Qualified Business Income Deduction: What You Need To Know

For years, members of Congress (from both parties) have said that the U.S. corporate tax rate, which was one of the highest in the world, needed to be cut. The argument was that having such a high tax rate put U.S. companies at a competitive disadvantage on the world stage and was even driving some U.S. companies out of the country.  The 2017 tax act, known colloquially as the Tax Cuts and Jobs Act (TCJA), finally delivered a significant cut in corporate taxes. The previous graduated tax rates with an effective rate that topped out at 35% was replaced by a flat 21% rate.

However, according to a 2017 report by the Brookings Institute (https://tinyurl.com/y8h2wqfb), only about 5% of U.S. businesses file as “C” corporations.  The remainder are one of various forms of “pass-through” businesses. (A pass-through is a business that does not pay tax itself. Instead the owner or owners report the income directly on their personal tax returns and pay the tax personally.)  Congress realized that the corporate rate cut would not do much good if aid wasn’t provided to those businesses as well.

For that reason, the TCJA also included a new deduction available only to owners of pass-through businesses.  The Qualified Business Income (QBI) deduction allows pass-through business owners to deduct up to 20% of their business income on their personal returns.  The result is that the maximum income tax rate for pass-through income has been reduced, effectively, to 29.6% percent (down from 39.6% under the old law). While this benefit is not as good as the corporate rate cut, it is a significant benefit. Unfortunately, while the corporate rate cut has no expiration, this new deduction expires after 2025.

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The Basics

Unlike the corporate tax rate cut, Sec. 199A, which lays out the rules for this deduction, is an incredibly complicated piece of tax law.  It’s not practical to try to address all of these rules here, but here are some general principles that need to be understood to begin to grasp how this new deduction works.

1. The deduction is equal to the lower of 20% of Qualified Business Income (QBI) or a cap.
2. The cap is the greatest of 50% of W-2 wages or 2.5% of the original basis of assets used in the business (there are some interesting rules about the basis of the assets as well, but it’s too complicated for this eAlert) plus 25% of wages.
3. The limitation is calculated separately for each business. You then add the QBI (subject to limitation) for each business together to get the amount that the 20% deduction is based upon.
4. Within limits, you can aggregate businesses together. This allows you to combine their QBI and QBI limitations to get a better result.
5. An election to aggregate businesses is generally permanent. This means that if you make an aggregation election in 2019, you’re required to use that aggregation in future years, even if separating the businesses or aggregating differently would give you a better result in 2021 or 2035. Consequently, care must be exercised when making these elections.
6. If your income is low enough ($160,700 for single people in 2019 and $321,400 for married filing jointly), the limitations mentioned above are ignored and the deduction is based solely on QBI. Above that threshold, the limitations are phased in over the next $50,000 of taxable income ($100,000 for joint filers).
7. For companies engaged in certain service businesses, once you go over those same thresholds, the deduction begins to be phased out. (These rules apply to “Specified Service Trades or Businesses (SSTBs).

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Planning: Why a Tax Professional is Needed

As you can see, this deduction is not the simplest part of the tax law to understand. If you have a business that is small and relatively straight-forward, you might be able to plan for this deduction on your own.  However, if your income is near the phase-in/phase-out threshold, you have a service business, or you own interests in multiple businesses, it’s a good idea to work with a tax professional to help you maximize this deduction.

Here are just a few ways a tax professional may be able to help you:

1. Determining whether your business is an SSTB or not. The rules here can be quite complex and can lead to surprising results.
2. Finding the best methodology to aggregate your businesses can be difficult. A tax professional can help you analyze the best method for the current year, as well as assist you in looking ahead to reduce the chances that you’ll regret any elections you make.
3. There are complicated rules used to determine whether rental real estate activities qualify for the deduction. A tax professional can help you navigate the rules and advise you regarding the possible risks.
4. Smaller businesses, especially ones with few or no employees, may find that they don’t benefit from the deduction because of the wage limit. A tax professional may be able to help you find ways to fix this problem.
5. Sometimes a married couple might get much different results if they file separately vs. jointly. A tax professional can help analyze scenarios to determine the best filing options.

There are many more issues that must be considered as well. A tax professional can help you navigate these murky waters.

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Conclusion

The Qualified Business Income deduction can provide a great benefit to business owners. However, the rules involved in calculating the deduction are very complex and may catch the uninitiated unaware, leading to a lower deduction than they might otherwise receive.

Reaching out to a tax professional at SVA is a great way to avoid these problems. We have people who have spent extensive time studying these new rules and looking for ways to maximize the deduction. We’d love to help you.