Qualified Business Income Deduction
The Internal Revenue Service provided additional guidance through the issuance of final regulations relating to the new rules allowing many owners of sole proprietorships, partnerships, trusts and S corporations to deduct up to 20 percent of their qualified business income (QBI). The new rules also allow eligible taxpayers a deduction of up to 20 percent of their qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. Wages earned as an employee are not eligible for the deduction. Income earned by a C corporation is also not eligible for the deduction.
The new deduction — referred to as the Section 199A deduction or the deduction for qualified business income — was created by the Tax Cuts and Jobs Act. The deduction is available for tax years beginning after Dec. 31, 2017. Eligible taxpayers can claim it for the first time on their 2018 federal income tax return. The deduction is available, regardless of whether a taxpayer itemizes their deductions on Schedule A or takes the standard deduction. The Section 199A deduction is set to expire in 2025.
The deduction is generally available to eligible taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers. For those taxpayers, the deduction is generally equal to the lesser of (1) 20 percent of QBI plus 20 percent of their qualified REIT dividends and qualified PTP income, or (2) 20 percent of taxable income minus net capital gain. QBI includes domestic income from a qualified trade or business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. Amounts received as wages, capital gain, interest, and dividend income are not included.
For certain taxpayers who are engaged in a rental real estate enterprise and are unsure of whether they meet the section 162 trade or business test, see the safe harbor rules and requirements in IRS Notice 2019-07.
The deduction for taxpayers above the $157,500/$315,000 taxable income thresholds is subject to additional limitations. First, QBI from a business is limited to the lesser of (1) 20% of the taxpayer’s QBI from the business or (2) the greater of these two amounts:
• 50 percent of the taxpayer’s share of Form W-2 wages paid by the business; or
• 25 percent of the taxpayer’s share of Form W-2 wages paid by the business plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the business.
In addition, for taxpayers with income above the threshold amounts, a taxpayer’s trade or business income will not be eligible for the deduction if the business is considered a specified service trade or business (SSTB). The W-2 wage, UBIA, and SSTB limitations are phased in for taxpayers with income above the taxable income threshold amounts and do not apply to taxpayers with taxable income below the threshold amounts. The threshold amounts are adjusted annually for inflation.
The limitations and additional rules are fully described in the final regulations.
Not Applicable
The new tax law allows many owners of sole proprietorships, partnerships, trusts and S corporations to deduct 20 percent of their qualified business income.
How will this affect me?
Scenario 1 (single filer under the $157,500 threshold with no capital gain)
Sam is a sole proprietor with qualified business income (QBI) of $120,000 for tax year 2018. He has no other source of income or loss outside of his sole proprietorship as a mechanic. After applying the standard deduction but before determining the section 199A deduction, Sam’s taxable income for 2018 is $108,000. Under section 199A, Sam is entitled to a deduction equal to the lesser of (1) 20 percent of his QBI or (2) 20 percent of his taxable income minus net capital gain. 20 percent of Sam’s QBI is $24,000 ($120,000 x 20%). 20 percent of Sam’s taxable income minus net capital gain is $21,600 ($108,000 x 20%). Thus, Sam is entitled to a section 199A deduction of $21,600. This deduction may be taken in addition to the standard deduction, reducing Sam’s taxable income for 2018 to $86,400.
Scenario 2 (joint filer over the $315,000 threshold, but below the phase-in threshold of $415,000)
Henry and Wanda are married and intend to file jointly for tax year 2018. Henry is a partner in a real estate partnership. Henry’s share of the partnership’s QBI is $300,000, and his share of W-2 wages paid by the partnership is $40,000. The partnership holds no qualified property so Henry’s share of UBIA is $0. Wanda earns wages from an unrelated company. Henry and Wanda’s combined taxable income for 2018 is $375,000 (which is within the phase-in threshold of $415,000). Harry and Wanda have no capital gain or loss for tax year 2018.
