The 20 Percent Tax Break for Businesses Is Not So Simple
Tax reform via the Tax Cuts and Jobs Act brings us a new 20 percent deduction computed on qualified business income (Section 199A). This deduction may look simple to compute. After all, tax reform promised simplicity, right?
Is it as simple as creating a deduction equal to 20 percent of the bottom line of Schedule C (sole proprietor business) or 20 percent of the income from a partnership or S corporation? Not so fast. Taxpayers need to first determine “qualified business income.” Then, various limitations may apply.
Qualified business income (QBI) includes income, gains, deductions, and losses from a qualified trade or business. QBI is more than the bottom line of the Schedule C; it also includes the ordinary income and loss from the sale of depreciable assets used in the business. QBI may also include real estate rental income.
Taxpayers with tentative taxable income (before this deduction) below threshold levels may claim the 20 percent deduction. However, it is limited to the tentative taxable income less long-term capital income.
Example of married filing jointly
Joe and Mary receive a Schedule K-1 from their partnership reflecting $200,000 of QBI. The tentative deduction is $40,000 (i.e., 20 percent of $200,000). The remainder of their individual income tax return needs to be computed to determine the tentative taxable income.
After adding other income and claiming itemized deductions, they have a tentative taxable income of $150,000, of which $20,000 is from long-term capital gain. Their QBI amount is limited to $26,000 ($150,000 less $20,000 long-term capital gain, multiplied by 20 percent).
For a married couple, the threshold amount of tentative taxable income is $315,000 ($157,500 for other taxpayers). If their tentative taxable income is greater than the threshold, the QBI amount is subject to additional limitations: the greater of 50 percent of wages expense in the business, or 25 percent of wages plus 2.5 percent of qualified property used in the business.
An insufficient amount of wages or qualified investment in property may limit the 20 percent business deduction.
Specified business activities
Not all businesses qualify for the 20 percent deduction if the tentative taxable income is above the threshold. The deduction may be limited or eliminated for specified business activities. But those business activities are not well-defined. They include any trade or business involving services performed in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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.
The IRS has not had occasion to provide guidance to assist in interpreting these terms. The courts have not had to rule on the issue. Is “brokerage” referring to the brokering of financial products, or any brokering (e.g., brokering of logistic services)? What is a business whose principal asset is the reputation or skill of one or more of its employees?
A taxpayer computes the QBI amount for each trade or business, based on the limitations applicable to each business. One business may have multiple activities, which may require further analysis if one of the activities is a specified business activity.
If the aggregate QBI amount is positive, it is limited to 20 percent of the tentative taxable income (determined after subtracting that portion treated as long-term capital gain). After all of the aggregation is complete, the taxpayer may have a net QBI loss. That loss is carried over to the following year, to reduce the following year’s QBI.
Estimated tax payment taxpayer for 2018 should consider the Section 199A QBI deduction. Although there is no penalty for over-paying estimated taxes, many people do not want to pay taxes earlier or in an amount that is more than required.
How we can help
Restructuring your entity may enhance the amount of 20 percent QBI deduction. For taxpayers with tentative taxable income near the threshold level, income planning may also enhance the deduction. Our tax professionals are available to meet with you to review how the 20 percent deduction might apply to lower your tax liability.