If your small business operates as a pass-through entity, you may benefit from significant tax savings under the Tax Cuts and Jobs Act (TCJA). Owners of S corporations, partnerships, sole proprietorships and, typically, limited liability companies (LLCs) may enjoy a large new tax break — the qualified business income (QBI) deduction.
What is the QBI deduction?
The QBI deduction generally allows owners of pass-through entities to deduct 20% of QBI received. It’s available for 2018 through 2025.
QBI is the net amount of income, gains, deductions and losses, exclusive of reasonable compensation, certain investment items and payments to partners for services rendered. The calculation is performed for each qualified business and aggregated. (If the net amount is below zero, it’s treated as a loss for the following year, thereby reducing that year’s QBI deduction.)
The QBI deduction is subtracted from taxable income (as itemized deductions are), not from gross income (as above-the-line deductions are when computing adjusted gross income). It’s available whether or not a taxpayer itemizes deductions.
What are the limits?
Once taxable income — not QBI — exceeds $157,500 for single filers or $315,000 for married couples filing jointly, a wage limit begins to phase in, under which taxpayers can deduct only the lesser of 20% of QBI or 50% of their allocable share of W-2 wages paid by the business. The wage limit is intended to deter high-income taxpayers from converting wages or other compensation for personal services to QBI that qualifies for the deduction.
Alternatively, taxpayers subject to the income-based limit can deduct the lesser of 20% of QBI or 25% of wages plus 2.5% of their allocable share of the unadjusted basis of qualified business property — essentially, the purchase price of tangible depreciable property held at the end of the tax year. This option makes it easier for capital-intensive businesses with relatively low wages (for example, real estate, construction or manufacturing businesses) to take advantage of the deduction.
The wage limit phases in completely when taxable income exceeds $207,500 for single filers and $415,000 for joint filers. When it applies but isn’t yet fully phased in, the gross (without any wage limit) deduction is reduced by the same ratio of the difference between the amount of the gross deduction and the fully wage-limited deduction as the ratio of 1) the amount by which the taxable income exceeds the threshold to 2) $50,000 for single filers or $100,000 for married couples filing jointly.
The amount of the deduction may not exceed 20% of the taxable income less any net capital gains. So, for example, if the QBI for a married couple is $400,000 and their taxable income is $300,000, the deduction is limited to 20% of $300,000, or $60,000.
The QBI deduction is also limited for specified service trades or businesses (SSTBs). SSTBs include businesses involving law, financial, health care, brokerage and consulting services firms, as well as any business where the principal asset is the reputation or skill of one or more of its employees. (Architecture and engineering firms, however, are excluded.) The QBI deduction limit for SSTBs phases in over the same taxable income ranges as the wage limit.
If the taxable income equals or exceeds the top of the applicable range, SSTB owners receive no QBI deduction.
With any new legislation that is this massive, it will take time for all of the consequences to be fully understood. In addition, the IRS will likely issue regulations and guidance concerning various aspects, such as reporting requirements and the allocation of items and wages. Contact us for help navigating these uncharted waters.
Sidebar: What’s the deduction?
The amount of the qualified business income (QBI) deduction depends largely on taxpayers’ taxable income — that is, their adjusted gross income (AGI) less itemized deductions (or the standard deduction). The QBI deduction is most easily calculated when taxable income is under the threshold for the wage-limit phase-in so the wage limit doesn’t apply.
For example, joint filers Bruce and Melissa have taxable income of $200,000, including $100,000 in QBI. They can deduct 20% of $100,000, or $20,000, from their taxable income.
Computing the deduction also is fairly straightforward when taxable income exceeds the top of the phase-in range for the limit. Let’s say Bruce and Melissa’s taxable income is $500,000, and the business pays $25,000 in wages and has $100,000 of qualified business property. The first option for the wage limit calculation is $12,500 (50% of $25,000), and the second option is $8,750 (25% of $25,000 + 2.5% of $100,000) — making the wage limit, and the deduction, $12,500.
What if Bruce and Melissa’s taxable income falls into the range where the wage limit is phasing in? If their taxable income is, say, $400,000, only 85% of the full limit applies: ($400,000 taxable income – $315,000 threshold)/$100,000 = 85%. To calculate the amount of their deduction, the couple must determine what is 85% of the difference between the gross deduction of $20,000 and the $12,500 deduction if the full wage limit applied: ($20,000 – $12,500) × 85% = $6,375. That amount is subtracted from the gross deduction, for a final deduction of $13,625 ($20,000 – $6,375).
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.