The IRS has recently issued proposed reliance regulations that help clarify the new qualified business income (QBI) deduction that was introduced as part of the Tax Cuts and Jobs Act. The guidance is involved and goes on for hundreds of pages. The IRS explained that as part of the proposed regulations, if certain requirements are met, individuals, estates, and trusts (all referred to as “individuals” by the proposed regulations) that own interests in more than one qualifying trade or business can, but are not required to, aggregate them by treating them as a single trade or business.
The proposed regulations also provide instructions for how businesses can calculate the W-2 wage and property basis limitations that are imposed on the QBI deduction.
This post will cover the basics of the QBI deduction including who qualifies for the deduction and how much one could potentially save in taxes.
What is the QBI deduction?
Under prior law, net taxable income from so-called “pass-through” business entities was passed through to owners and taxed at the owner level at the standard rates. For tax years beginning in 2018 through 2025, the TCJA establishes a new deduction based on a non-corporate owner’s (meaning an individual, estate or trust) qualified business income (QBI). It’s also known as the “pass-through” deduction or “Section 199A” deduction.
This deduction is available to eligible individuals, estates and trusts with income from qualifying pass-through entities. S corporations and partnerships aren’t generally taxpayers and can not take the deduction themselves. However, S corporations and partnerships report each shareholder’s or partner’s share of QBI, W-2 wages, unadjusted basis immediately after acquisition of qualified property, qualified REIT dividends and qualified publicly traded partnership income on Schedule K-1 so the shareholders or partners may determine their deduction. The same is true for LLCs that are treated as partnerships for tax purposes.
The deduction can be up to 20% of QBI, subject to restrictions that may apply at higher income levels and a separate restriction based on taxable income. The QBI deduction is not allowed in calculating the non-corporate owner’s adjusted gross income (AGI), but it reduces taxable income. Essentially, it is treated the same as an allowable itemized deduction.
Who qualifies for the deduction?
The QBI deduction applies to qualified income from sole proprietorships, partnerships, limited liability companies (LLCs) that are treated as sole proprietorships or as partnerships for tax purposes, and S corporations. The deduction is subject to the limitations explained below, which begin to phase in when an individual’s taxable income (before any QBI deduction) passes $157,500 or $315,000 for a married joint-filer. The limitations are fully phased in when taxable income exceeds $207,500 or $415,000 for a married joint filer.
W-2 wage and qualified property limitations. When an individual’s taxable income (before any QBI deduction) exceeds $207,500 or $415,000 for a joint-filer, the QBI deduction can not exceed the greater of the individual’s share of:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property means depreciable tangible property (including real estate) a qualified business owns as of the tax year-end and used by the business for the production of qualified business income at any point during the tax year.
Service business disallowance rule. The QBI deduction generally isn’t available for income from specified service businesses. Examples include doctors, lawyers, accountants, actuaries, actors, singers, consultants, athletes, investment managers, stock traders and any other trade or business where the principal asset is the reputation or skill of one or more of its employees.
The disallowance rule begins to phase in when an individual’s taxable income (before any QBI deduction) exceeds $157,500 or $315,000 for a married joint-filer. The disallowance rule is fully phased in when taxable income exceeds $207,500 or $415,000 for a married joint filer. At that point, the individual cannot claim any QBI deduction based on income from a specified service business.
Important note: The W-2 wage and qualified property limitations and the service business disallowance rule don’t apply as long as your taxable income is under the applicable threshold. In that case, you should qualify for the full 20% QBI deduction.
Tip of the Iceberg
Over 90% of U.S. businesses operate as pass-through entities. So many businesses will need to catch up on the recent IRS guidance before the start of next year’s tax filing season for 2018 returns. The new QBI deduction is subject to numerous rules, exceptions, and limitations that can make it difficult to calculate in some situations. Contact your tax advisor to help interpret the rules and explain how they apply in your unique circumstances.