There’s a provision in the new tax law that allows owners of sole proprietorships, S corporations and partnerships to deduct up to 20% of income earned by the business. It’s known as the Qualified Business Income (QBI) deduction, or more formally, Internal Revenue Code §199A.
The QBI deduction was introduced in the Tax Cuts and Jobs Act, which was signed into law on December 22, 2017, and represents the largest change to the tax system since 1986.
The intent of this new deduction is to give these business owners a level playing field to keep pace with the significant corporate tax cut, previously a top rate of 35%, reduced to a flat 21%.
As with any tax legislation, there are certain requirements, limitations and exceptions. In this article, we’ll discuss the general provisions of the QBI deduction, who qualifies, and how eligible taxpayers can benefit.
The points we discuss are important factors in determining whether your business should be structured as a pass-through entity – like a sole proprietorship, S corporation or partnership – or a C corporation.
Before we dig in, let’s take a quick look at the difference between how these types of entities are taxed.
Income earned by a C corporation is subject to double taxation, first at the entity level, and then a second time at the shareholder level when the corporation distributes its income as a dividend. In comparison, income earned by a pass-through business is subject to only a single level of tax. Generally, there is no tax at the pass-through entity level. Instead, owners of these businesses report their share of the business’s income directly on their tax return and pay the corresponding tax at ordinary rates. The top rate on ordinary income for individuals is 37%, so one can see the benefit this potential 20% deduction can provide to eligible business owners.
Qualified Business Income Deduction: An Overview
For tax years beginning after December 31, 2017, and before January 1, 2026, taxpayers other than corporations are entitled to a deduction of up to 20% of their “qualified business Income” (QBI) earned in a “qualified trade or business” (QTB). QBI is income earned from a sole proprietorship, S corporation, or partnership. However, it does not include wages earned as an employee.
Who Qualifies for the QBI Deduction?
A taxpayer must be engaged in a qualified trade or business in order to claim the deduction. A QTB is any trade or business other than the trade or business of performing services as an employee, and a Specified Service Trade or Business (SSTB).
An SSTB is any trade or business involving services performed in the fields of:
- Actuarial science
- Performing arts
- Financial services
- Brokerage services
An SSTB can also be:
- Any business that involves performing services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities
- Any trade or business in which the principal asset is the reputation or skill of one or more of its employees or owners
The list of ineligible qualified trade or businesses is extensive. However, in a moment we’ll look at the income threshold exception to the denial of the deduction for a SSTB.
Determining the Amount of Eligible Deduction
Once it’s determined that a taxpayer has QBI from a QTB, absent any threshold limitations, the tax code allows eligible taxpayers to deduct 20% of their QBI from their taxable income. The taxpayer determines their deductible amount separately for each QTB, beginning by computing a tentative deduction equal to 20% of QBI.
Threshold limitations do not apply when the taxpayer claiming the deduction has taxable income for the year that is less than $315,000 (if married filing jointly; $157,500 for all other taxpayers). For taxpayers with taxable income in excess of one of those thresholds, the tentative deduction attributable to each separate QTB is limited to the greater of:
- 50% of the W-2 wages with respect to the QTB; or
- The sum of 25% of the W-2 wages with respect to the QTB, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
The W-2 and qualified property limitations are phased in over the next $100,000 of taxable income (if married filing jointly; $50,000 for all other taxpayers). Once taxable income reaches $415,000 for a married taxpayer filing jointly ($207,500 for all other taxpayers), these limitations apply in full.
Recall that an SSTB is not a QTB for purposes of the deduction. However, there is an exception to this rule: the prohibition of claiming the deduction based on income earned from an SSTB does not apply if the taxpayer claiming the deduction has taxable income of less than $315,000 (if married filing jointly; $157,500 for all other taxpayers).
Because the previously mentioned W-2 limitations do not apply when taxable income is below these thresholds, a taxpayer in an SSTB with taxable income below the thresholds would simply deduct 20% of any QBI.
If a taxpayer is in a SSTB and taxable income is above the thresholds, the deduction is gradually reduced over the next $100,000 (if married filing jointly; $50,000 for all other taxpayers). The deduction is ultimately zero for a taxpayer in an SSTB with taxable income at or above $415,000 (if married filing jointly; $207,500 for all other taxpayers).
Real-life Examples that Illustrate the Nuances of the Deduction
Following are a few basic examples that help explain the nuances of the deduction.
Example 1 – Below Taxable Income Threshold – Wage Limitation Does Not Apply
Terry operates a business that generates $25,000 of QBI during the year and he pays $8,000 of W-2 wages during the year. Terry files a joint return with taxable income of $300,000. Terry’s deduction is $5,000 ($25,000 x 20%). Because his taxable income is less than the $315,000 threshold amount, the W-2 wage limitation does not apply to limit Terry’s deduction.
Example 2 – Above Taxable Income Threshold – Wage Limitation Phases In
Assume the same facts as Example 1, except that Terry’s taxable income for the year is $355,000. The W-2 wage limitation is phased in because his taxable income is between $315,000 and $415,000. The phase-in percentage is equal to 40% (($355,000 - $315,000)/$100,000). The amount of the deduction disallowed by the phased in limitation is $400 (($5,000 - $4,000) x 40%). Thus, Terry’s deduction is limited to $4,600 ($5,000 - $400).
Example 3 – Above Taxable Income Threshold – Wage Limitation Fully Applies
Assume the same facts as Example 1, except that Terry’s taxable income for the year is $420,000. The W-2 wage limitation fully applies to limit his deduction because his taxable income exceeds $415,000 ($315,000 threshold amount plus $100,000). The W-2 wage limitation is $4,000 ($8,000 W-2 wages x 50%). Thus, Terry’s deduction is limited to $4,000.
How Does the QBI Deduction Effect Your Tax Return?
The QBI deduction does not reduce a taxpayer’s adjusted gross income. The deduction is taken after adjusted gross income is determined, but it is not an itemized deduction. Therefore, the deduction is available to taxpayers who itemize deductions as well as taxpayers who claim the standard deduction.
There are no alternative minimum tax adjustments or preference items when computing QBI. As a result, the deduction is the same for both alternative minimum tax and regular tax purposes.
The deduction is allowed only for purposes of income taxes. Therefore, the deduction does not reduce a taxpayer’s self-employment income or net investment income, and is not allowed in determining a net operating loss deduction.
This is only the tip of the iceberg when it comes to the QBI deduction. The deduction could provide a tremendous benefit to owners of sole proprietorships, S corporations and partnerships. The QBI deduction is complex and fortunately, the IRS plans to issue guidance (anticipated late July 2018) on this new statutory provision of the tax code.
In the meantime, we can help you determine whether you are eligible for the deduction, or if the structure of your business should be, or remain, a pass-through entity or a C corporation.
Contact our tax department online or call 800.899.4623 to discuss your options regarding the QBI deduction.