By: Carlos Nazario CPA, JD, Tax Director at Millan and Co, PC, Austin, TX. February, 2019. firstname.lastname@example.org
The Tax Cuts and Jobs Act of 2017 (TCJA) created a new 20 percent deduction for qualified business income from sole proprietorships, passthrough entities like S corporations, partnerships, and limited liability companies taxed as partnerships. This new 20% qualified business income deduction (QBID) is subject to some complicated restrictions and limitations. (1)
You may increase your qualified business income deduction up to 20% by planning how much of your compensation from your pass-through entities is channeled. Please note that the effective date is for tax years commenced after Dec. 31, 2017, therefore your 2018 tax year is affected and now it’s a great time for tax planning.
The QBID is a new deduction for 2018 that is potentially available to all taxpayers other than C corporations, it may benefit any taxpayer (individuals, estates and trusts) who reports income from a “qualified trade or business” (a “QTB”).
The eligibility list includes taxpayers operating a QTB through a sole proprietorship, as well as taxpayers who are owners of passthrough entities, including S corporations, LLCs and partnerships.
The QBID is equal to 20% of “qualified business income” subject to limitations based on the type of trade or business engaged in by the taxpayer, the amount of W-2 wages paid with respect to the trade or business (W-2 wages), and/or the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (UBIA of qualified property), and the taxable income (with certain adjustments) of the taxpayer.
In general, if you operate a QTB through a passthrough entity, you may be able to deduct much as 20% of the otherwise taxable income from that business.
The QBID allows a taxpayer (subject to all the other limitations) to deduct the 20% of QBI income that would otherwise be taxed in the taxpayer’s highest tax bracket. This will have a greater impact than a 20% reduction in taxes, due to the stepping of tax brackets.
To be eligible for the QBID, items of income, gain, deduction, and loss must be from domestic activities, meaning that they are effectively connected with the conduct of a trade or business within the United States. The QTB needs to be a “qualified trade or business,” but that appears to include almost any active business. Rentals in many cases count as qualified business.
Certain service businesses, which are technically designated as a “specified service trade or business” or “SSTB,” get to enjoy the benefit of the QBID only if the individual taxpayer’s taxable income “TI” is below certain income thresholds.
These limitations start at the Initial Threshold of $157,500 of TI for a single filer and $315,000 of TI for a joint filer (each an “Initial Threshold”). The QBID is completely phased out at the Maximum Threshold of $207,500 (a $50,000 phase-out range) for single filers and $415,000 (a $100,000 phase-out range) for joint filers. This aggressive phase-out of the QBI Deduction is referred to herein as the SSTB Limitation.
The definition of SSTB covers a rather broad group service businesses, but expressly excludes engineers and architects. SSTB is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. It also includes any business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.
If a taxpayer engaged in an SSTB has TI below the Initial Threshold Amount, the QBID will generally be equal to the limitation imposed by the “20% Caps,” which is an amount equal to the lesser of 20% of QBI (the “20% of QBI Limitation”) or 20% of taxable income reduced by net capital gain (the “20% of Modified TI Limitation”).
If the same taxpayer exceeds the Maximum Threshold Amount ($207,500 for an individual taxpayer and $415,000 for a married filing jointly taxpayer), the QTB Limitation for an SSTB comes into play, and, as a result, the QBID is zero for taxpayers with TI above the Maximum Threshold.
If the taxpayer is somewhere between the Initial Threshold Amount and Maximum Threshold Amount, the various limitations applicable to an SSTB are phased in ratably, in proportion to the amount by which the TI exceeds the Initial Threshold Amount. Therefore, the QBID decreases precipitously from the amount determined by the 20% Caps down to zero over the applicable phaseout range.
SSTB taxpayers whose TI is under the initial threshold amount ($157,500 of TI for single filers and $315,000 of TI for joint filers) get the full benefit of the QBID. But the QBID is thereafter phased out aggressively for an SSTB over the next $50,000 of TI for single filers (or over the next $100,000 for joint filers), and above the maximum threshold ($207,500 for single filers and $415,000 for joint filers), the QBID is completely phased out.
Wage and Property Limitations
The wage and property limitations begin to apply when TI equals the initial threshold and are fully phased-in when TI equals the maximum threshold. The QBID transitions from the “20% Caps” to a calculation subject to an alternative second “cap” based on W-2 wages and tax basis in depreciable business property.
Basically, the QBID, once the taxpayer’s TI exceeds the initial threshold amount, becomes increasingly restricted and capped by the wage and property limitations, until, above the maximum threshold, the QBID will equal the lesser of the 20% Caps or the wage and property limitations.
Note that if a taxpayer’s TI is below the initial threshold amount, then the taxpayer is subject only to the limitation imposed by the 20% Caps, and the wage and property limitation is irrelevant.
Second, between the initial threshold amount and the maximum threshold, the Wage and Property Limitations are fully phased in. This phase-in is a bad thing if the business in question has very little in the way of W-2 wages and/or investment in business property, but in many or most cases this second limitation should be easily met by a substantial operating business.
The 20% of Modified TI Limitation
In addition to the 20% Caps and the Wage and Property Limitations, the QBID is also subject to yet another concurrent limitation referred to as the “20% of Modified TI Limitation,” which equals 20% of the excess of TI over net capital gain.
Note that it is very possible for QBI to exceed Modified TI. Any taxpayer with only QBI income (meaning little or no income from any other sources) would claim a standard deduction or itemized deductions and have TI lower than QBI.
Maximizing your QBID
One advantage of having an S corporation paying W-2 wages to owners is that the owners can plan ahead and adjust their W-2 wages for 2018 in order to get the maximum QBID and reducing the W-2 limitations. It can be done by optimizing the amount of wages that will impact the QBI net income in order to get it as close to the maximum 20% deduction.
There is another possible tax saving opportunity for a SSTB that owns its own building. Generally speaking, the SSTB would be categorized as a service business and limit the QBID. However, the SSTB could spin off its real estate holdings into a separate business, which would then charge the SSTB very high rent to use its facilities. Because the real estate business would not count as a service business, this would be an effective way for the partners of the SSTB to transform their service business income into non-service business income and therefore increase your QBID and reduce your taxes.
Please contact our Senior Tax Advisor, Carlos Nazario email@example.com to discuss how to maximize your 2018 qualified business income deduction (QBID). At Millan and Co. we are business consulting CPAs who can help you in your business tax preparation and overall tax compliance.
Notes: (1) Section 199A of the Internal Revenue Code and IRS Section 199A Proposed Regulations of August 2018.