By Rene Schaefer, CPA MST
The Tax Cuts and Jobs Act (TCJA) added a new tax deduction for owners of pass-through entities – a 20% deduction of qualified business income (QBI) from a qualified trade or business.
This new provision may potentially lower the maximum individual tax rate of 37% on pass-through income to 29.8%, which makes it more comparable to the new C corporation tax rate of 21%. However, the new law contains limitations that may reduce or eliminate the deduction for some business owners.
What Is the 20% QBI Deduction?
For tax years beginning after December 31, 2017 through 2025, the QBI deduction is 20% of QBI from an S corporation, partnership, sole proprietorship, trust or estate at the owner level. The definition of QBI includes only income associated with business activity conducted in the United States. It does not include reasonable owner compensation, guaranteed payments to a partner, or investment income (including capital gains).
The 20% QBI deduction is computed separately for each business. Once combined, the 20% QBI deductions are limited to 20% of the individual’s taxable income in excess of any capital gains.
Who Qualifies for the Deduction?
Qualified trades or businesses include all trades or businesses except those classified as a “specified service trade or business” (SSTB). An SSTB is a business that provides services in any one of the following business types: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more employees or owners.
Engineering and architecture services are specifically excluded from the definition of an SSTB and are considered qualified businesses. However, even income from an SSTB can generate a potential deduction if the taxpayer’s taxable income is under the threshold amounts discussed below.
What Are the Limitations?
Several limitations may apply to limit the potential deduction, depending on the owner’s taxable income level. First, the QBI deduction can’t exceed 20% of “modified” taxable income. For this purpose, taxable income is reduced by net capital gain (including qualified dividend income).
If the owner’s taxable income before the deduction is under $315,000 (married filing jointly) and $157,500 (all other filers), no additional limitations apply. This is true for any type of trade or business, including SSTBs.
If the owner’s taxable income before the deduction is between $315,000 and $415,000 (married filing jointly) and $157,500 and $207,500 (all other filers), a limitation phase-in calculation is required. The limitation phase-in rules reduce or eliminate the 20% QBI deduction, depending on the owner’s taxable income level.
Owners of SSTBs get no deduction if their taxable income exceeds these thresholds.
The amount of the deduction is limited to the greater of 50% of the owner’s allocated share of W-2 wages, or 25% of W-2 wages plus 2.5% of the owner’s allocated share of qualified property used in the business. The definition of qualified property is generally based on the original cost of the property.
Note that the passive activity loss and the at-risk limitations should also be considered in applying the new deduction rules.
The new law also includes special penalties for taxpayers who understate their income through the misapplication of the new QBI rules.
Owners of Multiple QBIs
If the taxpayer owns multiple QBIs and the total combined amount of QBI for all qualified businesses is a net loss for the year, the taxpayer gets no deduction for the current year. Instead, the loss is carried forward as a loss to offset total combined QBI in the next tax year. Otherwise, the limitation provisions apply separately to each qualified business, and the potential deduction is combined.
Additional Guidance Needed
At this time (August 2018), many unanswered questions remain regarding the application of the 20% QBI deduction rules. The federal government has announced that it expects to publish more guidance in the near future.
While the potential for tax benefit associated with the new 20% deduction rules may be substantial, the existing provisions are complex, and can be ambiguous. For assistance, please contact your Clark Nuber professional or Rene Schaefer to determine if your business qualifies for the new 20% QBI deduction and what limitations may apply.
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