The Tax Cuts and Jobs Act (TCJA) introduced Section 199A, the Qualified Business Income Deduction (QBID), arguably one of the most important sections found in the new law.
As part of the TCJA, C-Corporate tax rates decreased substantially. QBID was developed as an effort to lower overall tax rates for entities other than C-Corporations and balance tax rates among different entity structures. QBID allows for a deduction of up to 20% of Qualified Business Income (QBI), subject to certain restrictions.
QBID may apply to income derived from a sole proprietorship, partnership, LLC, S-Corporation, trust, or an estate. It is important to note that ultimately, this deduction flows through to the owner’s individual tax return as a below-the-line deduction. The deduction doesn’t reduce self-employment (SE) income, SE tax, or increase any net operating loss. The rules related to the new deduction can be quite complicated, with limited guidance to-date from the IRS. Although we are waiting for IRS guidance, planning for the implementation of this new code section should be considered right away.
A “qualified trade or business” under IRC Section 199(A)(d)(1), is any business other than a specified service business or performing services as an employee. According to IRC section 1202(e)(3)(A), a “specified service business” means any business that is involved in the performance of service in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. Additionally, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees is considered a specified service business. Generally, owners of qualified businesses are not subject to QBID phaseouts, while owners of specified service businesses may be subject to phaseouts.
QBID is generally the lesser of:
1. 20% of QBI; or
2. The greater of 50% of wages or the sum of 25% of wages plus 2.5% of unadjusted basis of qualified property immediately after acquisition (i.e., original cost basis).
To calculate QBI, IRC Section 199A requires the business to recalculate net income. QBI doesn’t include certain investment income such as interest income, dividend income, and capital gains and losses that are not allocable to a trade or business. QBI also doesn’t include guaranteed payment paid to partner(s) for services rendered and W-2 wages paid by the business.
For purposes of calculating the wage limitation, “wages” are considered to be wages or salaries paid to employees that are 1) paid by the business to its employees during the applicable calendar year; 2) properly allocable to the qualified business; and 3) properly included in a government filing, such as Form W-2.
Like other deductions on an individual tax return, this deduction can be subject to phaseout or limitations, based on individual income levels. In general, the QBID may not exceed 20% of the taxpayer’s taxable income regardless of whether they are owners of a qualified trade or business or a specified service business. Owners of specified service businesses may be subject to a reduced deduction based on their taxable income level. There are three tiers to the phaseout. Current phaseout amounts are included below and future phaseout amounts will be indexed for inflation.
1. Full deduction: taxable income up to $315,000 for a married filing joint return ($157,500 for other taxpayers)
2. Phased out deduction: taxable income between $315,000 and $415,000 for a married filing joint return (between $157,000 and $207,500 for other taxpayers)
3. No deduction: taxable income above $415,000 for married filing joint returns ($207,500 for other taxpayers)
If you are in higher tax bracket you should consider meeting with a tax professional to determine the optimal amount of wages and/or property in an effort to maximize your QBID. The nuances of IRC Section 199A can be quite confusing, and it is important to rely on experts to fully understand how this new deduction impacts your specific situation. If you have any questions regarding changes to your 2018 taxes, please contact our office to schedule a consultation.