One of the most talked about changes to the tax code under the Tax Cuts and Jobs Act of 2017 (TCJA) is the creation of a new code section, Section 199A also known as the Qualified Business Income (QBI) deduction. This section creates a significant tax break for taxpayer with pass through income subject to specific rules and limitations that we will address here.
What is the Qualified Business Income Deduction?
The QBI deduction is a deduction from adjusted gross income to arrive at taxable income. A taxpayer that generates "qualified business income" will be entitled to take a deduction of 20% of qualified business income on their tax return subject to some limitations. Before we get into those limitation let's define a few terms.
C corporation - One of the four main entities to operate a business under. Owners of a "C corporation" are subject to double taxation. When income is earned by the corporation, it is first taxed at the business level, at a top tax rate of 35% under current law. Then, when the corporation distributes the income to the shareholder, the shareholder pays tax on the dividend, at a top rate of 23.8%.
S corporation - Another one of the four main entities to operate a business under. In the case of an S corporation, the income of the business is allocated among the owners and then included on their individual returns. This offers a single level of taxation. The business owner pays tax on their share of the income at ordinary rates, which rise to as high as 39.6% under current law.
Partnership - Another one of the four main entities to operate a business under. Much like an S corporation, the income of the business is allocated among the owners and then included on their individual returns.
Sole proprietorship - A sole proprietor simply reports his or her income directly on Schedule C of their Form 1040. The business owner pays tax on the business income at ordinary rates, which rise to as high as 39.6% under current law along with an additional 15.3% self-employment tax on the net profit of the business.
Qualified business income (QBI) - QBI is defined in Section 199A(c) as the "ordinary" income, less ordinary deductions, you earn from a sole-proprietorship, S corporation, or partnership. QBI does not include, however, any wages you earn as an employee. This means you could have two people doing the exact same job, one as an independent contractor and one as an employee, with the self-employment income of the former being considered QBI (and thus eligible for a 20% deduction), while the wages earned by the latter would not be eligible for the 20% deduction. QBI does NOT include investment income such as, short-term capital gain or loss, long-term capital gain or loss, dividend income, and interest income.
Qualified business property - Is defined as any tangible property, subject to depreciation (meaning inventory doesn't count), which is held by the business at the end of the year and is used, at ANY point in the year, in the production of QBI.
Entity Tax Rates Under TCJA
The Tax Cuts and Jobs Act resulted in a reduction in the C corporation tax rate from 35% to 21%. This cut done in isolation would have reduced or even, in some cases, eliminated the tax advantage that flow-through entities, such as S corporations, have over C corporations. In order to prevent this tax cut from tilting the field away from flow-through entities, Congress created a new code section, Section 199A, allowing owners of sole proprietorships, S corporations and partnerships to take a deduction of 20% against their income from the business. The result of such a provision is to reduce the effective top rate on these types of business income from 39.6% under current law to 29.6% under the new law (a new 37% top rate * a 20% deduction= 29.6%).
Now let's start tackling the specifics of this new code section.
Who Can Take the Deduction?
Section 199A(a) makes clear that the deduction is available to all taxpayers other than a corporation. This would include partnerships, sole proprietorships, S corporations and, thanks to a last minute addition, trusts and estates that own an interest in a flow-through business.
How Much is the Deduction?
Starting January 1, 2018, anyone who generates "qualified business income" will be entitled to take a deduction of 20% of that qualified business income on their tax return subject to certain limitations.
What Are the Limitations?
Here is the fun part. Stick with me here as we break this down into parts.
The deduction is equal to the SUM OF:
1. The LESSER OF:
· the "combined qualified business income" of the taxpayer, or
· 20% of the excess of taxable income over the sum of any net capital gain
- PLUS the LESSER OF:
· 20% of qualified cooperative dividends, or
· taxable income less net capital gain.
Let's focus on that first bullet point since that is the part that will affect a majority of taxpayers. The first bullet point mentions "combined qualified business income". What is "combined qualified business income"? Combined qualified business income is actually not income, but rather a deduction. It is:
- THE SUM OF:
The LESSER of:
· 20% of the taxpayer's "qualified business income" or
The GREATER of:
· 50% of your allocable share of the W-2 wages with respect to the business, or
· 25% of your allocable share the W-2 wages with respect to the business plus 2.5% of your allocable share of the unadjusted basis immediately after acquisition of all "qualified business property." .
