Fundamentals of the Qualified Business Income Deduction
Tax reform ushered in many tax law changes that business and individual taxpayers can leverage to reduce their taxable income. While it’s true the overall tax rate was reduced, it’s also true that many of the other tax saving benefits were sharply reduced or eliminated. A good example of such changes are the changes to the meals and entertainment deduction. The shift in tax law has left many business owners looking for new ways to limit taxes as the end of year approaches. For pass-through entities there is good news in the form of the Qualified Business Income (QBI) Deduction (formally Section 199a). This tax law change allows business owners to take a deduction that can reduce income by 20%. This is a significant opportunity and one that will result in tax savings for qualifying business owners. To help prospects, clients and others understand the deduction and how it can benefit their specific tax situation, Hanson & Co. has provided a summary of key details below.
The QBI Deduction is available to individual taxpayers who own a small business that is classified as a pass-through entity. This classification includes sole proprietorships, S corporations, partnerships, and, in some cases, trusts and estates. The new law became effective for tax years that begin on or after January 1, 2018. For most taxpayers, this means that they can claim the QBI deduction when they file their 2018 tax returns.
The deduction is calculated to be 20% of the taxpayer’s Qualified Business Income (QBI) from eligible pass-through entities. QBI for any one business is, in essence, its net income without considering investment activity. Recently, the IRS released a set of proposed regulations that provided a more thorough definition of QBI. The deduction is a below-the-line deduction, meaning it will not reduce a taxpayer’s Adjusted Gross Income. It is, however, available to taxpayers whether or not they itemize their deductions. In effect, the QBI Deduction will reduce an individual’s taxable income, reducing their tax base and therefore their tax bill.
Only certain taxpayers will be eligible to take the full 20% deduction. Many will have to consider one or more of the following limitations.
Deduction Limit – The deduction is limited to 20% of the taxpayer’s net income, without considering capital gains.
Specified Service Business Limitation – Individuals who provide certain services, including those in the fields of law, health, accounting, and financial services, may find their deduction reduced or erased completely if their income is too high. When taxable income before the QBI deduction exceeds $315,000, a married taxpayer’s deduction will begin to phase out. When it reaches $415,000, it will disappear completely. The lower and upper thresholds for non-married taxpayers are $157,500 and $207,500, respectively.
Business Wages or Property Limitation – Even individuals who are not in a specified service trade or business may find themselves facing a limitation. The limitation is as follows:
The deduction will be limited to the lesser of:
The greater of 20% of the business’s QBI (without considering capital gains)
(1) 50% of business W-2 wages
(2) The sum of 25% of business W-2 wages and 2.5% of the business’s basis in qualified property
This limitation will only be a concern to taxpayers whose taxable incomes exceed the lower thresholds mentioned above ($315,000 for married taxpayers, and $157,500 for non-married taxpayers). At that point, the limitation will begin to phase in, and will fully apply when their incomes exceed the upper thresholds mentioned above ($415,000 for married taxpayers, and $207,500 for non-married taxpayers).
Other Essential Details
A few other important features of the deduction are:
It is taken at the individual level, not at the business level.
It cannot be taken in loss years, but a qualified business loss can be carried forward to offset future QBI.
The proposed regulations bar existing employees from quitting their current job, forming their own pass-through business, and then contracting with their former firm in order to qualify for the deduction. These de-facto employees would be in violation of the law’s anti-abuse provisions.
The QBI deduction will not reduce self-employment tax.
Businesses are barred from bifurcating their business into service and non-service activities in order to avoid the specified service business limitation.
Pass-through entities that are owners in other pass-through entities can take a QBI deduction to pass down to its individual owners.
The QBI Deduction can be a powerful tax planning and savings tool for qualifying taxpayers. Since the IRS has not yet released final guidance it’s important to be aware that additional changes may be made which will impact the current guidance. If you have questions about the QBI Deduction, need assistance with year-end tax planning, or have another issue to discuss, Hanson & Co. can help. For additional information please call us at 303-388-1010 or click here to contact us. We look forward to speaking with you soon.