When Congress passed the Tax Cuts and Jobs Act (“TCJA”) in late 2017, it dramatically reduced the income tax rates paid by corporations to a flat rate of 21%. In an attempt to equalize those non-corporate taxpayers, Congress enacted new Internal Revenue Code Section 199A creating the Qualified Business Income (“QBI”) deduction. This new provision applies to 2018 income tax returns of certain non-corporate taxpayers whose businesses operate as sole proprietorships and such pass-through entities as partnerships, S corporations and some trusts and estates.
Under this new Section 199A, this group of non-corporate taxpayers can deduct up to 20% of income from a domestic trade or business. The new deduction is available in full to those taxpayers (married filing jointly) with taxable income before the deduction that is below $315,000 (the “Threshold Level”). For other taxpayers, this Threshold Level is $157,500. This ability to deduct in full is phased out for married couples after $415,000 ($207,500 for single individuals) of taxable income before the QBI deduction.
No income tax deduction, however, is worth its salt if it does not come saddled with limitations. Thus, Code Section 199A does not disappoint as it has 3 primary limitations among its many.
First, the new Section 199A only applies to an activity that is a “trade or business,” and the deduction is based on the amount of QBI. Section 199A states that QBI is income from a trade or business, but generally excludes passive investment income and compensatory income such as salaries and wages. Thus, QBI means the net amount of qualified items of income, gain, deduction, and loss with respect to a “Qualified Trade or Business” (“QTB”).
Next, the new law limits a QTB to any trade or business other than a “specified service trade or business” (“SSTB”) and other than the trade or business of being an employee. The definition of a SSTB has 2 parts: a stated list of occupations and a general definition. The stated list of occupations includes any trade or business involving the performance of services in the following fields:
4. Actuarial Science
5. Performing Arts
8. Financial Services
9. Brokerage Services
10. Investing and Investment Management
11. Trading, or dealing in securities, partnership interests, or commodities
Late in the legislative process of enacting Section 199A, Congress dropped the fields or engineering and architecture from the above list. The general definition is 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. Some authors have called this SSTB group as the “Out of Favor” group.
The third limitation to the QBI deduction to note is the wages and property limitations. These limitations were intended to restrict the deduction to “real” businesses rather than investment partnerships. This limitation serves as an “alternative base amount” in calculating the QBI deduction. Generally, the QBI deduction is the lesser of 20% of the taxpayer’s QBI or this “alternative base amount.” Section 199A defines this “alternative base amount” as the greater of the following:
1. 50% of the W-2 wages with respect to a business, or
2. The sum of 25% of the W-2 wages and 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of all qualified property.
The law defines the term “qualified property” as depreciable tangible property
• that is held by, and available for use in, the QTB at the close of the taxable year;
• that is used at any point during the taxable year in the production of QBI; and
• for which the “depreciable period” has not ended before the close of the taxable year.
Earlier we noted that some individuals with QBI and taxable income under the Threshold Level could claim the entire deduction without being subject to the SSTB and Wage and Property limitations. For example, assume a married couple with only the husband generating income of $300,000 of QBI from his practice of law as a sole practitioner. Assume further that the balance of income and deductions for the couple result in taxable income before the QBI deduction of $314,000. Even though the husband is engaged in a SSBT, that limitation as well as the Wage and Property limitation, will not apply since the couple’s total taxable income before the QBI deduction is less than $315,000 Threshold Level. Thus the couple will qualify for a QBI deduction of $60,000 (20% of $300,000 of QBI).
Now, let’s assume the same example with the couple’s taxable income before the QBI deduction of $375,000, and the husband, instead of practicing law, still generates $300,000 of QBI from a QTB that is NOT a SSTB. Since the couple’s taxable income before the QBI deduction exceeds the limitation of $315,000, the wage and property limitation will now phase into the calculation of the QBI deduction. Also, for purposes of this example, let’s assume the husband’s business has $100,000 of W-2 wages to other employees and no UBIA. For this married couple, the QBI deduction of 20% of QBI of $300,000 (or $60,000) is limited to 50% of the W-2 salaries associated with the business or $50,000 plus the excess amount that is not disallowed of $4,000 (or 40% of $10,000) for a total QBI deduction of $54,000.
As you can see from the second example above, the computation of the QBI deduction becomes more complex once that taxpayer exceeds the Threshold Level of $315,000 (for married filing jointly) and $157,500 (for other taxpayers). While the second example has more factors to consider, there are certainly other situations that will add further complications to the calculation of the QBI deduction on the 2018 income tax returns.
On March 13th of this year, the Staff of the Joint Committee on Taxation (“JCT”) released a slideshow overview of the Section 199A QBI deduction. Among the slides, the JCT estimates that out of 39.2 million federal income tax returns that include business income on Schedule C (for sole proprietorships), Schedule E (for reporting income from partnerships, S corporations, trusts and estates) and Schedule F (income from farming activities), 26.8 million will be eligible for the QBI deduction for the 2019 taxable year. Of all the taxpayers claiming the QBI deduction, the JCT estimates that over 95% of that group are below the Threshold Level. Many of the lawmakers on Capitol Hill consider the Section 199A QBI deduction to be one of the most complex and controversial provisions of the TCJA, and our firm stands ready to assist you in navigating through its provisions.