The Tax Cuts and Jobs Act took effect in 2018, but businesses and individuals alike are continuing to unpack what it means for them. The Act resulted in changes for businesses, including a lower corporate tax rate, as well as individuals. One of the more complex changes affecting individuals includes those surrounding pass-through entities. To maintain the incentive for individuals to own and operate a pass-through entity, the Act introduced the new Section 199A Qualified Business Income Deduction. The maximum deduction is now 20 percent of Qualified Business Income; however, the calculation is nuanced, and determining if and how much can be applied should be established by an expert.
What exactly is the Qualified Business Income Deduction, commonly referred to as QBI?
In broad terms, it is a deduction for business owners and participants in pass-through entities that could effectively permit those entities to only be taxed on 80 percent of their income.
Below we’ve highlighted some frequently asked questions with answers to help you better understand this complex issue:
How do you determine what is “Qualified Business Income” and how do you know if you are “Qualified?”
Qualified Business Income is the ordinary earnings of a business, including rental income (if reported on Sch. E). The QBI deduction is a non-corporate deduction taken on the tax return and is deducted after adjusted gross income to arrive at taxable income. This deduction can be taken whether you claim the standard deduction or itemize. However, it is not available in a year that the business is claiming a loss.
If you have ownership in more than one entity to which the QBI deduction applies, the deduction can be calculated separately for each qualified trade or business. You may be able to aggregate certain businesses to optimize their deduction by making an election. Once an election to aggregate two or more businesses is made, it is binding on all subsequent years. A new business can be added to the aggregated group if all requirements are met. If there are changes to a business in the prior aggregation that makes it no longer qualify, the grouping could be changed to determine the new aggregation. A statement disclosing each business that’s been aggregated must be attached to the tax return every year.
To whom does the QBI Deduction apply?
Individuals, Trusts and Estates that receive income from the following pass-through entities:
- Sole proprietors that report business income on their personal tax return
- Real Estate Investors reporting on Schedule E (must be an active participant, not just collect a rent check each month)
- Single member LLCs
- Multi-member LLCs
- S Corporations
What are some items not included in the calculation of QBI?
- Earnings from investments
- Gains from sales of property
- Reasonable compensation paid
- Guaranteed Payments from a Partnership
- W-2 Wages from an S-Corp
That does not necessarily mean you get to take a 20 percent deduction from your taxable income. There are several stipulations to this new regulation that could affect your deduction, and it is important to discuss this with your tax planning professional to determine how this will affect you and your business.
How does taxable income limit amount of deduction?
Here is where it gets a little trickier. There is a modified taxable income threshold that imposes limitations for taxpayers to be able to take advantage of this deduction. Those thresholds are as follows for 2018:
- Single individuals, Trusts and Estates – $157,500 – $207,500
- Married couples – $315,000 – $415,000
After these thresholds are reached, there are phase-outs that apply, and they are different based on whether your business is considered a specified service related business or a non-service business. Some professions that are included in the specified service category are as follows: health professionals, legal professionals, accounting, actuarial services, performing arts, consulting, athletics, financial services, brokerage service and any other trade or business where the business relies on the reputation or skills of its employees. However, architects and engineers are not included in this specified service group.
So, what does the effect on the specified service business look like compared to a non-service business? This chart shows the impacts of the limitation phase-ins based on taxable income.
|Taxable income less than |
$315,000 (Married filing jointly) or
$157,500 (all other taxpayers)
20 percent deduction
20 percent deduction
|Taxable income between |
$315,000 and $415,000 (MFJ) or
$157,500 and $207,500 (all others)
|Taxable income greater than $415,000 (Married filing jointly) or|
$207,500 (all other taxpayers)
Wage and Capital Testing
For non-service businesses that have taxable income above $415,000/$207,500, the deduction limitation is subject to wage and/or capital testing:
- 50 percent of W-2 wages, or
- 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquiring qualified property, which is another way to say original cost, not including depreciation.
This could mean if you are over the threshold and have no employees and no depreciable property, then you receive no deduction! The reform act did this to encourage pass-through owners to hire employees and/or to reinvest in their business by buying assets for their business.
What are some things you can be doing now to maximize your QBI deduction?
If you are the owner of a pass-through entity, it is important to consult with your tax professional sooner rather than later. There are several things you can be doing to increase your deduction.
- This deduction was designed to give employers incentive to increase workers and/or wages. Therefore, increasing W-2 Wages by increasing current employee wages or replacing subcontractors with employees could be beneficial in increasing your deduction if you are above the threshold.
- Increase qualified property. If you are currently leasing equipment, consider purchasing it. Another benefit is that bonus depreciation rules changed from a 50 percent deduction to a 100 percent deduction for 2018, allowing for that purchased equipment expense be fully deducted to reduce taxable income in the current year. If you think you may be close to the threshold, consider making new furniture or equipment purchases to offset this.
- Split out or merge businesses to plan for taking advantage of this deduction.
- Minimize taxable income by maximizing contributions to retirement accounts.
- Increase personal charitable giving to reduce taxable income if close to threshold.
