Tax Reform: QBI and Your New Deductions

On Dec. 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law. Another article in this issue lists many of the provisions, but one of the most complex provisions enacted in this law is a 20 percent deduction for individuals related to qualified business income, including business income from self-employment and other pass-through businesses. 

You may also hear this referred to as the Section 199A deduction, since that is the new provision  in the Internal Revenue Code that allows it. Since the corporate rate was reduced to 21 percent, this 20 percent deduction provision was enacted to give individuals—including partners in partnerships and owners of S-corporations, trusts, and estates with qualifying business income—a tax break as well. While the flat 21 percent corporate rate was made permanent in the tax law, this 20 percent deduction starts in 2018 and ends in 2025.

Here is a very simplistic explanation of the provision, but there are many details not covered here. Also, there are many unanswered questions about what qualifies and who is entitled to the deduction, so everyone will be anxiously awaiting IRS guidance on this new, complex provision.

The good news is that taxpayers with taxable income (before this new deduction) less than $315,000 for married couples filing jointly, and $157,500 for other filers, will get a 20 percent deduction, creating a significant tax savings.

So, what is the deduction? First, we must determine what qualified business income is, then determine what we multiply the 20 percent by to arrive at the deduction amount. Then we must look at rules for higher-income taxpayers that could reduce or eliminate the deduction amount. 

QBI is one’s allocable share of trade or business income, less deductions. It excludes investment income, such as capital gains/losses, dividends, and non-business interest income, and it also excludes reasonable compensation paid to the person and guaranteed payments from partnerships. QBI is calculated separately for each business, and if there are losses, there could be reductions in the deduction for the subsequent year.

To arrive at the deduction amount (before the limitation for higher-income taxpayers), 20 percent is multiplied by the LESSER of:

• QBI (defined above), OR 
• Taxable income less any net capital gain (before the 20 percent deduction).

Now we look at the limitations for higher-income taxpayers. For those with taxable incomes above the thresholds for joint and individual filers, we then determine if the QBI relates to certain service fields, since the deduction phases out in those cases. Defining service fields is not as easy as it sounds, but generally includes the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of its employees. 

Architects and engineers are specifically exempt from the definition of a service field and therefore eligible for the 20 percent deduction. The upper limit of the phase-out range is $415,000 for joint filers and $207,500 for other filers, with a complex computation to determine the amount of the deduction that is allowed for taxpayers in the phase-out range. Once those amounts are exceeded, there is no deduction for those in the service fields.  

If taxable income exceeds the phase-out ranges of $415,00 for joint filers and $207,500 for other filers, for non-service fields, the deduction cannot exceed the GREATER of:

•  W-2 wages x 50 percent, OR
•  W-2 wages x 25 percent PLUS 2.5 percent of the unadjusted basis of tangible depreciable property used in the business.

If there are no W-2 wages, then the deduction is limited to 2.5 percent of the unadjusted basis of tangible depreciable property used in the business.

A few examples: Leslie is an attorney doing business in an S-corporation with taxable income of $100,000 entirely from the law practice after payment of a reasonable salary. Since she is not a higher-income taxpayer, her 20 percent deduction is $20,000; it is irrelevant that she is in a service business.

Lindsey is a CPA doing business in an S corporation with taxable income of $500,000 entirely from the CPA practice after payment of a reasonable salary. Since Lindsey is a higher-income taxpayer in a service business, she is ineligible for the 20 percent deduction and thus receives no deduction.

Jimmy owns 20 percent of an S corporation that manufactures toys and works full-time for the corporation. W-2 wages of the S corporation are $500,000, and Jimmy’s allocable share is $100,000. The corporation earns $2 million, and Jimmy’s allocable share is $400,000. The adjusted basis of the assets is $200,000, and Jimmy’s allocable share is $40,000. Jimmy’s taxable income is $700,000. His 20 percent deduction would be $80,000 ($400,000 x 20 percnet); however since he is a higher-income taxpayer, his deduction is limited to the greater of $50,000 ($100,000 x 50 percent) or $26,000 ($100,000 x 25 percent plus 2.5 percent x $40,000). Thus, his deduction is actually $50,000 and reduces his taxable income from $700,000 to $650,000, reducing his tax by $18,500 ($50,000 deduction times 37 percent tax rate). 

The calculation of the new 20 percent deduction for individuals related to self-employment and other pass through business income is complex. However, wading through the rules can help one reduce taxable income and thus end up with a lower tax liability.