Many of our readers are likely already aware of the Sec. 199A “Qualified Business Income” (QBI) deduction. For those who aren’t, this deduction provides a 20% reduction in taxable income for owners of pass-through entities, such as sole proprietorships, partnerships, and S-Corporation shareholders. It was created by the Tax Cuts and Jobs Act of 2017 and became law in December of 2017. While the statute contained a fairly complex set of rules for calculating the deduction, it also left a great deal of uncertainty in their application. Many tax professionals advised their clients to hold off on making any major changes until the Treasury issued guidance.
On August 8, 2018, the Treasury issued proposed regulations intended to clear up some of the uncertainties created by the new deduction. While there are still some issues that would benefit from additional clarity, this is a great time for small business owners to familiarize themselves with the new deduction.
In this, the first of a series of blog posts regarding the new deduction, we will provide a brief overview of the deduction, including who may claim it, and how it is calculated. In future posts, we will discuss rules applicable to specific business types (ie, S-Corporations, Real Estate Investment Trusts, etc), income netting rules, permissible and impermissible strategies for maximizing the deduction, and other issues arising under the new Sec. 199A.
Who May Claim
The short answer to the question of what types of businesses may claim the 20% QBI deduction is that it can be claimed by the owners of any pass-through entity, provided the income of such business is U.S. sourced income. This includes sole proprietors who report their income and expenses directly on Schedule C of their personal income tax returns, rather than filing a separate business tax return. It also includes owners of most partnership interests and shareholders of S-Corporation stock. It even includes the beneficiaries of many trusts. Whether it includes the owners of rental properties is a bit of an unsettled question, which we will address in future posts. It does not, however, apply to owners of C-Corporation stock (ie, “traditional” corporate stock), or to wage earners.
Taxpayers should also be aware that the deduction does not apply to previous years, nor does it apply indefinitely. While the new deduction was created at the end of 2017, it is not available for taxpayers filing their 2017 taxes. Instead, it is available for tax years starting in 2018, and ending before 2026.
How Calculated
The starting point for calculating a taxpayer’s QBI deduction is their Qualified Business Income. This is defined as 20% of the net income from domestic (non-foreign) businesses operated as sole proprietorships, S-Corporations, trusts, or estates, including Real Estate Investment Trusts (REITs) and Publicly Traded Partnerships (PTPs).
This amount may not, however, exceed 20% of the difference between a taxpayer’s taxable income from all sources (ie, gross income after deductions, found on line 43 of a taxpayer’s Form 1040) over their net capital gain. This essentially limits or disallows the deduction for taxpayers who have low business income, but high investment income, and for taxpayers whose income is already low enough to be essentially wiped out by the standard or itemized deduction.
For some of our clients, calculating their deduction will be as simple as taking the lower of 20% of their Schedule C income, or 20% of their taxable income. Others, however, will be subject to special rules that apply to high-income taxpayers, as well as owners of Specified Service Trades or Businesses (SSTBs).
Example #1
A husband and wife file a joint return. The wife has $100,000 in wages, while the husband operates a convenience store as a sole proprietorship, with net yearly income of $60,000. They claim the new standard deduction of $24,000.
Without the deduction, the husband would owe $9,180 in self-employment tax, and the couple would have $136,000 ($100,000 + $60,000 – $24,000) in taxable income giving rise to $21,799 in income taxes. Their combined tax bill would thus be $30,979.
With the deduction, the husband would still owe $9,180 in self-employment tax. The couple’s taxable income, however, would be reduced by $12,000 (20% of $60,000) to $124,000, giving rise to an income tax of $19,159. Their combined tax bill would thus be $28,339.
Because they have no capital gain, and because their income does not exceed the thresholds discussed below, their deduction is not limited.
Definition of High Income
While “high income” may be a rather subjective term, Sec. 199A sets a “threshold amount” above which certain restrictions apply – $315,000 of taxable income for married taxpayers filing a joint return, and $157,500 of taxable income for everyone else. Note that the threshold contemplates the taxpayer’s total income from all sources after deductions (ie, line 43 of their Form 1040), rather than the income of the pass-through entity itself.
