Tax Reform: What it Means for Businesses – Qualified Business Income Deduction Part 2
November 07, 2018

This week we take a deeper look into Qualified Business Income. Click here to read Part 1.

 

Widely considered one of the most significant, and complex, provisions of the Tax Cuts and Jobs Act (TCJA), new Internal Revenue Code Section 199A, Qualified Business Income (QBI), allows a deduction of up to 20% of QBI from partnerships, limited liability companies, S corporations, trusts, estates, and sole proprietorships.

Code 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.

The Internal Revenue Service (IRS) issued proposed regulations on August 8, 2018. The regulations can be divided into 6 primary sections. The sections cover operational procedures and definitions as well as anti-abuse rules. Treasury has authority to issue future regulations on many other aspects as well.

Let’s look at a few key definitions:

  • Trade or business – proposed regulations rely on Code Section 162 for the definition of “trade or business.” Despite a 100+ year history of cases and rulings, there is still no definitive guidance as to what constitutes a trade or business.

Through the years, one of the most contentious debates has been, when does a rental activity rise to the level of a trade or business? The proposed regulations give examples that appear to indicate the bar may be lower than the courts have historically required.

  • W-2 Wages – total wages subject to wage withholding, elective deferrals and deferred compensation and properly included on Form W-2 during the calendar year ending during the entity’s tax year.

 

  • SSTB – no changes were made to the specified fields identified in the Code; however, clarification was given to the phrase “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners…is a SSTB.” Practitioners were concerned that any business could potentially meet a definition this broad.

 

The regulations clarify the “reputation or skill” language to mean only trade or businesses that consist of individuals receiving fees for: the use of their image, likeness, name, voice, etc., to endorse products, or make an appearance.

In summary, if you conduct a trade or business, show a profit, and have taxable income of less than $157,500 single/$315,000 married filing jointly (MFJ), you likely qualify for the deduction and it will be the lesser of 20% of QBI or 20% of taxable income.

If you conduct a SSTB and have taxable income in excess of $207,500 single/$415,000 MFJ, you are not eligible for 199A deduction.

For all other taxpayers with a trade or business or SSTB, the 199A calculation will include wage or unadjusted basis of qualified property limitations.

The following examples illustrate the calculation of the 199A deduction at various income levels.

Example 1

Jack and Jill have QBI of $200,000 from their consulting business. They file MFJ and have taxable income of $150,000. Despite their consulting business being a SSTB, because their taxable income is less than $315,000, they are eligible for the 199A deduction and are also not subject to the W-2 limitation. Their 199A deduction is $30,000, the lower of:

-        20% x $200,000 = $40,000; or

-        20% x $150,000 = $30,000.

Example 2

Jack and Diane receive wages of $400,000 from their closely-held medical practice. The practice also passes through $250,000 of net income. After deductions, total taxable income is $550,000.

Because the taxpayers own an interest in a SSTB and taxable income is more than $415,000, they are not eligible for the 199A deduction.

Example 3

Brady is single. He owns a tool and die company structured as an S corporation. Brady received wages of $90,000 and $180,000 of QBI from the S corporation. After deductions, his taxable income is $240,000. The S corporation paid wages of $500,000. The unadjusted basis of all qualified property is $1,000,000.

Despite taxable income exceeding $207,500, Brady is eligible for the 199A deduction because he owns a trade or business that is not a SSTB. Brady is subject to the W-2 limitation. His QBID is:

  • The lesser of:

o   20% x $180,000 = $36,000; or

o   20% x $240,000 = $48,000

Or

  • The greater of:

o   50% x $500,000 = $250,000; or

o   (25% x $500,000) + (2.5% x $1,000,000) = $150,000

Brady’s 199A deduction is $36,000.

Example 4

Kyle and Megan are married and file jointly. Kyle is a 25% shareholder of ABC, Inc., an S corporation. ABC conducts a single trade or business that is not a SSTB. ABC holds no qualified property. Kyle’s share of QBI and W-2 wages are $300,000 and $40,000, respectively. Megan has wages from her employment.

After allowable deductions, Kyle and Megan’s taxable income is $375,000. Because taxable income is between $315,000 - $415,000, their 199A deduction may be limited by W-2 wages, but the limitation will be phased-in.

Before applying the W-2 limit, Kyle and Megan must first determine 20% of ABC’s QBI (20% x $300,000 = $60,000).

Next, 50% of wages is $20,000.

Because 50% of wages is less than 20% of QBI, Kyle and Megan must determine the QBI component of their 199A deduction by reducing 20% of QBI by the Reduction Amount. Kyle and Megan are 60% through the phase-in range (taxable income of $375,000 - $315,000 divided by $100,000).

As a result, the Excess Amount must be calculated. The Excess Amount is $40,000 (20% of QBI – 50% of W-2 wages).

The Reduction Amount is $24,000 (60% x the Excess Amount).

Kyle and Megan’s 199A deduction is $36,000, the lesser of:

  • 20% of QBI as limited, $36,000; or
  • 20% of taxable income, $75,000.

 

These examples only begin to illustrate the nuances and complexity of the 199A deduction. Give BMM a call to discuss how your business fits into Code Section 199A.

This article concludes our series on tax reform. To catch up on previous articles, be sure to check out our blog.