Tax Reform Series#1: Qualified Business Income Deduction

As you are aware, The Tax Cuts and Jobs Act was signed by the President on December 22nd “simplifying” taxes. As you may also be aware, the new tax law is more complex than it appears. We will be sending out a series of tax advisors over the next few months diving into the various aspects of the bill. This first article will explain the 20% Qualified Business Income Deduction.

What is it?

In a nutshell, this is a 20% deduction on business income from S-corporations, partnerships, and sole proprietorships. This deduction is taken on your individual tax return to reduce your taxable income, and as a result, your income tax. The deduction can be taken whether or not you itemize your deductions and is available for tax years 2018-2025.

What qualifies as business income for this deduction?

Qualified business income is defined as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer”. This definition of business income does have some exceptions. Some of the items that are specifically excluded are: capital gains and losses, interest and dividend income, and annuity income. Also excluded are reasonable compensation to shareholders and any guaranteed payments to partners.

There are also certain service related businesses that are excluded as well if the taxable income of the individual claiming the deduction is greater than the phase-out amount. The phase-out amounts are between $157,500 and $207,500 for individual taxpayers, and between $315,000 and $415,000 on a joint return. The service-related businesses that have this limitation are businesses such as healthcare professionals, law, accounting, actuarial science, performing artists, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation of skill of one or more of its employees.

How is the deduction calculated?

There are several parts to consider when calculating the deduction so we will explain this part by part.

• The deduction is equal to the lesser of:
  • The “combined qualified business income”, or
  • 20% of the excess of taxable income over any capital gains
• Plus the lesser of:
  • 20% of qualified cooperative dividends, or
  • taxable income less net capital gain

This sounds confusing, and it is, but it is even a little more complicated than that. The definition of “combined qualified business income” is the sum of:

• The lesser of:
  • 20% of the qualified business income, or
  • the greater of:
    • 50% of the W-2 wages of the business (all wages, not limited to wages paid to you), or
    • 25% of the W-2 wages of the business plus
    • 2.5% of the unadjusted basis of all qualified property of the business
• Plus:
  • 20% of the qualified REIT dividends, and
  • 20% of qualified publicly traded partnership ordinary income

Also, just to add one more wrinkle to the calculation, the wage limitations above do not apply to taxpayers below the threshold amount. The phase-out amounts are between $157,500 and $207,500 for individual taxpayers, and between $315,000 and $415,000 on a joint return.

Conclusion

So basically to oversimplify the calculation, the deduction is 20% of your business income (assuming your business pays enough wages) but that deduction cannot be greater than 20% of your taxable income (before the QBI deduction) minus any capital gains.

Here is a quick example. Let’s assume the following facts:

Also, assume that this is not a service related business and we have a single taxpayer.

S-Corp income 100,000 x 20% = 20,000. Since this is not a service related business and the taxable income is above the threshold of $207,500 we need to do the wage calculation as well. Wages 50,000 x 50% = 25,000. Since the 25,000 is higher than 20% of S-Corp income, your deduction will be the lesser of these two amounts. Next, look at your overall taxable income limitation which is taxable income less capital gains x 20% (210,000 – 120,000 = 90,000 x 20% = 18,000). The 18,000 is less than the 20,000 so your 20% business deduction would be limited to 18,000.

As you can see, this is not a simple calculation even using the simple facts above, but this deduction could equate to a rather large tax savings in the right circumstances.