For taxpayers below this threshold, their QBI is simply 20% of the net income of their pass-through business. For taxpayers above this threshold, a restriction is phased in ratably over the next $100,000 or $50,000, meaning it applies fully to married taxpayer’s filing a joint return with over $415,000 in taxable income, and to other taxpayers with over $207,500 of taxable income.
The restriction, which applies partially to taxpayers above the threshold amount and fully to taxpayers above the phase in range, states that QBI is limited to the greater of (1) 50% of the W-2 wages paid by the businesses, or (2) 25% of the W-2 wages paid by the business, plus 2.5% of the business’ unadjusted basis in all qualified property. The precise meaning of “W-2 wages” and “unadjusted basis in qualified property” will be discussed in a future post.
Readers should note that this “exception” generally applies on a per-business basis, meaning that a high-income taxpayer who pays high wages from one business, may still be unable to claim a deduction with respect to the income from another business. Partners and S-Corporation owners should also note that just as their deduction is based on their share of the businesses’ income, the exception to the high-income phase-in is also based on their share (rather than the total) of the wages paid or property held by the business.
Example #2
Take the same facts as in Example #1, except that the wife earns $300,000 in wages, and the husband’s business nets $200,000 per year. Additionally, the husband’s business has employees who he pays $50,000 per year, and owns a building it purchased several years ago for $200,000. Their taxable income is $476,000 ($300,000 + $200,000 – $24,000).
While 20% of the husband’s income would be $40,000 per year, the taxpayers’ taxable income is above the income limits described above, and their deduction will be limited to the greater of 50% of wages paid by the business, or 25% of wages plus 2.5% of the unadjusted basis in qualified property of the business.
The first limitation equals $25,000 – 50% of the wages paid. The second limitation equals $17,500 – 25% of the wages paid plus 2.5% of the business’ basis in the building. Because $25,000 is the higher of these numbers, the taxpayers are entitled to a deduction of $25,000.
Specified Service Trade or Business
When Congress passed the new Sec. 199A QBI deduction, they specifically disfavored certain types of businesses referred to as “Specified Service Trades or Businesses” (SSTBs). Specifically, the income, wages, and property of SSTBs are not used to calculate a taxpayer’s QBI deduction.
An exception exists, however, that allows taxpayers with taxable income below the threshold amount described above to include the business in calculating their deduction, and taxpayers within the phase-in range to include a portion of the business in calculating their deduction. Unlike the purely income-based limitation described in the previous section, taxpayers above the phase-in range cannot claim any deduction based on their income from SSTBs, regardless of how much wages are paid or property is held by the business.
So what is an SSTB? Section 199A defines it as (1) any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial service, 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 owners, and (2) and trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. Notably, engineers and architects are specifically exempted from this definition.
Given that any business necessarily involves some level of skill or reputation, this definition may encompass a fairly large number of taxpayers. In a later post, we will examine the specific guidance provided in the new proposed regulations.
Example #3
Take the same facts as in Example #2, except that the husband operates a law firm rather than a convenience store. Because their taxable income is over the threshold amount and the business is an SSTB, the taxpayers are not entitled to any QBI deduction.
In Conclusion
The new Sec. 199A “Qualified Business Income” Deduction will provide an immediate benefit to the majority of taxpayers with small, pass-through businesses. Wealthier taxpayers, however, especially those in fields such as accounting, law, or entertainment will have to navigate a complex set of rules for properly calculating their deduction. Additionally, new proposed regulations must be carefully examined by taxpayers who wish to re-structure their businesses to take full advantage of the deduction. In future posts, we will further examine the definitions and rules that different taxpayers will encounter when calculating their deduction.
If you’d like to speak to one of our tax attorneys, send us a message through the form below or call our firm at 816-561-5000 to schedule a consultation.
*This post was originally published on August 31, 2018
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