October 2018
By Neil Krishnaswamy, CFP®
When the Tax Cuts and Jobs Act (TJCA)1 was passed into law late last year, a notable provision2 was introduced for small businesses. Certain taxpayers can now potentially receive a significant tax deduction on qualified business income (QBI).
This piece hopes to answer common questions related to the QBI deduction, and serve as a primer for small business owners to help determine if and to what extent they can reap these new tax benefits.
1. What is QBI and who is eligible for a deduction? QBI is simply the net profits from a business, but certain types of investment income might also be included. To be eligible, you must be an owner of a “pass-through” business entity. This includes limited liability companies (LLCs), S corporations and partnerships. Sole proprietors, who don’t have a true business entity established, are also eligible. However, C corporations and employees of small businesses are not eligible2.
2. What is the deduction and where is it claimed? The amount of the tax deduction is up to 20 percent of QBI2. In other words, business owners who qualify are only taxed on 80 cents of every dollar of profits! Note that QBI excludes guaranteed payments for LLCs and salary paid to S-corp owners. This deduction is claimed on the business owner’s personal tax return. Additionally, it can be claimed regardless of whether you claim the standard deduction or itemize your deductions.
3. What are the limitations of this deduction? To answer this, it may help to look at two different levels of limitation. At the first level, the main question is whether your household taxable income is less than $157,500 for individuals and $315,000 for married couples filing jointly (2018 levels). If the answer is yes, you qualify for the full deduction (20 percent of pass-through business income).
The only other limitation to note here is you can’t deduct more than 20 percent of your taxable income, excluding QBI deduction and capital gain income. This generally will only be a factor if QBI is the main source of your taxable income, and there is minimal spousal or other investment income in the picture.
To bring this together, let’s look at a theoretical example. Mike is a consultant with a business classified as an LLC. He has $200,000 of business profits that pass through to his personal tax return. He files that return jointly with his wife Julie who has $100,000 of wage income as an employee. They also have portfolio income of $30,000. After deductions (excluding QBI), their taxable income is $295,000. Since this is less than the $315,000 limit for married couples, they qualify for the full QBI deduction of $40,000 (20 percent of $200,000 QBI). This brings their taxable income down to $255,000. At their marginal tax bracket of 24 percent, this saves Mike and Julie nearly $10,000 in federal taxes!
Now for the second limitation level. What happens if you’re over the income limits mentioned above? There are a couple more tests to determine if you qualify for a full or partial deduction.
4. Is your business a “Specified Service Business”3? If you fall under this category, you may be eligible for a partial QBI deduction as long as your taxable income is under $207,500 for individuals and $415,000 for married couples filing jointly. If you exceed these limits, you do not get a QBI deduction. In other words, you’re completely phased out.
5. Do you meet the wage and/or property limits? If your business doesn’t fall into the specified service business category, you still might be affected by the income limits mentioned above, but you ensure eligibility by meeting one of the following tests. Is your potential deduction (20 percent of QBI) greater than either of the following?
a. 50 percent of wages paid (not including payments to independent contractors).
b. 25 percent of wages paid, plus 2.5 percent of unadjusted basis of business assets. This is a fancy way of saying that capital intensive businesses can preserve their deduction by owning sufficient assets.
This is where things start to get more complicated. The chart4 below may help you better understand the overall flow. If you think you qualify for this tax benefit, but might also be subject to one of the limitations above, consult with your advisor and tax professionals.
Source: Kitces.com – Understanding the new pass-through business deduction for qualified business income
Clearer planning strategies will emerge as we get more clarity on the more ambiguous definitions in the new tax law. At this point, we would generally caution against making any large scale changes, such as changing your business structure, to maximize this deduction. This deduction is scheduled to “sunset,” or be eliminated after the year 20255, and there is also risk it can be eliminated by future administrations.
Sources:
1 Congress.gov – H.R.1 – An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018
2 IRS – Tax Cuts and Jobs Act, Provision 11011 Section 199A – Deduction for qualified business income FAQs
3 Kitces – Proposed regulations refine definitions for specified service businesses eligible for QBI deduction
4 Kitces – Understanding the new pass-through business deduction for qualified business income
5 The CPA Journal – Tax act first look: The complex new world of the qualified business deduction rule
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