The Tax Cuts and Jobs Act (TCJA) has made some significant changes to the Tax Code, one of which is the implementation of the qualified business income (QBI) deduction. This deduction is found in Section 199A of the Tax Code. Although one goal of the TCJA was to simplify the Tax Code, when it comes to taxes, simplifying is often a relative term. Let's take a closer look at the Qualified Business Income Deduction, and how your choice of business entity affects what you can deduct.
The QBI deduction allows businesses other than C corporations to take a deduction in the amount of 20% of qualified business income. The effect of the QBI deduction is to reduce the top income tax rate on these businesses to 29.6%. This figure represents the new top rate of 37% of such businesses, less 20% of that amount.
In a nutshell, "qualified business income" the income that the business was intended to generate, minus the expenses incurred in generating it. It does not include investment income, interest or dividend income, or capital gains from selling property. If the business in question makes and sells widgets, its QBI will be primarily its profits from widget sales.
The following are eligible for the QBI deduction:
In short, owners of just about every type of business entity with the exception of a corporation qualifies to claim a QBI deduction. While corporations are double-taxed (once at the business level, and again as income at the shareholder level), business entities whose owners qualify for the QBI deduction are taxed only once, at the individual level.
Here's where things get a little confusing. The QBI is not calculated solely as 20% of qualified business income. Instead, the taxpayer taking the deduction can deduct the lesser of either:
However, the limitation of 50% of total W-2 wages doesn't apply under certain circumstances: if the business owner's total taxable income is $157,500 (or $315,000 if married filing jointly), the limitation of 50% of W-2 wages does not apply. The business can simply deduct 20% of qualified business income. The limitation is phased in, to the point that if the taxpayer has taxable income of $207,500 (or $415,000 if married filing jointly), it applies in full.
An example may help illustrate. Let's say that Joe is a married business owner with one W-2 employee, who is paid $40,000 per year. Joe earns in income $250,000 from the business in 2018. He files taxes jointly with his wife, and his total taxable income for the year is $300,000.
If the W-2 wage limitation were in play, Joe would have to deduct the lesser of either 20% of QBI (in this case, $50,000) or 50% of total W-2 wages paid by the business (in this case, $20,000). However, because Joe's taxable income is less than $315,000, there is no W-2 wage limitation on the deduction. He can claim a deduction of $50,000 (20% of QBI).
Now imagine that everything remains the same, except that Joe's income from the business is $450,000, and his total taxable income for the year is $500,000. Joe's QBI deduction would be limited to the lesser of 20% of QBI ($90,000) or 50% of W-2 wages paid by the business ($20,000). He would be able to deduct only $20,000 in this scenario.
These are relatively straightforward scenarios, however, and things could get more complex depending on the structure of the business and the income of the taxpayer. It is quite possible that the deduction could get wiped out altogether. For instance, if Joe's business were a sole proprietorship with income of $450,000 (meaning the W-2 wage limitation on the deduction applies, but no employees (meaning that 50% of W-2 income equals zero), Joe would get no deduction. He would be forced to deduct the lesser of $90,000 (20% of QBI) or $0.
Things would look quite different for Joe if, with all other facts remaining the same, he were the sole owner of an S corporation. As owner of an S corporation, he could choose to take distributions instead of wages, an attractive option because S corporation distributions are not subject to self-employment tax. Unfortunately for Joe, failing to receive "reasonable compensation" from the company puts him at high risk of an audit, so he pays himself a salary of $100,000 per year.
Joe may have dodged the bullet of an audit, but since the IRS doesn't consider "reasonable compensation to the taxpayer" qualified business income, Joe's company's QBI is now reduced by the amount of his salary, to $350,000.
Joe's deduction for QBI is limited to the lesser of 20% of QBI ($70,000) or 50% of W-2 wages paid by the company ($50,000). Therefore, Joe would be able to claim only a $50,000 QBI deduction.
Now, let's imagine that Joe has a partnership with Sam, and that the business has no employees. The partnership, in which they have equal shares, earns $1,000,000 in income in 2018, meaning Joe's share is $500,000. As a partner in a partnership, Joe cannot pay himself wages. Rather, Joe and Sam are entitled to a "guaranteed payment" under Section 707 of the Tax Code. This "guaranteed payment" is not considered part of QBI.
Joe takes a "guaranteed payment" of $100,000, leaving QBI of $400,000. His QBI deduction is limited to the lesser of 20% of QBI ($80,000) or 50% of W-2 wages paid by the company ($0). Once again, in this scenario, Joe cannot claim a deduction.
Clearly, choice of business entity makes a great difference in terms of how useful the deduction for qualified business income proves to be. Of course, there are many factors that affect the decision of business entity, and the QBI deduction is only one. We invite you to contact our law office to discuss this and other taxation issues that may be facing your business.
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