- Keep the type of business structure in mind:
- LLCs cannot pay wages to their owners, and guaranteed payments are not allowed in the wage limit calculation.
- S-Corps can pay wages to their owners. If an S-Corp provides bonuses that amount to earnings for the year, they eliminate any QBI deduction. However, if the pay what would be considered “reasonable compensation,” they could still take advantage of the deduction.
- Now could be a good time to re-evaluate your business structure to make sure you are in the best position possible given your situation and the current changes to the tax law.
- In a situation where the spouse’s income could create threshold limitations or complete exclusion, it could be worth exploring filing married or filing separately so that you can still reap the benefits of the QBI deduction.
Overall, the Qualified Business Income Deduction could possibly lower your tax bill as a business owner, but careful planning and discussions with your tax professional are the key to making the most out of this deduction given its complex nature.
One of the most valuable, important and complex deductions introduced in the Tax Cuts and Jobs Acts is the Section 199A 20% Qualified Business Income Deduction. Its purpose is to give sole proprietors and pass-through entity owners the same business tax discount that corporations get.
This new deduction is effective for tax years 2018 through 2025. It allows taxpayers other than corporations (individuals, trusts and estates) a deduction of up to 20 percent of qualified business income from a partnership, S corporation or sole proprietorship.
- Qualified Business is defined by exclusion. It is every trade or business that is not:
- The trade or business of performing services as an employee, and
- A specified service trade or business (only applicable if income is above thresholds).
- Specified service trade or business (SSTB) includes fields of health, law, accounting, consulting, investing, etc. or any trade or business where the principal asset is the reputation or skill of one or more of its employees.
The purpose of these disqualified businesses is to prevent the conversion of personal service income into qualified business income.
- Taxable Income Thresholds can limit the amount of deduction.
- Single Individuals, Trusts and Estates – $157,500- $207,500
- Married couples – $315,000- $415,000
Consider ways to reduce taxable income if near thresholds and deduction will be limited.
The QBI Deduction limitation thresholds are based on modified taxable income, unlike most other calculations that are based on Adjusted Gross Income (AGI). Therefore, increasing itemized deductions and retirement account contributions can reduce the income to below the limitation threshold.
- Deduction subject to overall limitation equal to 20 percent of the excess of:
- The taxable income for the year, over
- The sum of net capital gain (including qualified dividends)
The purpose of this overall limitation is to ensure that the 20 percent deduction is not taken against income that is being taxed at preferential rates.
This new deduction will reduce taxable income, but not adjusted gross income, and is available regardless if you itemize your deductions. There are many limitations and restrictions to this deduction, so we advise that you schedule a personal consultation with your LBMC tax professional to fully understand the impact on your situation.
6/19/19: The IRS and the U.S. Treasury Department just issued legal guidance providing information on certain deductions to cooperatives and their patrons. The proposed regulations provide guidance on calculating the qualified business income (QBI) deduction and the deduction for domestic production activities for agricultural or horticultural cooperatives and their patrons (the Section 199A(g) deduction). For more information, here are the regs. In addition, the IRS issued Notice 2019-27, which provides guidance on calculating W-2 wages for purposes of the Section 199A(g) deduction. Contact us for assistance in your situation.
5/5/19: The IRS sets out rules for tax-exempt trusts claiming a Section 199A deduction. On its website, the tax agency has issued instructions for computing the qualified business income (QBI) deduction for tax-exempt trusts with unrelated business income. Noncorporate taxpayers may claim an income tax deduction for their QBI in tax years 2018 to 2025. The deduction is generally 20% of a taxpayer’s QBI from a partnership, S corporation or sole proprietorship. Taxpayers with taxable income that exceeds a threshold amount are subject to limitations based on W-2 wages paid by the business and the unadjusted basis in the business’s acquired qualified property.
4/19/19: The IRS has released two draft forms to compute the qualified business income (QBI) deduction under Section 199A. The draft forms are Form 8995 (“Qualified Business Income Deduction Simplified Computation”) and Form 8995-A (“Qualified Business Income Deduction”). QBI generally is defined as the net amount of “qualified items of income, gain, deduction and loss” relating to any qualified trade or business of the taxpayer. Review draft Form 8995 and draft Form 8995-A for specific details.
1/22/19: As part of the recently issued Sec. 199A QBI deduction regulations, the IRS issued guidance for certain real estate businesses. It allows individuals and entities who own rental real estate directly or through a disregarded entity to treat a rental real estate enterprise as a trade or business (for purposes of the QBI deduction) if certain requirements are met. Not eligible for this safe harbor are real estate used as a residence for any part of the year and real estate rented under a “triple net lease.” To read more on IRS Notice 2019-07.
The qualified business income (QBI) deduction is beneficial, but complex and subject to limitations. There are two ways to claim the Sec. 199A QBI deduction. One involves 20% of a taxpayer’s QBI and the other uses the amount of W-2 wages paid by an employer. New IRS guidance describes how to calculate W-2 wages for purposes of the deduction. The IRS has provided 3 methods of calculating applicable W-2 wages in Revenue Procedure 2019-11. Click here for detailed explanations of the methods, or contact us for help with these complex calculations.