Understanding the New Qualified Business Income Deduction

One of the most discussed, and yet misunderstood, provisions of the Tax Cuts and Jobs Act is the new 20% deduction for reporting Qualified Business Income from partnerships, S corporations or sole proprietorships. Because of the way the legislation was introduced in the House or Representatives, this income is still referred to by some as “pass-through” income, although that term does not appear in the Internal Revenue Code Section 199A that gives life to the new deduction.

Interestingly, this deduction is not considered an itemized deduction, nor will it reduce a taxpayer’s adjusted gross income. Instead, the deduction is subtracted from what would have otherwise been the taxpayer’s taxable income. It applies to individuals, as well as trusts and estates.

Even though some of the drafters of the tax act expressed an effort to simplify tax laws, somewhere along the way that goal was lost for this provision. There are a few different definitions, steps and thresholds that must be taken into consideration to determine whether you can take the deduction and how much. If you own or invest in a qualified business, here’s how the new deduction would apply to you.

What is Qualified Business Income?

For starters, Qualified Business Income (QBI) is defined as the net amount of income, gain, deduction and loss you realize with respect to any “qualified” trade or business. The deduction is generally equal to 20% of your QBI from a qualified partnership, S corporation or sole proprietorship.

The business must be conducted within the U.S. Both active and passive business activities are considered.

Income earned as an employee, resulting in a W-2 form, does not qualify as QBI, however. And QBI does not include reasonable compensation received from an S corporation, or guaranteed payments received in exchange for services provided to a partnership’s business. Investment-related items — such as capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business) — are also not included.

The deduction is first determined for each qualified trades or businesses. If the sum of your income from qualified businesses is less than zero, you cannot claim the QBI deduction for the current year, and the net loss is treated as a loss from a qualified business in the next tax year.

Notably, qualified real estate investment trusts (REITs) and publicly traded partnerships are not considered qualified partnerships for QBI. Yet, you can still take a 20% deduction for income earned on these types of investments, even if you don’t qualify for a QBI deduction.

In general, the final deduction cannot exceed 20% of the excess of your taxable income over net capital gain.

Limits for high-income taxpayers

In addition, the law is designed to prevent high-income taxpayers from treating income from certain “specified service trades or businesses” as QBI. Limitations apply when taxable income exceeds $157,500 for individuals or $315,000 for married couples filing jointly (MFJ).

Specified service trades or businesses are activities providing professional services in the fields of:

  • Health
  • Law
  • Accounting
  • Actuarial science
  • Consulting
  • Athletics or performing arts
  • Financial or brokerage services
  • Where the principal asset is the reputation or skill of one or more employees or owners

If your taxable income is less than the above threshold, all non-employee domestic business income you report will be treated as QBI. If your taxable income is at least $50,000 ($100,000 for MFJ) more than the threshold, none of the income from any specified service trade or business is treated as QBI. Where taxable income falls within the applicable threshold range (MFJ: $315,000 ‒ $415,000; all others: $157,500‒$207,500), the exclusion of specified service trades or business income from QBI is phased in.

The wage/property limitation

Furthermore, if your taxable income exceeds the threshold range discussed above, the amount of the QBI deduction is limited based on either wages paid by that business or the wages paid plus a capital element.

Here’s how it works: If your taxable income is at least $207,500 ($415,000 for joint filers), your QBI deduction cannot exceed the greater of:

  • 50% of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or
  • The sum of 25% of such wages plus 2.5% of the original basis of the tangible depreciable property used in the business (including real estate)

Where taxable income falls within the middle threshold range (MFJ: $315,000 – $415,000; all others: $157,500 ‒ $207,500), the limitation is phased-in at 1% for every $1,000 of the excess amount for joint returns and 1% for every $500 of the excess for all other returns.

What does this mean for you?

Clearly, there are a lot of moving pieces to this provision depending on your taxable income, the nature of the business you own, and how you withdraw income from the activity. It’s this last element where a wealth manager with tax expertise can really help you with tax strategies.

In an upcoming fathom article, I’ll discuss options for how you may want to reconsider your compensation from partnerships, S Corps and sole proprietorships to maximize the tax savings available from this new deduction.

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