The Tax Cuts and Jobs Act (TCJA) added a new tax deduction for owners of pass-through entities – a 20 percent deduction of qualified business income (QBI) from a qualified trade or business. This new provision may potentially lower the maximum individual tax rate of 37 percent on pass-through income to 29.8 percent, which makes it more comparable to the new C corporation tax rate of 21 percent. However, the new law contains limitations that may reduce or eliminate the deduction for some business owners.
What is the 20 Percent QBI Deduction?
For tax years beginning after December 31, 2017 through 2025, the QBI deduction is 20 percent of QBI from an S corporation, partnership, sole proprietorship, trust or estate at the owner level. The definition of QBI only includes income associated with business activity conducted in the United States. It does not include reasonable owner compensation, guaranteed payments to a partner or investment income (including capital gains).
The 20 percent QBI deduction is computed separately for each business. The combined 20 percent QBI deductions are limited to 20 percent of the individual’s taxable income in excess of any capital gains. The new deduction reduces taxable income (as computed before the new deduction).
Who qualifies for the deduction?
Qualified trades or businesses include all trades or businesses except those classified as a “specified service trade or business” (SSTB).
An SSTB is a business that provides services in any one of the following business types: 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 1 or more employees or owners. (Note that engineering & architecture services were granted a favorable exclusion from the definition of an SSTB. Those services are not included in the definition of a SSTB, and therefore, are considered qualified businesses). However, even income from an SSTB can be generate a potential deduction if the taxpayer’s taxable income is below the threshold amounts (discussed below).
What are the limitations?
Several limitations may apply to limit the potential deduction, depending on the owner’s taxable income level. First, the QBI deduction can’t exceed 20 percent of “modified” taxable income. For this purpose, taxable income is reduced by net capital gain (including qualified dividend income).
If the owner’s taxable income before the deduction is under $315,000 (married filing joint) and $157,500 (all other filers), no additional limitations apply. (This is true for any type of trade or business, including SSTBs).
If the owner’s taxable income before the deduction is between $315,000 and $415,000 (married filing joint) and $157,500 and $207,500 (all other filers), a limitation phase-in calculation is required. The limitation phase-in rules reduce or eliminate the 20 percent QBI deduction, depending on the owner’s taxable income level. Note: owners of SSTBs get no deduction if their taxable income exceeds these thresholds.
In some instants, the amount of the deduction is limited to the greater of 50 percent of the owner’s allocated share of W-2 wages, or 25 percent of W-2 wages plus 2.5 percent of the owner’s allocated share of qualified property used in the business. The definition of qualified property is generally based on the original cost of the property. Note that the passive activity loss and the at-risk limitations should also be considered in applying the new deduction rules.
Owners of Multiple QBIs
If the taxpayer owns multiple QBIs, and the aggregate amount of QBI for all qualified businesses is a net loss for the year, the taxpayer gets no deduction for the current year. Instead, the loss is carried forward as a loss to offset aggregate QBI in the next tax year. Otherwise, the limitation provisions apply separately to each qualified business, and then the potential deduction is aggregated.
Many unanswered questions remain regarding the application of the 20 percent QBI deduction rules. Recently, proposed regulations were issued that provide some additional guidance on the types of service businesses that qualify for the deduction.
New Penalties Imposed
The new law includes special penalties for taxpayers who understate their income through the mis-application of the new law. The new penalty risk increases the need for special attention to the details of the new law.
While the potential for tax benefit associated with the new 20 percent deduction rules may be substantial, the existing provisions are complex, and can be ambiguous. Advanced planning with a well-informed tax professional is advised.
Need help finding and hiring the right lawyer for your startup? We break down the best practices for picking a lawyer in our blog post, The Startup’s Guide to Hiring a Lawyer.