Understanding the New Qualified Business Income Deduction

Mike Burt, CPA, MBA (May, 2018)

The highly publicized Tax Cuts and Jobs Act (TCJA) signed into law on December 22, 2017 had a rippling effect that changed, or modified, almost every area of the Internal Revenue Code (IRC). One of the more taxpayer-friendly provisions of the TCJA was the creation of a new IRC Section 199A which allows up to a 20% deduction for "Qualified Business Income" (QBI) from pass-through entities such as partnerships, S Corporations, as well as sole proprietorships.  The new deduction is allowed for tax years beginning on or after January 1, 2018 through December 31, 2025. For tax years beginning after December 31, 2025, the provisions under IRC Section 199A will expire, unless extended by Congress.

This deduction will be taken what is referred to as “below the line” on an individual's personal income tax return filed for the year.  It reduces taxable income, rather than being taken “above the line” in determining Adjusted Gross Income. The deduction is not an itemized deduction and can be taken by taxpayers who take the standard deduction.  Also, it does not reduce net earnings for self-employment purposes.

QBI is determined separately for all of a taxpayer's businesses.  QBI is defined as a pass-through entity's net amount of items of income, gain, loss, and deduction that are connected with a U.S. trade or business used in calculating its taxable income. Items such as tax-exempt income, tax-exempt related expenses, as well as non-deductible expenses are not included in calculating QBI.  Certain types of investment-related items (such as capital gains or losses, dividends, and interest income) are also excluded from QBI, unless they are properly allocable to the business. QBI does not include reasonable compensation received from S corporation owners, or a guaranteed payment received from a partnership for services provided to a partnership's business. 

Generally, the deduction is equal to the sum of:

  • the lesser of: (a) 20% of an individual's combined QBI from each of their pass-through entities, or (b) 20% of the excess of their taxable income over the net capital gains plus qualified cooperative dividends; and
  • the lesser of: (a) 20% of an individual's cooperative dividends, or (b) 20% of the individual's taxable income reduced by their net capital gains.

Example:

A and B file a joint return on which they report taxable income of $210,000, of which $10,000 is net capital gain and $180,000 is ordinary net income from A's interest in an S corporation. A and B's combined QBI is $36,000 (20% × QBI of $180,000). Combined QBI is $36,000 before applying the overall limitation of $40,000 (20% × [$210,000 taxable income — $10,000 net capital gain]). A and B's Sec. 199A deduction is $36,000.

Unfortunately, the calculation may not always be this simple.  The deductible QBI amount could be limited if: (a) the business is a specified service trade or business, and/or (b) by a wage or capital limitation (capital in this case means the unadjusted basis of certain business assets).  The calculation also depends on whether the taxpayer's taxable income is: (1) below a low taxable income threshold ($315,000 for a married couple filing joint or $157,500 for all other filers) where the 32% tax bracket begins, (2) above a high taxable income threshold ($415,000 for a married couple filing joint or $207,500 for all other filers) inside the 35% tax bracket, or (3) between the lower and higher taxable income thresholds.

A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and 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.  Any business not meeting the definition of a specified business is a non-specified business.

For both a specified and non-specified service trade or business, if the taxpayer's taxable income is below the "lower threshold" ($315,000 for a married couple filing joint or $157,500 for all other filers) the deduction will be equal to the lesser of 20% of QBI, or 20% of the excess of taxable income over net capital gains.  

If a taxpayer's taxable income is between the lower and higher taxable income thresholds, the QBI deduction for both a specified and non-specified service trade or business is subject to a wage and capital limitation based on the following formula:

The lesser of:

1. 20% of the taxpayer’s QBI with respect to the qualified trade or business, or
2. The greater of:
    i.     50% of the W-2 wages paid (directly or indirectly) for the qualified business including

           wages to S corporation owners, or

ii.    25% of the W-2 wages paid for the qualified business plus 2.5% of the original unadjusted

       cost of depreciable property.

If the taxpayer is above the lower threshold, but below the upper threshold then the amount of exclusion calculated using the above formula will need to be prorated (described below).  If the taxpayer is above the upper threshold then you will need to use 100% of the exclusion, and the full limitation in the formula above will apply. It is important to note S corporation wages paid to owners do not qualify for the new QBI deduction, but they do count as wages that are part of the limitation calculation above.

