One of the most significant components of the Tax Cuts and Jobs Act of 2017 (“TCJA”) was the new Section 199A deduction for Qualified Business Income (QBI). The 199A deduction (also called the QBI deduction or pass-through deduction) [reviewer’s note –is equal to 20% of a taxpayer’s QBI from sole proprietorships and pass-through entities and is effective for tax years beginning after December 31, 2017 and continuing through 2025. The deduction can be claimed by individuals, estates and trusts but not by corporations.
The purpose of the QBI deduction was to allow pass-through business owners – whose income would otherwise be subject to the highest individual income tax rates – to get close to the same lower rates as corporations as a result of TCJA. With the 20% QBI deduction and the reduction in the top individual rate from 39.6% to 37%, the tax rate for pass-through income drops to 29.6% (37% x 80%.)
The QBI must be from a domestic business and can be operated through a sole proprietorship, partnership, S corporation, trust or estate. Very briefly, the QBI deduction is the lesser of 20% of the “combined qualified business income” of the taxpayer or the excess, if any, of the taxpayer’s taxable income for the tax year over the sum of net capital gains and qualified cooperative dividends.
Basic Rules of the QBI Deduction
New Code Section 199A allows individuals, as well as some estates and trusts, to deduct up to 20% of income from a qualified trade or business (QBI). The deduction is limited to the greater of:
- 50% of the W-2 wages of the trade or business
- The sum of 25% of the W-2 wages of the trade or business, plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of all qualified property (generally tangible property subject to depreciation).
The W-2 and UBIA limitations on the QBI deduction do not apply to taxpayers whose taxable income determined without regard to the QBI deduction is less than $315,000 ($157,500 for all other taxpayers). The W-2 and UBIA limitation is phased in for additional taxable income up to $100,000 (married filing jointly) or $50,000 for other taxpayers, such that the limitation will fully apply to taxpayers whose income reaches $415,000 or $207,500, respectively.
Qualified Business Income
Qualified business income (QBI) is the net amount of all income, gain, deductions and losses for a qualified trade or business that is effectively connected with a U.S. trade or business; thus, only domestic businesses would qualify. Per recently issued regulations, a trade or business for purposes of 199A is generally determined in a manner consistent with IRC Section 162, which provides the rules for deductibility of expenses of a trade or business.
Most investment-type income is excluded from the definition of QBI – including capital gains and losses, dividends, interest income (except where allocable to a trade or business), foreign currency and commodities gains among others. In order to take a QBI deduction, a taxpayer must be engaged in a qualified trade or business as described in Section 199A. This generally would include any trade or business except (1) the trade or business of performing services as an employee and (2) a specified service trade or business (“SSTB”). This means that an employee cannot claim a QBI deduction against salary income. Certain types of gains from the sale or exchange of business assets (Section 1231 gains) would be considered eligible QBI. Rental income may be considered QBI depending on the facts and circumstances.
The first step for the QBI deduction requires the taxpayer to compute the deductible amount for each trade or business, which is the lesser of (1) 20% of the taxpayer’s qualified business income or (2) the greater of the two amounts described above – 50% of W-2 wages or 25% of W-2 wages plus 2.5% of UBIA. Recently issued IRS rules would allow aggregation of certain trades or businesses subject to several conditions, including common ownership and some sharing of facilities or operations.
All the deductible amounts thus determined for each separate trade or business are then added together. This tentative deduction amount is further limited to the lesser of (1) the combined QBI of the taxpayer, or (2) 20% of the excess of the taxable income of the taxpayer for the year over the sum of any net capital gain plus the aggregate amount of qualified cooperative dividends. If there is a net QBI loss for the year, it is treated as a loss in the succeeding year
Specified Service Trade or Business
A specified service trade or business (SSTB) is 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 and any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The proposed regulations limit this last category to individuals (1) receiving income for endorsing products or services, (2) licensing or receiving income for the use of an individual’s image, likeness, name, voice, signature, trademark, etc. (3) receiving appearance fees, etc. An SSTB also includes a trade or business performing certain investment related services: investing and investment management; trading; dealing in securities, partnership interests or commodities. Under the proposed regulations, an SSTB also includes any T or B with 50% or more common ownership that provides more than 80% of its services to an SSTB.
Taxpayers whose income do not exceed the income thresholds described earlier will not be subject to the SSTB limitation. In other words, a taxpayer whose taxable income determined without regard to the QBI deduction is less than $315,000 would be able to claim a QBI deduction for an SSTB.
We Can Help
For a more detailed discussion of the 199A deduction or if you need help in assessing how the QBI deduction may impact your taxes, please contact your Elliott Davis tax advisor.