This week we take a look at new rules impacting non-corporate taxpayers.
Tax reform cut the corporate tax rate from 35% to 21%. Because our country’s largest businesses are corporations, this rate reduction received a lot of press. However, the US Small Business Administration reports there are over 30 million small businesses which make up 99.9% of all US businesses.
The majority of small businesses are structured as pass-through entities (PTEs), generally taxed as S Corporations, Partnerships or sole proprietorships.
In general, items of income or loss pass-through from S Corporations or Partnerships and are included on the owner’s personal income tax return. Although the marginal tax rates for individuals also decreased, the top rate is still 37%.
Internal Revenue Code Section 199A, Qualified Business Income Deduction, is an attempt to help level the playing field for PTEs and sole proprietors. The 199A deduction effectively reduces the highest marginal tax rate applicable to owners of PTEs to 29.6%.
The Qualified Business Income Deduction (QBID) is available from 2018 through 2025. The deduction expires after 2025.
The QBID is ultimately limited to total overall qualified business income. Both itemizers and non-itemizers may take the deduction. The deduction is the same for regular tax and alternative minimum tax. It does not reduce self-employment tax.
For purposes of the 199A deduction, items of income and deductions are only eligible if connected with the conduct of a trade or business within the United States.
The calculation of the 199A deduction is one of the most complex provisions of tax reform. In general, the deduction equals:
- 20% of the taxpayer’s QBI (or taxable income, if less than QBI)
- 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.
Various limitations apply depending on the taxpayer’s taxable income and the nature of the trade or business.
A single individual with taxable income of $157,500 or less and married individuals filing jointly with taxable income of $315,000 or less may take the 199A deduction without regard to the wage limitation.
As mentioned above, Section 199A requires QBI be earned in a “qualified trade or business.” This means any trade or business other than a specified service trade or business (SSTB) or the business of being an employee. Once taxable income exceeds $207,500 single/$415,000 MFJ, QBI does not include income from SSTBs.
SSTB income is from a trade or business that involves the performance of services consisting of investing and investment management, trading or dealing in securities or services in the fields of:
An SSTB also includes a trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
There is always confusion when an entirely new code section is created. The original legislation may have created more questions than it answered. As a result, it took the IRS longer than expected to finally release guidance in the form of proposed regulations in August.
Next week we will look at what the regulations have to say about what constitutes a trade or business and SSTB, as well as illustrate the calculation of the 199A deduction at various income levels.