by Greg Yoder
One of the biggest changes to come with the Tax Cut and Jobs Act (TCJA) of 2017 was the addition of Section 199A, or the qualified business income deduction. The stated purpose of this deduction was to provide a lower rate of tax for owners of and investors in certain types of business so that their rates would be closer to corporate rates.
In the simplest possible terms, taxpayers get a deduction for 20% of their qualified business income (QBI). QBI can come from a business that a taxpayer participates in directly (e.g., a Schedule C business or Schedule E rental property) or it can come from various kinds of pass-through entities (partnerships, LLCs, S corporations, REITs, etc.). This deduction is taken separately from and after either itemized deductions or the standard deduction.
Qualified Trade or Business
Because QBI can only be generated by a qualified trade or business, the first step in determining the deduction is determining whether the taxpayer’s business is qualified. In general, a trade or business is a qualified trade or business if it’s based in the U.S. and it is NOT one of the “specified service trade or businesses.” These businesses include:
- Actuarial science
- Brokerage services
- Dealing in securities
- Financial services
- Investing and investment management
- Performing arts
- Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners
While it’s fairly obvious what constitutes some of these businesses (accounting, for example), other categories are defined more broadly or narrowly than you might expect. A health spa, for example, would generally not be considered a health business as defined in the regulations under §199A, so income from a health spa would qualify for the deduction. On the other hand, income from a medical practice (which does meet the regulatory definition of health services) would not qualify for the deduction.
Because being an employee is also specifically excluded by the law from being a qualified trade or business, the wage income of employees is not QBI.
The calculation of QBI for a particular business is beyond the scope of this article, but let’s summarize by saying, “It’s complicated.” Just as an example, businesses that engage in multiple activities may find that some of their activities are qualified but others aren’t. In general, these businesses will need to allocate their income and deductions between qualified and non-qualified businesses. Treasury regulations released this summer provide methods for allocating income and expenses for such entities.
Limits and Exceptions
While the general rule for the QBI deduction is 20% of QBI, there are multiple limits on the amount of the deduction. The first of these is the wage limitation. In general, a qualified business must also generate U.S. wages to generate a deduction. The amount that can be deducted with respect to a particular trade or business is the lesser of a) 20% of the QBI from that business and b) 50% of the W-2 wages paid during the year by that business. A special rule added to favor real estate investors provides that in lieu of the 50% of wages limitation, a business can deduct up to 25% of its wages PLUS 2.5% of the unadjusted basis of its qualified property. That means that a business that pays no wages but uses a large amount of qualified property may still generate a deductible amount.
The deductible amount is determined on a business-by-business basis, and then the amounts are aggregated to determine a taxpayer’s overall QBI deduction. Businesses that generate deductible losses will generate negative QBI, thereby reducing the overall deduction.
There are two principal exceptions to QBI limitations that were added to favor taxpayers with incomes below a certain level. The calculation of these limitations is (wait for it) complicated, but if a married taxpayer filing a joint return has taxable income (before the QBI deduction) of less than $315,000 ($157,500 for other filing statuses), then the taxpayer will typically be able to take a QBI deduction even if he or she has income from a business that doesn’t meet the wage limitation. Similarly, taxpayers with the same level of income will be able to take a deduction for QBI from one of the specified service trades or businesses, even though that business doesn’t meet the definition of a qualified trade or business.
Another limitation provides that the QBI deduction can’t be greater than 20% of the taxable income before the QBI deduction. In making this calculation, any income taxed at long-term capital gains rates can’t be included.
As an example, assume that a taxpayer has adjusted gross income of $400,000, made up of $250K of QBI and $150K of net long-term capital gains. The taxpayer also has itemized deductions of $100,000. In this case, the taxpayer would be entitled to a QBI deduction of $30,000, calculated thusly:
|Qualified Business Income||250,000||[A]|
|Long Term Capital Gains||150,000|
|Adjusted Gross Income||400,000|
|Taxable Income before QBI Deduction||300,000|
|Less Long Term Capital Gains||(150,000)|
|Taxable Income before QBI Deduction Net of Long Term Capital Gains||150,000||[B]|
|QBI Deduction||30,000||20% of lesser of [A] or [B]|
Of the taxpayer’s $270K taxable income, $150K would be taxed at long term capital gain rates, and the remainder would be taxed at regular graduated income tax rates.
This was — honestly — the simplest example I could come up with. For most taxpayers who can take the deduction, the calculation will be substantially more complicated, and there are plenty of additional complications that I’ve left out of this article.
Notwithstanding the enormous complexities involved in the QBI deduction, it represents a tremendous tax savings opportunity for a select group of taxpayers. If you have questions about whether you qualify for and how much benefit you can expect from this deduction (or any of the many other provisions of the TCJA), please get in touch with us for tax planning. For many taxpayers, there are actions you can take prior to year-end to maximize the deduction — and minimize your taxes.