The Tax Cuts and Jobs Act created a new personal deduction, called the qualified business income (QBI) deduction, for owners of pass-through entities that is effective starting on 2018 returns. The deduction cuts the effective tax rate on your business income. Sole proprietors, S corporation shareholders, partners, LLC members, and self-employed independent contractors should familiarize themselves with the rules for the QBI deduction. Here are 10 things to know about it.
1. The new deduction is based on only certain pass-through income
The QBI deduction, also referred to as the Section 199A deduction (based on the Tax Code provision covering it) is figured on qualified business income (QBI) from a business within the U.S., including Puerto Rico. This isn’t merely the net income from your pass-through business. Adjustments are made to exclude capital gains and losses, dividends, interest on working capital (investment-type interest), and reasonable compensation for S corporation owner-employees or guaranteed payments to partners and LLC members for services rendered to the business.
2. The maximum deduction is 20%
The top deduction is 20 percent of QBI. It applies if your taxable income does not exceed $315,000 on a joint return, or $157,500 on any other type of return. It doesn’t matter whether you’re in a specified service trade or business (explained later), as long as your taxable income is within this limit. If taxable income is higher, then limits apply.
3. You can’t use the deduction to reduce business income
The QBI deduction is just like the standard deduction or itemized deductions in reducing adjusted gross income. It’s reported directly on Form 1040. It doesn’t reduce business income that is reported on Schedule C, E, or F. And it isn’t subtracted from gross income like certain other business-related deductions (e.g., self-employed health insurance, contributions to retirement plans, half of self-employment tax).
4. Wages and the cost of equipment count
If your taxable income is higher than the limits listed earlier, then a special formula is used to figure the deduction. Factored into the formula are:
- W-2 wages: taxable compensation subject to wage withholding plus elective deferrals to 401(k) and similar plans. If your company uses a professional employer organization (PEO) to handle payroll, you count the wages paid under the PEO’s name and tax ID as long as you are the common law employer.
- Unadjusted basis immediately after acquisition (UBIA) of qualified property: essentially the cost of tangible property held by or used in a trade or business as of the end of the year and for which the depreciable period has not ended.
5. If you provide services, you may face a special limitation
If your taxable income is above the limits listed earlier and you’re in a specified service trade or business (SSTB*), then the amount of QBI and other items taken in the earlier limitation phases out. As a result, if your taxable income is over $415,000 on a joint return, or $207,500 on another return, then you don’t get any QBI deduction.
*SSTBs are businesses providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees — which only includes payments for endorsing products or services, licensing of the person’s images, voice, etc., or fees for media appearances.
6. Businesses can’t be chopped
Businesses can’t be cut into parts in order to avoid SSTB status. You can’t parse administrative activities or sales of products by an SSTB to create a non-SSTB business. Proposed regulations address action. If a business has a 50 percent-plus common ownership with an SSTB and has shared expenses (e.g., wages and overhead), then product sales are part of an SSTB if gross receipts of those sales are no more than 5 percent of total gross receipts.
7. Businesses can be aggregated
Usually you figure the QBI deduction for each business you own and then combine them to enter a single amount on your return. If you own more than one business and none of them are SSTBs, you can elect to aggregate them if you qualify. This can help with meeting the W-2 wages and UBIA amounts to optimize your deduction.
8. Fiscal year businesses don’t prorate amounts
If your pass-through is on a fiscal year, you can include all of the amounts reported on your Schedule K-1 in your QBI computation. For example, if your S corporation’s 2018 fiscal year ends on September 30, 2018, items such as your share of QBI are taken into account in full when figuring your 2018 deduction.
9. Employees can’t flip to independent contractor status
Employees cannot use the deduction. They may prefer to be treated as independent contractors so they can use it, but proposed regulations create a presumption that a former employee is still an employee barred from the QBI deduction. For example, two law firm associates who quit, form their own firm, and continue to provide the same services to their old firm are still viewed as employees for purposes of the QBI deduction.
The presumption can only be overcome using the usual worker classification criteria.
10. The deduction has no impact on self-employment tax
Owners of pass-throughs that are self-employed cannot use the QBI deduction to reduce their self-employment tax.
You need to discuss your situation with your CPA or other tax advisor to determine whether you need to take any action this year to get the largest QBI deduction possible. If you want to learn more about the new write-off, look at the IRS' FAQs on the QBI deduction.