When the Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017, it significantly reduced corporate tax rates from 35% to 21%. Thanks to the small business lobby, the new legislation included the Internal Revenue Code §199A Qualified Business Deduction which provides taxpayers other than C corporations with a deduction of up to 20% of their Qualified Business Income (QBI) which serves to level the playing field for small business owners.
In the absence of the QBI deduction, small business owners would have been left holding the proverbial bag. This is because small businesses are typically structured as pass-through entities such as limited liability companies, S corporations and partnerships which are not subject to corporate tax rates. Rather, such small business owners pay taxes on business profits passed through to the owners and taxed as personal income at individual tax rates which currently range as high as 37%.
Without the QBI deduction, the TCJA would create a situation antithetical to one of the driving factors behind structuring a small business as a pass-through entity. Specifically, by forming as a pass-through entity, small business owners simplify tax reporting obligations by eliminating what is commonly referred to as double taxation of corporations whereby income taxes are paid twice on the same source of income. Corporate income is taxed both at the corporate level and at the personal level when paid out as salary or service fees. Limited liability company, S corporation and partnership income, by contrast, is only taxed once as profits are distributed or “passed through” to owners as personal income and the business itself is not taxed.
Enter the §199A deduction of up to 20% of QBI. So, what is QBI? Generally speaking, QBI is income earned from a sole proprietorship, S corporation, limited liability company or partnership subject to various requirements, limitations and exceptions. Most notably, the QBI deduction applies only to QBI earned in a Qualified Trade or Business (QTB).
So, what is a QTB then? Generally speaking, a QBT is any trade or business other than one that involves the performance of services (i) as an employee or (ii)in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, or dealing in securities. In addition, QTB excludes any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The trades and businesses referenced in item (ii) above in this paragraph are each referred to as a Specified Service Trade or Business (SSTB).
Although the general rule under §199A is that an SSTB is not a QTB for purposes of the QBI deduction, there is one extremely notable exception to this rule. The prohibition of claiming a QBI deduction based on income earned from an SSTB does not apply if the business-owner taxpayer has taxable income of less than $315,000 for joint tax filers or $157,500 for individual tax filers.
Upon determining that trade or business services qualify for the QBI deduction, a pass-through business entity owner must next determine whether any of the 199A threshold limitations apply. There are no limitations on the 20% QBI deduction provided that the taxable income for the applicable business owner taxpayer does not exceed $315,000 for joint tax filers or $157,500 for individual tax filers.
With respect to business owner taxpayers with taxable income in excess of those thresholds, the preliminary deduction (subject to variousrequirements, limitations and exceptions)is limited to the greater of (i) 50% of the applicable W-2 wages with respect to the QTB (note that the taxpayer determines their deductible amount separately for each QTB), and (ii) the sum of 25% of the W-2 wages with respect to the QTB, plus 2.5% of the unadjusted basis immediately after acquisition of any qualified property.
However, the actual computation is more complicated as the W-2 and qualified property limitations are phased in over the next $100,000 of taxable income for joint tax filers (up to $415,000) and $50,000 for individual tax filers (up to $207,500). Further, no QBI deduction is permitted for joint tax return filers with taxable income of $415,000 or above or individual tax return filers with taxable income of $207,500 or above.
For purposes of tax planning, taxpayers should note that under §199A, the QBI deduction is available for tax years beginning after December 31, 2017 and before January 1, 2026. In terms of applying the QBI deduction, the taxpayer determines the deductible amount separately for each QTB and the QBI deduction does not reduce a taxpayer’s adjusted gross income. Rather, each QBI deduction is applied after adjusted gross income is determined. As QBI deductions are not itemized, they are available to all taxpayers whether they itemize deductions or take the standard deduction.
In addition to those summarized above, there are numerous other requirements, limitations and exceptions regarding eligibility and applicability of the QBI deduction. Accordingly, the determination of applicability of QBI and the amount of any eligible deduction should always be done in consultation with legal, financial and tax advisors. Please contact Cramer & Anderson Business, Corporate and Commercial Law Partner Dennis Bishop at (203) 403-4005 for additional information.