First things first, this new provision, Section 199A, as part of the Tax Cuts and Jobs Act allows for a 20% deduction for qualified business income deduction. There are exceptions and it can get complicated, but, to keep it simple, a 20% deduction for running your small business is pretty nice. Let’s talk further details about the qualified business income deduction.
In a nutshell, the Sec 199A qualified business income deduction gives owners of pass-through businesses such as sole proprietors, partnerships, S corps and even real estate investors a deduction equal to 20% of their qualified business income.
While this deduction will produce savings for many pass-through entities including real estate investors, the deduction requires some complicated calculations and has some limitations. To understand and begin planning for the deduction, let’s dig into the details a little further.
What is Qualified Business Income?
Qualified business income (QBI) is actually pretty simple; it’s defined in Section 199A as the “ordinary” income minus ordinary deductions you earn from a sole-proprietorship, S corporation, or partnership. QBI does not include, however, any wages you earn as an employee. This means that beginning in 2018 as an independent contractor your the self-employment income is considered QBI (and thus eligible for a 20% deduction).
QBI includes the profit from an active trade or business as well rental income as long as you operate as a pass-through entity. For more information about a pass-through entities, see Chapter 14 .
This means your QBI includes profits from an active trade or business as shown on a Schedule C, partnership or S corp K-1, or on a Schedule E and any gains that may occur when a business asset is sold.
To calculate the deduction, add up all these numbers and then multiply the total by 20%. Seems simple, right?
Let’s take a look at a couple of basic examples.
If you have $100,000 of qualified business income, you potentially get a $20,000 deduction.
If you have a $1,000,000 of qualified business income, you potentially get a $200,000 deduction.
A technical point: Qualified business income also includes REIT dividends and qualified coop dividends. This logically makes sense since REITs (real estate investment trusts) and qualified coops are also pass-though entities.
What is not Sec. 199A Qualified Business Income
Two types of income you might at first consider qualified business income, but don’t actually count:
- QBI does NOT include reasonable compensation paid to S corporation shareholders nor does it include guaranteed payments paid to any partners.
For example, you own a S corp with $150,000 in revenue. You pay yourself $50,000 in W-2 wages which gets subtracted from revenue to create your net profit. Now you could potentially take the 20% deduction on the $100,000 profit.
The situation works the same way if you receive a guaranteed payment from a partnership. If your share of partnership profits equal $150,000 and you received $50,000 as a guaranteed payment, you only get the 20% deduction on the remaining $100,000 of profits.
2. QBI does NOT include foreign earned income.
If your business operates outside the United States, for example, you don’t get to take advantage of the QBI deduction.
Note: This domestic business requirement replaces the old Sec. 199 Domestic Production Activities Income deduction.
QBI also does NOT include the following items of investment income:
- short-term capital gain or loss;
- long-term capital gain or loss;
- dividend income; or
- interest income.
Limitations on qualified business income deduction
The qualified business income deduction gets limited in a couple of situations.
The first limitation applies if:
- you’re single and earn more than $157,500 or
- you’re married and earn more than $315,000
In either case, you can deduct
THE GREATER OF:
- 50% of the W-2 wages with respect to the business, or
- 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property.
For example, you have $500,000 of QBI and could potentially receive a $100,000 deduction. If your wages equal $150,000 and you hold no depreciable property, you can only deduct $75,000 because 50% of $150,000 equals $75,000.
This limitation means that high income sole proprietors, partnerships or real estate investors without W-2 employees might miss out on any deduction unless they have an S corp. Is it worth it to create an S Corp solely for this deduction? Well, that’s a discussion for your personal tax expert to run your individual numbers. Do consider the costs associated with owning a S Corp and the extra paperwork involved.
A second limitation exists where you can’t deduct more than 20% of your taxable income after subtracting any net capital gains, but before deducting the Sec. 199A deduction. Sound confusing?
Let’s look at an example:
Say that you should theoretically get a $20,000 QBI deduction based on the qualified business income from your S Corp. If due to deductions your taxable income actually equals $80,000 and this $80,000 includes $30,000 of net capital gains, your deduction equals 20% of the net $50,000 ($80,000 taxable income – $30,000 net capital gains), or $10,000.
Not every pass-through entity gets to use the QBI deduction.
The law disqualifies “specified service trades and businesses” including many of the traditional white collar professions – medicine, law, accounting, actuarial science, financial services and consulting. It also has a vague catchall for any trade or business that relies on the “reputation or skill of one or more employees.”
Therefore, professional service firms with high-income owners potentially might not get to use the Sec. 199A QBI deduction. Why potentially?
Because this disqualification doesn’t apply if you operate a specified service business and your taxable income falls under the $157,500, if you’re single or $315,000, if you’re married, threshold.
Furthermore, if your taxable income exceeds these thresholds, the QBI deduction doesn’t immediately zero out. Instead, the deduction phases out as your taxable income moves from
- $157,500 to $207,500, if you’re single or
- $315,000 to $415,000 if you’re married
If you’re below these thresholds, then no need to worry about not qualifying.
What if your small business is doing well and fits one of these trades or relies on your reputation or skill?
Let’s look further into this.
At first glance, the law says you get disqualified if you earn a high income in a situation where the principal asset of the business is reputation or skill. The law does not state you get disqualified because a principal asset is reputation or skill.
Most likely your reputation or skills do matter. However, here’s the kicker.
Think about the principal asset of the business. If at least one other obvious principal asset doesn’t “trump” your reputation or skill, well, I think you get disqualified.
For example, you’re a successful real estate investor with an income beyond the threshold, meaning you lose the pass-thru entity deduction. Other than your reputation or skill, what other item could you possibly label as the principal asset of your business? A cell phone? Your laptop? You get the picture.
Now apply that same situation to an independent contractor such as a software programmer or blogger.
In this situation, where someone, through skill or reputation, creates an asset and that new asset maybe becomes the principal asset.
For example, a successful blogger where advertisers pay the blogger because of heavily targeted website traffic. While the blogger has the necessary writing skills, the asset is not writing at all, but the high volume of traffic through the blogger’s website.
As another example, let’s look at a software engineer or an app developer. In this case, the developer doesn’t sell a service, but a digital good. In other words, a piece of software.
If you’re going to take the position that your reputation or your skills are the principal asset of the business, be ready to be able to point out something else really concrete and obvious as the principal asset.
Other Things to Consider
First, the Sec 199A qualified business income deduction starts in 2018 and ends after 2025. The deduction, in other words, only works for those 7 years. Tax laws are always changing and being updated or removed, so keep an eye out for any updates related to this deduction.
Second, while the deduction reduces your income subject to federal income taxes, it does NOT reduce your income for self-employment taxes or alternative minimum taxes.