As part of the Tax Cuts & Job Act, passed on December 22, 2017, a new provision with significant planning opportunities was added to the tax law. At its simplest level, the Qualified Business Income (QBI) deduction allows individuals a §199A deduction of up to 20% against income from passthrough businesses (partnerships, S corporations, and sole proprietorships) for tax years between 2018 and 2025. The deduction can have significant benefits, potentially decreasing the effective tax rate on business income from 37% to 29.6% for those in the top bracket.
Implementing strategies to optimize this deduction will be a critical aspect of tax planning going forward. Two initial considerations for any discussion will be the income level of the taxpayer and the type of business generating the income. This post covers the basics of the deduction; due to the complexity of the law and absence of authoritative guidance, we urge caution before making any major business changes.
Below the Threshold Amount
For individuals with taxable income below the Threshold Amount ($315,000 for married filing joint; $157,500 for all other filers) the deduction is the lesser of:
20% of QBI from passthroughs; or
20% of [taxable income less net capital gains]
QBI is generally ordinary income earned by a business within the United States. QBI does not include investment items such as interest, dividends, or capital gains, and it does not include wages earned as an employee or retirement income.
Keep in mind, taxable income is calculated after above-the-line deductions and either the standard or itemized deduction. That means a single taxpayer with $200,000 of QBI can qualify for the deduction if they have other deductions that bring their taxable income below the $157,500 Threshold Amount.
Above the Threshold Amount
Over the next $100,000 of taxable income for MFJ and $50,000 for all others, any deduction may be limited. When taxable income exceeds these upper limits ($415,000/$207,500), the deduction can be lost entirely if certain criteria are not met.
Taxpayers with income above these levels must meet two requirements to qualify for a §199A deduction:
The income may not be generated by a Specified Service Business; and
The Qualified Trade or Business generating the income must either pay wages or own property.
Specified Service Business vs. Qualified Trade or Business
A Specified Service Businesses (SSB) is broadly defined as any trade or business involving the performance of services in the fields:
Trading or Dealing in Securities
An SSB is also any trade or business where the principal asset is the reputation or skill of one or more of its owners or employees.
Any business that is not an SSB is considered a Qualified Trade or Business (QTB). For those with taxable income above the Threshold Amount, determining whether their business is an SSB or a QTB is central in determining whether the income from that business will qualify for the deduction. Due to the importance of this distinction and lack of clear guidance in the law, we expect whether or not a business is an SSB will be a significant point of contention between taxpayers and the IRS.
Wage and Property Limitation
For taxpayers with QTB income over the upper limit of the Threshold Amount, the 20% deduction is subject to another hurdle. This hurdle limits the 20% deduction against QBI to the greater of:
50% of allocable W-2 Wages paid by the business; or
25% of allocable W-2 Wages plus 2.5% of Qualified Property owned by the business
"W-2 Wages" and “Qualified Property” are terms of art but simply put, a QTB must pay wages to employees or own property, otherwise the deduction for owners with taxable income above the Threshold Amount will not be available.
The new QBI deduction will result in significant tax savings for many but those with taxable income over the Threshold Amount will need to clear additional obstacles to qualify for the full deduction. In some cases, business restructuring may be necessary.
Proactive planning in this area can identify opportunities to take advantage of this deduction. Similarly, poor planning may leave a meaningful deduction on the table. It is critical you have a tax advisor who understands your business and the opportunities available in the new law. Contact The Tax Warriors® to discuss how the new §199A deduction may reduce the federal tax liability generated by your business.