The newly signed Tax Cuts and Jobs Act (also known as the Federal Tax Bill) contains a significant new tax deduction effective for owners of “pass-through” businesses in 2018—specifically affecting partnerships, S corporations, LLCs or sole proprietorships—and it should provide a substantial tax benefit to those with qualified business income.
With certain limitations, this pass-through deduction is 20% of qualified business income. Qualified business income (QBI) is defined as the net amount of items of income, gain, deduction and loss with respect to a person’s trade or business. The business must be conducted within the U.S. to qualify; it is also important to note that specified investment-related items (capital gains or losses, dividends and interest income unless the interest is properly allocable to the business) are not included.
Additionally, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business. The deduction is taken “below the line”—it reduces taxable income but not adjusted gross income. However, it is available regardless of whether one takes itemized deductions or the standard deduction.
In general, the deduction cannot exceed 20% of the excess of taxable income over net capital gain. If QBI is less than zero, it is treated as a loss from a qualified business in the following year. Additionally, there are rules in place to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
Specifically, for taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
Here is how the phase-in works. Let’s say taxable income is at least $50,000 above the threshold, or $207,500 ($157,500 + $50,000)—in that instance all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, or $415,000.)
If taxable income is between $157,500 and $207,500, people exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. For example, if taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000/$50,000). For joint filers, the same formula would apply using the $315,000 threshold, and a $100,000 phase-out range.
What’s more, for taxpayers with taxable income more than the above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element. So if someone’s taxable income is at least $50,000 above the threshold ($207,500), the deduction for QBI cannot exceed the greater of either 1) 50% of the allocable share of the W-2 wages paid with respect to the qualified trade or business, or 2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if QBI was $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, the deduction would be limited to $16,000 and reduced by $4,000. And if taxable income was between $157,500 and $207,500, a person will only incur a percentage of the $4,000 reduction.
Other limitations may apply in certain circumstances—specifically, taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends or income from publicly traded partnerships—and those factors should be kept in mind when preparing to file.
It’s clear there are a number of complexities surrounding this substantial new deduction, and the task of adjusting to it can be formidable. However, for those who qualify, the opportunity does exist for significant tax savings based around the coming year’s earnings.
Due to the far reaching effects of the Tax Cuts and Jobs Act, determining the overall impact on any particular individual, business or family will depend on a variety of other complex changes made by this new law. While many planning opportunities are now present – there may be just as many pitfalls without the proper guidance and support. To ensure you are accounting for all scenarios and taking advantage of all potential tax planning strategies, we advise that you work closely with your tax advisor to assess your individual situation.
Our team of experts are continually monitoring developments for further guidance from Congress and the IRS on the above tax reform legislation provisions, and will provide updated information and analysis as necessary.
Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statues, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.