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What You Need to Know about the Qualified Business Income Deduction

Introduction to the Section 199A Deduction

2017’s taxes are done (hopefully), and now you’ve started thinking about 2018. You’ve heard of the new tax law and some of the benefits in store for the business owner. Let’s talk about one of the most advantageous parts of the Tax Cuts and Jobs Act for you as a small business owner. If you own a business that is not taxed as a corporation, here is what you need to know about the new Section 199A qualified business income deduction (199A deduction). Why is this section one of the best parts of the new law? This new code section allows the owner of a business (that is taxed as a sole proprietorship, partnership, or S corporation – more on this later) to receive a 20% tax deduction on qualified business income. 20% less taxes? I’ll take it! As part of the 2017 Tax Cuts and Jobs Act, Congress reduced the top corporate tax rate from 35% to 21%. Sounds awesome, right? However, the vast majority of businesses in the US are not taxed as corporations. For most business owners, the net profit of the business flows to the owner on the owner’s individual tax return and is taxed at personal income tax rates – not corporate tax rates. These non-corporate businesses include sole proprietors, partnerships, and S-corporations that elect to be taxed as a pass-through entity rather than as a corporation (yes, with an S-corporation you have options of how you want to be taxed). To ensure the average business owner would receive a similar tax benefit to the larger corporate tax-payers, Congress added the 199A 20% tax deduction on qualified business income. Now, while you would think that the U.S. Congress and the IRS would keep things simple and straight forward (wait. . . you weren’t thinking that?), there are many rules and exceptions to the rules when it comes to the Section 199A qualified business income deduction. Let’s dive in to how this deduction works, and how you could benefit from it in 2018.

Who Benefits from the Deduction and What is Qualified Business Income?

First off, what type of income does this deduction apply to? This deduction applies to United States business income from businesses that are taxed as a:

·       Sole proprietor

·       Partnership

·       S-corporation

Not sure if your business is taxed as one of the above? Here’s a test: did you report anything on lines 12 or 17 of your 2017 1040 personal income tax return? If so, your business falls into one of the categories mentioned above. There is also a 20% deduction available under Section 199A for certain rental real estate investment income, publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives. Now, let’s look at the definition of qualified business income. First, qualified business income does not include income from publicly traded partnerships, REITs, or qualified cooperatives. While there is a 20% deduction for these types of income included in the Section 199A deduction, this income is not part of the qualified business income deduction calculation. Confusing? Yes. Here is what qualified business income is:

·       Income from the conduct of trades or businesses within the United States

·       Items specifically excluded:

o   Short or long-term capital gains or losses

o   Dividends

o   Reasonable compensation paid to you for work you perform for the qualified business or trade (for example, if you receive a salary from your S-corporation)

o   Guaranteed payments made to you under IRC Section 707(c) paid to you as a partner for services rendered to the partnership

Now that we’ve defined what qualified business income is and is not, how is the full 20% deduction (that includes a deduction on qualified business income and deduction on publicly traded partnership, REIT, or cooperative dividend income) calculated? Total up the income from these sources and multiply by 20%? Nope – that would be way too easy.

How to Calculate the Section 199A Deduction

The deduction is equal to the sum of the smaller of(1) your combined qualified business income (combined qualified income equals 20% of your income with respect to a qualified trade or business plus 20% of qualified REIT or publicly traded partnership income) or (2) 20% of the amount that your total personal taxable income exceeds net capital gains and cooperative dividends reported on the personal return and the smaller of 20% of cooperative dividends or total personal taxable income (reduced by net capital gains). In simple terms, if 20% of your personal taxable income (excluding capital gains income) is less than your combined qualified business income, the IRS limits the deduction to 20% of your taxable income (less any capital gains).

