. For a specified service trade or business such as dentistry, the income, the W-2 wages and the qualified property are themselves phased out of the calculation, and once taxable income passes the top of the phase-in range they are excluded entirely. Here the threshold is 400,000 and the phase-in range is 100,000, so the deduction is fully gone at 500,000. Taxable income of 560,000 clears that point, so the deduction is nil and the wage figure never comes into play. Planning responses are to manage taxable income below the range, not to restructure the entity, since the restriction follows the nature of the trade rather than its legal form.

Why A is wrong: This applies the 50 percent of W-2 wages limitation to the 100,000 of staff wages. That limitation governs a business that is not a specified service trade or business above the threshold, but here the income is excluded before any wage test is reached.

Why B is correct: Taxable income of 560,000 sits above the top of the phase-in range at 500,000. For a specified service trade or business above that point, none of the income and none of the wages count as qualified, so no deduction survives.

Why C is wrong: This takes 20 percent of the 300,000 of qualified business income and ignores the specified service restriction entirely. It is the answer for a taxpayer below the threshold, or for a business outside the specified service category with sufficient wages.

Why D is wrong: This takes 20 percent of the 560,000 of taxable income. Taxable income sets an overall ceiling on the deduction rather than its starting point, and in any event the specified service restriction removes the deduction altogether at this income level.

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Exam traps in Tax Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

The credit, which saves 1,000 dollars against the 700 dollars the deduction would save
Why it is wrong: This values the deduction at her 14 percent effective rate, giving 700 dollars; the effective rate describes the average burden across all her income, whereas a deduction removes income from the top of the stack and is therefore worth the marginal rate.
Her entire 180,000 dollar share is subject to self-employment tax, because pass-through business income keeps the character of self-employment earnings in the owner's hands whatever the entity form.
Why it is wrong: This confuses the S corporation with a partnership or sole proprietorship. An S corporation shareholder's distributive share is not net earnings from self-employment, which is precisely why the reasonable compensation rule exists as the counterweight.
The fees take a basis equal to their value on the date of Colin's death under the general basis rules for property acquired from a decedent, so the estate recognises no taxable income when it collects them.
Why it is wrong: Tempting because the shares in the same estate do take a date of death basis and it is natural to extend that treatment to every asset. It is wrong because Internal Revenue Code Section 1014 expressly denies a basis adjustment to items of income in respect of a decedent, which is what unpaid earned fees are.

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