One of the most important — and complicated — tax deductions available to owners of “pass-through” entities is the qualified business income (QBI) deduction.
If you own one of these businesses you may get as much as a 20 percent reduction of your taxable business income. However, calculating the actual deduction can be very complex. Several factors are involved, including your level of income, your profession and the amount your business spends on wages and property acquired during the year.
QUALIFIED BUSINESS INCOME DEDUCTION BACKGROUND
Most small businesses in the U.S. use pass-through business structures, which pass profits on to the individual owners. Owners pay tax on those profits at their individual tax rates, in conjunction with other income. The current tax rates range from 10 percent to 37 percent for the 2019 tax year. Pass-through business structures include S Corporations, Partnerships and LLCs. Sole Proprietorships handle business income in a similar way using Form 1040 Schedule C and are also considered a pass-through entity.
Because the Tax Cuts and Jobs Act signed in late December 2017 changed the corporate tax rate structure to a flat 21 percent rate from a progressive scale with a top rate of 35 percent, many pass-through business structures pay more than regular C Corporations. To offset this, Congress gave pass-through owners a new 20 percent business income deduction.
But Congress also put in place special rules limiting the ability of a specified service trade or business (SSTB) to take the full deduction. The list includes health, law, consulting, athletics, financial services, brokerage services, accounting firms or “any trade or business where the principal asset... is the reputation or skill of one or more of its employees or owners.”
Note: The threshold amounts cited in this memo are for tax year 2019 and are indexed for inflation in subsequent years.
HOW TO FIGURE OUT YOUR DEDUCTION
First, make a rough calculation of your expected qualified business income (QBI), which is generally your net income other than income in the way of compensation. This figure excludes business investment income (capital gains, dividends and interest), reasonable compensation to S Corporation shareholders, and guaranteed payments to partners. The QBI is figured separately for each of the taxpayer’s qualified businesses and then netted together to calculate the deduction.
Easy Case 1: If your taxable income is less than $160,700 as an individual filer, or $321,400 as a married couple filing jointly, you can take the 20 percent deduction from your QBI. Most taxpayers will fall into this category.
Easy Case 2: If your taxable income is greater than $210,700 as an individual filer, or $421,400 as a married couple filing jointly, and you are in one of the specified service professions (health, law, consulting, athletics, financial services, accounting, brokerage services, etc.), you can’t take the deduction.
HOW TO FIGURE OUT YOUR DEDUCTION
If you don’t fall into either of the easy cases, figuring out your pass-through deduction gets much more difficult.
Who is affected: Small business owners with taxable income of more than $160,700 as individual filers ($321,400 for married filing jointly) but less than the phaseout of $210,700 as an individual filer ($421,400 married filing jointly).
After your taxable income passes the threshold amount of $160,700 as an individual filer, or $321,400 as a married couple filing jointly, special wage and capital limits that reduce your deduction start to apply.
After your taxable income passes the threshold amount plus the phaseout amount, which is $210,700 as an individual filer, or $421,400 as a married couple filing jointly, the wage and capital limits are applied fully to reduce your deduction. You’ll still get a reduced deduction (unless you are in one of those specified service professions — then your deduction is eliminated completely).
The formula for calculating the wage and capital limits is based on the greater of 50 percent of the W-2 wages paid by your business, or 25 percent of the W-2 wages, plus 2.5 percent of the unadjusted basis of all qualified property acquired by your business during the year.
Sound confusing? In most cases the calculation will be straightforward — but not for everyone.
Reminder: If you’re familiar with the wage and capital limits calculation, it may be because your small business used the Domestic Production Activities Deduction (DPAD) in the past, which uses a somewhat similar calculation. The DPAD was repealed in the Tax Cuts and Jobs Act for 2018 and subsequent tax years, so keep that in mind as you chart your business plans.
BONUS QUESTIONS AND ANSWERS
Complex business tax laws such as the QBI deduction always prompt multiple questions. Here are answers to some common questions businesses are asking.
Q: Why are there certain trades that have different rules for taking the deduction?
A: It appears to have been an attempt by legislators to prevent SSTBs from converting what would otherwise be wages subject to ordinary income tax rates into QBI that gets a 20 percent deduction. However, the rules do appear to be somewhat arbitrary. An earlier version of the bill included the engineering and architectural professions, but those were later taken off the list, so they are considered exempt from the service trade limits.
Q: Why are there wage, capital and service business limit calculations in the deduction?
A: Again, it appears to be an attempt to limit the ability of some businesses to change how they operate in order to maximize the 20 percent deduction. A preliminary version of the bill contained an explanation about how lawmakers were concerned that the owners of service businesses would change how they pay themselves in order to reduce their tax burden. They said they intended to “deter high-income taxpayers from attempting to convert wages or other compensation for personal services to income eligible for the 20-percent deduction.”
Source: U.S. Congress Conference Report 115-466, page 222
Q: My company is involved in several business lines, one of which is a “specified service trade.” How do I calculate my deduction when there are different rules for different businesses?
A: The regulations provide a de minimis rule to partially address this question. For businesses with less than $25 million in gross receipts, 10 percent or less of the company’s revenue can be attributable to the SSTB business line and still be fully deductible. For businesses over $25 million, it drops to 5 percent. If your business has an SSTB over the de minimis percentage, it gets tricky. Based on IRS guidance, it appears that you can deduct the non-SSTB portion as long as you keep separate records AND have separate employees for each business line.
Q: I’ve heard that rental property owners could possibly get this deduction. Is this correct?
A: Yes, a safe harbor is provided for individuals and companies owning rental real estate as long as they meet three requirements: (1) separate records are maintained for each rental activity, (2) rental services of 250 hours or more are performed per year, and (3) contemporaneous records (proof of rental activity) are maintained.
Q: What about losses? Do they affect my ability to get the deduction?
A: Yes, losses will lower your eligible income. Excess losses will carry over to future years, limiting your ability to take the deduction in the future.
Q: How is qualified property calculated? How do bonus depreciation and Section 179 expensing affect the 2.5 percent property calculation?
A: Qualified property must be tangible property subject to depreciation and available for use in a qualified trade or business. The calculation for businesses subject to limitation will be based on 2.5 percent of the property value. In general, the value of the property is its basis on the date it is placed into service, and it must be actively used as of the end of the year. The basis of the property is NOT reduced by depreciation (including bonus depreciation and Section 179 expensing).
Q: Where is the deduction taken on Form 1040?
A: The deduction is taken on page 2 of Form 1040, line 9, following the calculation of adjusted gross income.
Q: Is there a limit to the overall deduction?
A: Yes, the overall deduction is limited to 20 percent of your taxable income for the year (before the QBI deduction) less the sum of your net capital gains. This is to ensure that the deduction only applies to income taxed at ordinary tax rates.
Q: What about my hobby activity, does it get this deduction?
A: No. To take the deduction, the entity must be a Section 162 trade or business. According to the U.S. Supreme Court, “a sporadic activity, a hobby or an amusement diversion does not qualify” as a Section 162 business.
This brief summary of the pass-through rules in the tax reform act is provided for your information. Any major financial decisions or tax-planning activities in light of this new legislation should be considered with the advice of a tax professional. Call if you have questions regarding your particular situation. Feel free to share this memo with those you think may benefit from it.
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