The Tax Cuts and Jobs Act (TCJA) offers a new tax deduction to the Entrepreneur.
- TCJA was enacted on December 22, 2017.
- TCJA is effective for tax years beginning after December 31, 2017, and before January 1, 2026.
- TCJA added a new provision of QBI as Internal Revenue Code Section 199A.
What is the Deduction for Qualified Business Income (QBI)?
- It applies to qualifying entities: Partnerships, S-corporations, and sole proprietorships.
- It provides owners of qualifying entities of a potential deduction to taxable income on his or her personal tax return (not on the business’s tax return).
- It offers up to a 20% deduction of QBI depending on the owner’s total taxable income.
- It will not reduce the owner’s adjusted gross income (AGI).
- It is allowed for determining alternative minimum tax (AMT).
What type of income qualifies?
- Income must be earned in a “qualified trade or business.”
- The deduction is determined separately for each qualified business, and then each deduction amount is added together.
- A qualified trade or business does not include service businesses (i.e., consultants, accountants, performing artists, etc.). But there is an exception: If the owner’s total taxable income is below certain thresholds, then the owner’s “specified service trade or business” will qualify for a QBI deduction.
- These items are excluded from QBI:
- Investment income and losses not allocated to a trade or business
- Reasonable compensation payments (S-Corps)
- Guaranteed payments (Partnerships)
Is the deduction limited?
Well… that depends… on the owner’s total taxable income that is reported on his or her individual tax return.
1. Lower Income… It’s Straightforward if you have total taxable income of less than $157,500 ($315,000 if married filing jointly). It is likely you will qualify for the whole deduction.
2. Higher Income… It’s Complicated if you have total taxable income of $207,500 ($415,000 if married filing jointly) or more. Then you must determine one of two limitations.
- Limitation #1: If the business qualifies as a “specified service trade or business,” then not one penny qualifies for the QBI deduction.
- Limitation #2: If you’re not a “specified service trade or business,” then you are automatically subject to a W-2 wage and business asset limitation, which is a two-step process. To find your deduction for QBI, determine the lower of two calculations:
- Calculation 1 – Determine 20% of QBI
- Calculation 2 – Determine the greater of the following two calculations.
- 50% of the qualified trade or business’s W-2 wages, or
- 25% of the qualified trade or business’s W-2 wages + 2.5% of the unadjusted basis immediately after the purchase of all qualified property.
3. "Middler" Income… It’s Complicated… with a Twist… if you have total taxable income of $157,500 but less than $207,500 (or $315,000 and $415,000 if married filing jointly). Sorry, but you’re stuck calculating the limitations as outlined above for having “high” taxable income, plus needing to determine a “reduction ratio” multiplied by an “excess amount” of the limitations. In addition, if it is a specified service business, an “applicable percentage” will need to be determined. While these calculations will reduce your deduction, you’ll still be allowed a partial deduction. See? Twisted complications.
Sometimes, parts of new tax laws can be clear as mud… which happens to be the case with parts of the QBI deduction. Over the coming months, the IRS will likely (and hopefully!) be providing clarifications to troublesome areas to help you and your accountant. Stay tuned, and be patient!
I thought it would be helpful to provide a list of items that have not changed with the recent Tax Cuts and Jobs Act of 2017. This list is not exhaustive, but it does include the most common for clients I have served. There was discussion about changes to these items, but nothing changed.
- Selling your personal residence? You’re still able to exclude a gain of $250,000 (or $500,000 if married) when you sell your home and if you lived in the home two out of the last five years.
- Age 65 before the close of the tax year? You’ll still qualify for the additional standard deduction.
- Adopting a child? You can still exclude from income amounts paid by your employer under a qualified adoption assistance program.
- Paying out-of-pocket qualified educator expenses as a teacher? You may still track and deduct $250 of expenses above-the-line on your tax return.
- Attending college? The credit options remain the same for qualified higher education expenses. You may take either the Lifetime Learning Credit or the American Opportunity Credit.
- Paying student loan interest? You’ll still be able to deduct up to $2,500 of interest paid under a qualified student loan.
If you’re in doubt about a tax provision, please remember to research using reliable resources and/or ask your tax preparer to help you understand how the issue applies to you.