This article is part of Inc.'s Ultimate Guide to the New Tax Law for Business Owners.
Following the passage of the Tax Cuts and Jobs Act, you may be wondering how the new qualified business income (QBI) deduction affects your taxes. There are many variables that can mean a big write-off, a modest one, or none at all.
Let's take this example: An S corporation owner who runs a successful home remodeling business in a suburb of New York City wants to know what the new federal tax law does for him. He's got 25 employees and takes a salary of $200,000. The business has revenue of $10 million, and he personally expects his taxable income along with his spouse's to be about $400,000 in 2018. The answer is that the Act will entitle him to a significant personal deduction on his 2018 Form 1040 based on the S corporation income that's passed through to him.
The new Section 199A deduction
When the Act lowered the tax rate on C corporations to a flat 21 percent (down from graduated rates as high as 35 percent) starting in 2018, Congress tried to create a way to lower the tax rate on owners of pass-through businesses--sole proprietorships, partnerships, limited liability companies, and S corporations. What it came up with was the Section 199A deduction (named after the code section that governs it). The deduction can be as much as 20 percent of qualified business income, or QBI. (It can't be more than an individual's taxable income minus capital gains.) Thus, for a business owner in the top tax bracket who can qualify for the deduction, instead of paying 37 percent on QBI, the effective tax rate after the deduction becomes 29.6 percent.
Your taxable income
The deduction is pretty simple for some business owners, but very complicated for others; it all depends on taxable income. For owners with taxable income in 2018 of no more than $315,000 on a joint return, or $157,500 on another return, the deduction is 20 percent of QBI effectively connected with a U.S. trade or business. (To this can be added 20 percent of certain dividends from real estate investment trusts and income from publicly traded partnerships.)
QBI means the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business. Capital gains and losses, certain dividends, and interest income on reserves and working capital are not qualified items. Reasonable wages to S corporation owners and guaranteed payments to partners and LLC members for services performed for the business aren't taken into account.
For owners such as the home remodeler in the example with taxable income greater than these thresholds, special limitations come into play. The amount of the deduction for them is limited by various factors:
- W-2 wages, including reasonable compensation to S corporation owners, which are taxable compensation plus elective deferrals to 401(k) and similar plans
- Unadjusted basis immediately after acquisition (UBIA) of qualified tangible property (essentially the original cost of equipment and realty) that's still in use by the business and hasn't reached the end of its recovery period for depreciation purposes
And for owners who are in a specified service trade or business, which is explained next, there's an additional limitation.
Specified service trades or businesses
For those operating in certain fields called specified service trades or businesses (SSTB) with taxable income over the threshold amount, the deduction is further curtailed by another limitation. The amount of QBI, W-2 wages, and UBIA that can be taken into account are reduced proportionately by excess taxable income, meaning taxable income over the threshold amount. But the excess taxable income that can be used is limited to $100,000 on a joint return or $50,000 for other filers. So once taxable income is $415,000 for a joint filer or $207,500 for any other filer, no QBI deduction can be claimed by an owner of an SSTB.
Businesses that fall in the SSTB category include those providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets, or any trade or business where the principal asset is the reputation or skill of one or more of its employees. In proposed regulations, the IRS has clarified when the reputation or skill of one or more employees will be treated as being its own category of an SSTB, and it's favorable to taxpayers. This will only be treated as an SSTB if the person receives payment for endorsing products or services, for allowing the use of his or her image, voice, or other symbol associated with the individual's identity, or for appearing at an event or in the media. The proposed regulations give the example of a restaurant owner who endorses a line of cookware. The fees for the endorsements result in cookware activity being treated as an SSTB, but it doesn't make the restaurant an SSTB.
More on deductions
When an individual owns more than one pass-through business, the deduction is figured separately for each one and the totals are added together to become one entry on Form 1040. However, proposed regulations allow businesses to be aggregated in some situations to optimize the QBI deduction. If there's a loss for the year so that no QBI deduction can be claimed, the loss is carried forward and will reduce the QBI deduction for the following year. Again, the QBI deduction is not a business deduction, so it won't reduce self-employment tax for self-employed owners. It's a personal deduction that can be claimed whether the owner itemizes or uses the standard deduction.
A growing FAQ
Because the QBI deduction is new, there will continue to be clarifications, forms and instructions, and other help in handling the new write-off. The IRS has a FAQ page on the Section 199A deduction. Business owners of pass-throughs need to work with their tax advisers to determine whether they qualify for the QBI deduction and what they can do, if anything, to maximize their tax savings.