Because Henry’s and Wanda’s taxable income is above the threshold amount, their section 199A deduction is subject to additional limitations but, because they are within the phase-in range, the limitations will be phasedin. Because the partnership holds no qualified property, only the W-2 wage limitation applies. In order to apply the W-2 wage limitation, Henry and Wanda must first determine 20 percent of Henry’s share of the partnership’s QBI. 20 percent of Henry’s share of the partnership’s QBI is $60,000 ($300,000 x 20%). Next, Henry and Wanda must determine 50 percent of Henry’s share of the partnership’s W-2 wages. 50 percent of Henry’s share of the partnership’s W-2 wages is $20,000 ($40,000 x 50%). Because 50 percent of Henry’s share of the partnership’s W-2 wages is less than 20 percent of Henry’s share of the partnership’s QBI, Henry and Wanda must determine the QBI component of their section 199A deduction by reducing 20 percent of Henry’s share of the partnership’s QBI by the reduction amount.
Henry and Wanda are 60 percent through the phase-in range (that is, their taxable income exceeds the threshold amount by $60,000, and their phase-in range is $100,000). The excess amount is $40,000 (20 percent of Henry’s share of the partnership’s QBI, or $60,000, less 50 percent of Henry’s share of the partnership’s W-2 wages, or $20,000). The reduction amount is equal to 60 percent of the excess amount, or $24,000. Thus, the QBI component of Henry’s and Wanda’s section 199A deduction is equal to $36,000, 20% of B’s $300,000 share of the partnership’s QBI (that is, $60,000), reduced by $24,000. Henry’s and Wanda’s section 199A deduction is equal to the lesser of 20% of the QBI from the business as limited ($36,000) or (ii) 20% of Henry and Wanda’s taxable income ($375,000 x 20% = $75,000). Therefore, their section 199A deduction is $36,000 ($60,000 reduced by $24,000) for 2018.
Scenario 3 (joint filer over the $315,000 threshold, but below the phase-in threshold of $415,000 and with income from a specified service trade or business)
Assume the same facts as in Scenario 2, except that the partnership is engaged the practice of law, which is considered a specified service trade or business (SSTB). Because Henry and Wanda’s income is within the phase-in range, we must reduce the QBI and W-2 wages allocable to Henry from the SSTB to the applicable percentage. Their applicable percentage is 40 percent (100 percent reduced by the ratio that their taxable income for the taxable year ($375,000) exceeds their threshold amount ($315,000), or $60,000, bears to $100,000). The applicable percentage of Henry’s QBI is $120,000 ($300,000 x 40%) and the applicable percentage of Henry’ share of W-2 wages is $16,000 ($40,000 x 40%). These reduced numbers must then be used to determine how Henry’s section 199A deduction is limited.
The W-2 wage limitation is twenty percent of Henry’s share of the partnership’s QBI of $120,000, or $24,000. Fifty percent of Henry’s share of the partnership’s W-2 wages of $16,000 is $8,000. Because 50 percent of Henry’s share of the partnership’s W-2 wages ($8,000) is less than 20 percent of Henry’s share of the partnership’s QBI ($24,000), Henry and Wanda must determine the QBI component of their section 199A deduction by reducing 20 percent of Henry’s share of the partnership’s QBI by the reduction amount.
Henry and Wanda are 60 percent through the phase-in range, as previously calculated in Scenario 2. They must determine the excess amount, which is the excess of 20 percent of Henry’s share of the partnership’s adjusted QBI, or $24,000, over 50 percent of Henry’s share of the partnership’s adjusted W-2 wages, or $8,000. Thus, the excess amount is $16,000. The reduction amount is equal to 60 percent of the excess amount, or $9,600. Thus, the QBI component of Henry and Wanda’s section 199A deduction is equal to $14,400 – 20 percent of Henry’s share the partnership’s QBI of $24,000, reduced by the excess amount of $9,600. Henry and Wanda’s section 199A deduction is equal to the lesser of 20 percent of the QBI from the business as limited ($14,400) or 20 percent of their taxable income ($375,000 x 20% = $75,000). Therefore, Henry and Wanda’ section 199A deduction is $14,400 for 2018.