How Does the New IRS Qualified Business Income Deduction Work?
February 6, 2018
The following SC&H Group “2018 Tax Roadmap” blog post focuses on key changes the Tax Cuts and Jobs Act made for qualified business income deduction.
There is a significant new tax deduction taking effect in 2018 under the new tax law. It should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income.
The deduction is 20% of your “qualified business income (“QBI”)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. But it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year. So a QBI loss in 2018 would reduce the 20% deduction in 2019.
Rules are in place (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Here’s how the phase-in works: if your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, viz., $415,000.) If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. So, e.g., if taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000/$50,000). (For joint filers, the same operation would apply using the $315,000 threshold, and a $100,000 phase-out range.)
Additionally, for taxpayers with taxable income more than the above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000. And if your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via the fraction discussed in the preceding paragraph. (For joint filers, the same operations would apply using the $315,000 threshold, and a $100,000 phase-out range.)
Other limitations and deduction benefits may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
So, while many pass through businesses may be eligible for the new deduction, a number of questions remain:
- How do tiered entity structures compute the deduction? Does it flow through as is, or do you combine the lower tier result with the upper tier result?
- Which businesses do not qualify, unless taxable income is under the above-cited thresholds? While some are apparent (law and accounting firms, physician practices) some are less obvious (insurance brokers, consulting firms). The Internal Revenue Code Section that defines these businesses (IRC 1202(e)(a)(2)) has not seen much litigation and there are no regulations to provide guidance under this code section and obviously not the newly minted code sections that created the QBI deduction.
- How is a trade or business defined? Do we look to Internal Revenue Code Section 162, which contains a more substantive definition of a trade or business, or some other looser definition? This would impact rental properties, as perhaps some rental activity would not be deemed to be a trade or business, as is the case for the net investment income tax, which utilizes the IRC 162 definition.
- Could the IRS impose theoretical compensation into the calculations of the deduction? The language in the Act seems to allow the IRS the ability to subtract hypothetical reasonable compensation from qualified business income from S corporations and partnerships, if they feel that reasonable amounts were not reported to overstate the QBI deduction.
- Is the QBI deduction allowed under AMT? I would appear so, but it is not yet clear this is the case.
- A big question: How will the states handle this deduction? Many states may “decouple” from this deduction, while some may not. Add to the mix that for many owners of pass through businesses, they will no longer be able to deduct state taxes owed on pass through business income. This could drive taxpayers to compare the tax impacts of being taxed as a C corporation versus a pass through entity going forward.
- Partnerships should examine their use of guaranteed payments in order to maximize the deduction, while S corporations should continue to pay shareholder employees reasonable compensation as before.
Do you need assistance assessing the impact of the TCJA? Please contact us if you have any questions as you navigate 2018 tax planning.