So what does this mean in plain english? It means the your allocable share of the wages and unadjusted basis in qualified property act as a cap on the amount of the deduction.
Here is a simple example: My brand new S corporation incurs $800,000 in profit. My S corporation has paid no wages and has no assets. What is my deduction? It is $160,000 ($800,000 * 20%), right? Not so fast. Let's remember our wage caps.
My deduction is the LESSER OF:
- $160,000 (20% of $800,000), or
- The GREATER OF:
1. $0 (50% of W-2 wages), or
2. $0 (25% of W-2 wages, plus 2.5% of the unadjusted basis of the business's assets).
So, in this example my deductions is $0.
Now, what if my S corporation had paid $100,000 in wages. My deduction would now be $50,000 (the $160,000 deduction is capped at the greater of 50% of wages or 25% of wages plus 2.5% % of the unadjusted basis of the business's assets).
What Does "Allocable Share" mean?
For a shareholder in an S corporation the allocable share of W-2 wages is easy to determine, Section 1366 and Section 1377 require that all items of an S corporation be allocated pro-rata, on a per-share/per-day basis.
Things get a bit more tricky for a partner in a partnership, however, because partnerships can "specially allocate" different items of income, gain, loss and deduction among its partners at different percentages. Section 199A(f)(1) tells us that a partner's share of a partnership's W-2 wages is, determined in the same manner as his share of the partnership's wage deduction. Thus, if you are own a 20% capital stake in a partnership, but under the terms of the agreement you are allocated 80% of any depreciation but only 30% of Schedule K-1, Line 1 ordinary income, then because you are being allocated 30% of the partnership's wage deduction via your Line 1 allocation, you are stuck being allocated only 30% of the partnership's W-2 wage expense for the purposes of these limitations.
Important Facts Concerning Qualified Business Property
There are a few important items to keep in mind while calculating your qualified business property.
- The basis taken into consideration is "unadjusted basis," meaning it is NOT reduced by any depreciation deductions. In fact, Section 199A(b)(2)(B)(ii) requires that you take into consideration the basis of the property "immediately after acquisition."
- Any asset that was fully depreciated prior to 2018, unless it was placed in service after 2008, will not count towards basis.
- Just as with W-2 wages, a shareholder or partner may only take into consideration for purposes of applying the limitation 2.5% his or her allocable share of the basis of the property. So if the total basis of S corporation property is $1,000,000 and you are a 20% shareholder, your basis limitation is $1,000,000 * 20% * 2.5% = $5,000.
- If you are a partner in a partnership, you must allocate your share of asset basis in the same manner in which you are allocated depreciation expense from the partnership. So go back to my earlier example where a partnership allocated W-2 wages, and the partner owned 20% of the capital of a partnership, was allocated 80% of depreciation, and only 30% of Schedule K-1, Line 1, ordinary income or loss. While that partner would be allocated 30% of the W-2 wages paid by the partnership, he or she would be allocated 80% of the unadjusted basis of the property, because that is the percentage of depreciation he is allocated.
Exception to W-2 Wage Limitations
The TCJA provides that if your TAXABLE INCOME for the year, not adjusted gross income, but TAXABLE INCOME, is less than the "threshold amount" for the year, then you can simply ignore the two W-2-based limitations. The "threshold amounts" for 2018 are $315,000 if you are married, and $157,500 for all other taxpayers. These amounts will be indexed for inflation starting in 2019. You would determine taxable income WITHOUT factoring in any potential 20% deduction that we're discussing here.
For example, John has QBI of $200,000 from an S corporation that paid a total of $30,000 of W-2 wages and that has no qualified property. John's spouse has $50,000 of W-2 income, and the two have interest income of $20,000. Thus, total taxable income is $270,000.
Normally, John's deduction would be limited to $15,000, the LESSER OF:
- 20% of QBI of $200,000, or $40,000, or
- The GREATER OF:
1. 50% of W-2 wages of $30,000, or $15,000, or
2. 25% of $30,000 plus 2.5% of $0, or $7,500.
While normally, John's deduction would be limited to $15,000, because John's taxable income is $270,000 (less than the $315,000 threshold) the two limitations are disregarded, and John simply takes a deduction equal to 20% of QBI, or $40,000.