The last definition that is critical to nail down is the definition of a qualified trade or business. Not all businesses and trades are qualified for the deduction (kind of . . . we’ll hit the exceptions a little later). A qualified business is any trade or business other than a specified trade or business or the trade and business of performing services as an employee. Ok, so that’s not really that clear. Thankfully, the IRS has a definition in IRS Section 1202(e)(3)(A) of what a specified trade or business is (the “unfavored” businesses). This section defines a specified trade or business as “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Section 199A does remove “engineering and architecture” from the list, but if an engineering or architecture business’s principal asset is the reputation or skill of 1 or more of its employees, then the business would likely still be considered a specified trade or business. A specified trade or business does not qualify for the deduction unless one very important exception is met. Ok, here’s the exception – to qualify for the 20% qualified business income deduction as the owner of a specified trade or business listed above, personal taxable income must be less than $157,500 for a single taxpayer and $315,000 for a married filing joint taxpayer. A partial deduction for specified trades or businesses is allowed in the phase-in ranges of $157,500 to $207,500 for single taxpayers and $315,000 to $415,000 for married filing joint taxpayers. Let’s look at an example of how this would work for a taxpayer that makes less than $157,500 as a single taxpayer or $315,000 as a married filing joint taxpayer.

Example: James is a chiropractor that owns his own practice. The business is taxed as an S corporation. He takes a salary of $75,000 from the S corporation and a profit distribution of $45,000. He has no capital gains or cooperative dividends for the year. After a standard deduction of $12,000, his taxable income is $108,000. He files single on his tax returns. Is James’ practice a qualified trade or business? No, because the principal asset of his business is his reputation and skill. However, because James’ taxable income is less than $157,500 as a single filer, he gets an exemption from the specified business disqualification. Sweet! Next, we need to remember that reasonable compensation paid from an S corporation is excluded from the definition of qualified business income. He doesn’t have any qualified REIT dividends or publicly traded partnership income. Therefore, his combined qualified business income amount is 20%*his $45,000 profit distribution = $9,000. After a standard deduction of $12,000, his taxable income is $108,000 (salary of $75,000+profit distribution of $45,000-standard deduction of $12,000 = $108,000 taxable income on the 1040 personal return). His cooperative dividends are $0, and he has no capital gains. To determine the deduction, let’s first take the smaller of combined qualified business income ($9,000 as calculated above) or 20% of taxable income of $108,000 less capital gains ($0) and cooperative dividends ($0) (20%*($108,000-0-0) = $21,600). The smaller of $9,000 and $21,600 is $9,000, so we then add $9,000 to the smaller of 20% of taxable income or 20% of cooperative dividends. Since there are no cooperative dividends, the total deduction is calculated as $9,000+$0 = $9,000, reducing his taxable income to $99,000. In the 24% tax bracket, James saves $2,160 in taxes. Now, the harder question – what is James going to do with the extra money?

When taxable income exceeds $157,500 for a single taxpayer and $315,000 for a married filing joint taxpayer, the definition of combined qualified income changes from “20% of the qualified business income with respect to a qualified trade or business plus 20% of qualified REIT dividends and qualified publicly traded partnership income” to the lesser of 20% of qualified business income or the greater of 50% of the W-2 wages with respect to the qualified trade or business or the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. In simple terms, this means if you have taxable income of greater than $157,500 single or $315,000 married filing joint, you will not get a qualified business income deduction if you do not pay W-2 wages or have qualified property! And, remember, if you own a specified trade or business (the unfavored businesses discussed in a previous paragraph), you get no deduction at all (or at least not the full deduction – read on). There is a gradual phase-in of the rules for taxable incomes over the $157,500/$315,000 thresholds. The phase-in ranges are $157,500 to $207,500 for single taxpayers and $315,000 to $415,000 for married filing joint taxpayers. This phase-in range benefits taxpayers that own an unfavored business or those taxpayers that own a favored business, but do not pay W-2 wages or have qualified business property. Let’s look at two examples of taxpayers with taxable income over the phase-in thresholds.

Example: Dr. Ben is a married surgeon that owns a successful practice that generates business income of $500,000 to him each year. It is taxed as a sole proprietorship. Because he practices in the medical field, his business is considered an unfavored specified trade or business. He pays W-2 wages of $120,000 per year to employees. His wife also works. Combined, their taxable income for the year is $625,000. Because Dr. Ben’s taxable income is over the phase-in threshold of $415,000 ($315,000 threshold plus the $100,000 phase-in range), he is not eligible for the qualified business income deduction.

