A major provision in the Tax Cuts and Jobs Act is a 20% deduction available for pass-through entities with qualified business income. Pass-through entities include sole proprietors, partnerships, and S corporations.
The deduction, aptly named the Qualified Business Income Deduction (QBID), replaces the Domestic Production Activity Deduction (DPAD). The new tax deduction takes effect in 2018 should provide a substantial tax benefit to individuals with “qualified business income” (QBI).
The deduction equals 20% of your QBI from a partnership, LLC, S corporation, or sole proprietorship. QBI is defined as the net amount of income, gain, deduction, and loss from a trade or business. Specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income.
QBI also does not include compensation received from an S corporation, or a guaranteed payment received from a partnership. This means wages you earned as an employee-owner (or payments you received for services as a partner) are not eligible for the 20% deduction.
Legislators, trying to be one step ahead of taxpayers, put two rules in place to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
Rule #1 – Specified Service Limitations
Trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners have a limitation on the QBI exclusion.
The limitation is measured on each taxpayer’s 1040. For taxpayers with taxable income above $315,000 ($157,000 for single filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in.
Here’s how the phase-in works:
If taxable income is below the threshold, there is no limitation. The deduction is 20% of QBI. Easy, right?
However, if taxable income is above the threshold, the limitation begins to phase-in over the next $100,000 of income ($50,000 for single filers) and is completely phased-in when income exceeds the threshold, i.e., $415,000 ($315,000 + $100,000) for MFJ and $207,500 ($157,500 + $50,000) for other taxpayers. Above the threshold, there is no QBI deduction for the above-specified service businesses.
If taxable income is in the $100,000/$50,000 phase in range over threshold of $315,000 MFJ /$157,500 single, there is a partial QBI deduction. Here is where it gets fairly involved. Suffice it to say the partial deduction is based on the percentage of phaseout range utilized.
Rule #2-Wage and Capital Limitation
For taxpayers not subject to the above specified service business limitations, a limitation on the amount of the deduction is in play, which based either on wages paid or wages paid plus a capital element. This is similar to the wage limitation under prior law for DPAD.
Here’s how it works:
If taxable income is below $315,000 MFJ/$157,000 Single, there is no limitation. The deduction is 20% of QBI. The wage or wage/capital limitation does not apply to these income levels.
If taxable income is above the limitation phase in threshold, i.e., $415,000 ($315,000 + $100,000) for MFJ and $207,500 ($157,500 + $50,000) for other taxpayers, the QBI deduction cannot exceed the greater of:
- 50% of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or
- the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate).
For example, if QBI was $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, (i.e. the QBI deduction would be reduced by $4,000).
Finally, if taxable income is in the $100,000/$50,000 phase in range above taxable income of $315,000 MFJ/$157,500 single, there is a partial QBI deduction based on how deep taxable income landed in the phase-in range.
Contact Jackie Kennedy, CPA for additional information.