Phase-In of W-2 Limitations
The taxable income thresholds for the W-2 wage exceptions are not a cliff. Going over the taxable income threshold by one dollar won't instantly result in the total phase in of the W-2 limitations. Rather, the W-2 limitations will be "phased in" over the next $100,000 of taxable income if you're married filing jointly, or $50,000 for everyone else.
This is a complicated multi-step process that I won't go into here because I don't want to type another 2,000 words. Just be aware that if you go over the taxable income thresholds you may still be entitled to a partial deduction even if you do not meet the W-2 wage rules.
Treatment of "Specified Service Trades or Businesses"
NOT ALL BUSINESSES ARE ELIGIBLE FOR THE 20% DEDUCTION. This is likely to become one of the more impactful aspects of TCJA. Section 199A(d)(1) makes clear that there are two "trades or businesses" that are not eligible for the 20% of QBI deduction:
- Anyone who is in the business of being an employee, and
- Any "specified service trade or business."
The TCJA references Section 1202(e)(3)(A) to identify a "specified trade or business", which includes the following:
"any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees."
However, Section 199A does provide a carve out for some businesses in Section 1202(e)(3)(A). Those types of businesses which are disqualified under Section 1202 but NOT under Section 199A, include: banking, insurance, financing, leasing, farming, any business giving rise to depletion, any business of operating a hotel, motel, or restaurant.
Whether a business is a "specified service business" is going to be critical under the new law. The problem is that although Section 1202 was enacted in 1993, we have almost no available guidance from regulations, administrative rulings, or judicial precedent to help us determine what is and isn't a "service business" for purposes of Section 1202. It may take the IRS years to provide final regulations addressing these issues.
Exception to Specified Service Trades or Businesses
Even if you're in one of those prohibited "specified service businesses," you can still claim the 20% deduction, provided your taxable income is less than $315,000 (if you're married filing jointly, $157,500 for all other taxpayers). These are the same thresholds as the ones used for the W-2 limitations.
Phase-In rules for Specified Service Trades or Businesses
Just like the phase in rules for the wage limitations, the "specified service business" rule is "phased in" over the next $100,000 of taxable income if you're married filing jointly, or $50,000 for everyone else.
Again, I won't go into the math here but just be aware that if you go over the taxable income thresholds you may still be entitled to a partial deduction even if are in a specified service business.
Important Miscellaneous Issues
· The 20% deduction does not reduce a taxpayer's self employment income.
· If your sole proprietorship, S corporation, or partnership generates a loss there would obviously be no 20% deduction, since there's no income, and then that loss carries over to Year 2 and reduces Year 2 QBI solely for purposes of computing the 20% of QBI deduction. To illustrate:
John owns 50% of an S corporation. In 2018, the S corporation allocates a $100,000 loss to John. Because John materially participates in the S corporation, he is able to use the $100,000 loss in full to offset his other income.
In 2019, the S corporation allocates $200,000 of income to John. While John would generally start the process of determining his Section 199A deduction by taking 20% of $200,000, Section 199A(b)(6) provides that in determining A's QBI deduction for 2019, the $200,000 of income must be reduced by the $100,000 of loss from 2018. Thus, while John will still include the full $200,000 of S corporation income in his taxable income in 2019, his deduction will be limited to $20,000 (20% * $100,000) rather than $40,000 (20% * $200,000).
· The Section 199A deduction does not add to your NOL.
· QBI also doesn't include any income that's not "effectively connected with the conduct of a U.S. trade or business". This is an issue we are waiting on further guidance on from the IRS.
· We do not currently know if a single rental property that a taxpayer owns and reports Schedule E is entitled to a 20% deduction against the income. It appears, the 20% deduction is intended to apply to rental income, because a last-minute change to include the 2.5% limitation on unadjusted property. However, Section 199A(c)(c) requires only that QBI be earned in a "qualified trade or business," and the term "trade or business" is not well defined by the tax law. In fact, there are a number of different interpretations of what constitutes a trade or business for different purposes of the Code. The highest standard, however, is that of a "Section 162" trade or business, and in order for an activity to achieve this standard, the business must be regular, continuous, and substantial. And if that's the case, some rental activities will NOT rise to the level of a Section 162 trade or business, as is currently the case under the law, precluding owners of the activities from claiming the 20% deduction. Right now all we can do is wait for guidance from the IRS.