Example: Craig owns a dog bakery that distributes treats nationwide. He does millions in sales around the country. His company is taxed as an S corporation. He has business profit of $400,000 and W-2 wages from the S corporation of $100,000. In total, the S corporation paid $400,000 in W-2 wages. The business also owns various business property with an unadjusted basis of $1.5 million. He is married, and his wife makes $150,000 per year as a marketing executive. Their taxable income is $600,000. First, are Craig and his wife above the phase-in taxable income threshold? Yes, their taxable income is above the $315,000 initial threshold and the $415,000 phase-in threshold. Is Craig’s business a specified trade or business that receives unfavorable treatment? No, because the principal asset of Craig’s business is not the reputation or skill of one or more employees, the business is not a specified business. Because Craig’s business is not a specified business, he is still eligible for a qualified business income deduction even though his taxable income is over $415,000. Let’s calculate his deduction. He will take the lesser of (1) 20% of taxable income of $600,000 = $120,000, (2) 20% of qualified business income of $400,000 = $80,000 or (3) the greater of 50% of W-2 wages of $400,000 = $200,000 or 25% of W-2 wages of $400,000 + 2.5% of unadjusted qualified property basis of $1,500,000 = $137,500. Craig will have a deduction of $80,000 (the lesser of $120,000, $80,000, or $200,000). If Craig’s business had not paid W-2 wages or did not have any qualified business property, the amount of (3) above would have equaled zero and Craig would not have received a deduction.

Here are the steps in determining the 199A deduction:

1.       Do you have income from a US trade or business that is taxed as a sole-proprietor, partnership, or S-corporation or income from a qualified REIT or publicly traded Partnership?

2.       Is total taxable income less than $157,500 as a single taxpayer or $315,000 as a married filing joint taxpayer?

3.       If you answered “Yes” to question #2, then the deduction is equal to the sum of the smaller of(1) your combined qualified business income (combined qualified income equals 20% of your income with respect to a qualified trade or business plus 20% of qualified REIT or publicly traded partnership income) or (2) 20% of the amount that your total personal taxable income exceeds net capital gains and cooperative dividends reported on the personal return and the smaller of 20% of cooperative dividends or total personal taxable income (reduced by net capital gains). Remember, if your taxable income is less than $157,500 as a single taxpayer or $315,000 as a married filing joint taxpayer, the type of business you own does not matter. You may own a non-favored business and still receive the full deduction!

4.       If you answered “No” to question #2, and your income is between $157,500 and $207,500 as a single taxpayer or between $315,000 and $415,000 as a married filing joint taxpayer, you are in the phase-in range and will receive a partial deduction as an owner of a non-favored business. As the owner of a favored business in this range, the deduction is calculated under the method in #3 above, but the owner may receive a deduction even if the owner does not have W-2 wages or qualified business property (remember, once taxable income exceeds $157,500 as a single taxpayer or $315,000 as a married filing joint taxpayer, the calculation of the deduction includes W-2 wages and qualified business property). Only those that fall within the $50,000 or $100,000 phase-in windows will face this added complexity. If this is you, send me an e-mail and I’ll be happy to walk you through the phase-in calculation.

5.       If you answered “No” to question #2, and your income is over $207,500 as a single taxpayer or $415,000 as a married filing joint taxpayer, you get no deduction if the business is an unfavored service business. Yep, zero. However, if your business is in the favored category, then the definition of combined qualified income becomes 20% of qualified business income or the greater of 50% of the W-2 wages with respect to the qualified trade or business or the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. Remember, that this number is then limited to 20% of taxable income, less capital gains. If you own a favored business and your taxable income is over $207,500 (single) or $415,000 (married filing joint), your business better have W-2 wages or property. Otherwise, your deduction is also a big fat zero. Refer to examples in the post above.

The next post will discuss planning strategies to maximize your Section 199A qualified business income deduction.
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