The prorated amount of the reduction is the amount that bears the same ratio to the excess amount (see below) as the amount by which the taxpayer's taxable income for the year exceeds the "lower threshold" amount, bears to $50,000 ($100,000 for a joint return). The excess amount is the excess of 20% of the taxpayer's QBI from a qualified trade or business (determined without regard to this rule), over the greater of 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of the basis of qualified property (determined without regard to this rule).  This is a little complicated, but essentially it is illustrated as follows:

(20% of QBI) - (wage and property limitation above) x (taxable income) - ($157,500 ($207,500 for a joint return)

                                                                                                                $50,000 ($100,000 for a joint return)

A specified service trade or business is subject to the phase-in described above, but they are also subject to a phase-out if their taxable income falls between the "upper and lower threshold" amounts.  The applicable percentage of allowable deduction with respect to any taxable year is 100% reduced by the percentage equal to the ratio of the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return). You will also apply the phase-in limitation above before the phase-out limitation described in this section.

Only for a specified service trade or business, if taxable income of the taxpayer exceeds the "upper threshold" amount ($415,000 for a married couple filing joint or $207,500 for all other filers) the taxpayer will be fully phased-out.  No 20% QBI deduction will be allowed for that entity.  If the taxpayer has other entities that are not service trades or businesses, they could then potentially qualify for the deduction related to the other entities' QBI, subject to the phase-in limitations described above.

The new deduction paves the way for some food for thought.  Many companies will want to know what can be done regarding employee wages since they may limit the QBI deduction.  If the same services can be provided by an independent contractor, instead of an employee, then the amount paid to the independent contractor can potentially be a larger part of the QBI deduction.  The issue of properly classifying workers as independent contractors versus employees has been an IRS hot topic for years, and is sure to come under more scrutiny with the new rules.

In certain situations it may make sense to pay extra wages to S corporation shareholders.  When an S Corporation shareholder's taxable income exceeds the threshold amount, and the Section 199A deduction is limited by 50% of the company's W-2 wages, this could help. The amount of the extra Section 199A deduction will often outweigh the increase in payroll taxes in most situations.

Another thought is converting non-QBI into QBI by spinning off certain areas of a business (such as information technology, human resources, as well as certain assets like intellectual property or business owned real estate) into separate entities.  The IRS could challenge this on the grounds of not having economic substance.  One way to get around this IRS argument would be not having a similar ownership structure, though this may not be feasible in many circumstances.  Also, regarding related party transactions, it usually takes making sure activity between the companies is done at market rates, not discounted ones, to get past any IRS scrutiny.

Many companies have multiple lines of business in which some may be non-QBI specified service business related, with others qualified trade or business activities (such as the sale of products) that are QBI eligible.  Currently, there is no IRS guidance whether or not multiple lines of business within a company can be separated for purposes of calculating the QBI deduction.  It is thought that the QBI deduction is not determined at the entity level, but rather at the activity level.  For now it appears this will work, but separate books and records must be kept for each line of business.

Succession planning can lead to tax planning opportunities.  Pass-through business interests may be gifted to children or grandchildren.  Regardless of age or parents' income, the $157,500 per person threshold is available to each child ($315,000 for each married child filing joint) as it applies to each individual taxpayer.  If a business owner would not qualify for the full QBI deduction, this is a way of increasing the availability of the QBI deduction.  Business interests can also be moved to certain non-grantor type trusts.  Each non-grantor type trust that pays federal income tax may use its own $157,500 exemption.

The rules and calculations for this new deduction are very complicated.  Surrounding these complications are a few gray areas not addressed yet by the IRS.  The IRS specifically excluded both architects and engineers from the list of specified service trade or businesses. However, the IRS could rule architects and engineers fall under the definition of a specified service trade or business because the principal asset is the reputation or skill of one or more of its employees.  When the QBI is a loss it is allowed to be carried forward to be used as a loss in the following year.  It is unknown whether this loss can only be used the following year, or if it can be carried forward indefinitely.  Also, it is unknown if the loss can be used to offset income from all of a taxpayer's businesses, or only the income of the business that generated the loss.  At this time it is projected additional IRS guidance may be given around the end of July 2018.

This 20% deduction on "Qualified Business Income" will be a benefit to many taxpayers receiving pass-through income located on Schedule C, E, and F on personal income tax returns. There could be a number of tax planning opportunities implemented to maximize this new Section 199A deduction.  Now is the time to start looking ahead and planning for this deduction.  If you have any questions, or if you would like to speak with one of our tax professionals to analyze your potential section 199A deduction, please contact us at (315) 471-9171.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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