On December 22nd, 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA). The biggest tax overhaul since the Tax Reform Act of 1986, the TCJA created more than a hundred tax provisions, with QBI being one of the most anticipated and talked about features of the Act.
What is the QBI?
In April this year, the QBI tax deduction for partnerships, LLCs, S-Corporations, and sole proprietorships was added to the TCJA. A 20% deduction, the QBI is one of the biggest changes for pass-through entities under tax reform.
What are pass-through entities?
“A special business structure that is used to reduce the effects of double taxation. Pass-through entities don’t pay income taxes at the entity level. Instead, entity income is allocated among the owners, and income taxes are only levied at the individual owners’ level.”*
With the introduction of the QBI, taxpayers can now deduct up to 20% of domestic business income attributable to the aforementioned entity structures.
How do I qualify for the QBI deduction?
First and foremost, you must be an owner of a pass-through business/entity. The second and probably the most important requirement is for you to have Qualified Business Income. This is the net income (profit) your pass-through business generates during the year. You can calculate this by subtracting all your regular tax deductions from your total business income. If the net amount of QBI is less than zero, then the loss is carried over and will lower your QBI in the succeeding year.
How is the QBI tax deduction calculated?
The primary factor affecting the calculation of a taxpayer’s QBI deduction is whether their taxable income is:
- Below a lower taxable income threshold ($157,500 single, HOH, MFS or $315,000 joint).
- Above a higher taxable income threshold ($207,500 single, HOH, MFS or $415,000 joint).
Case A – Below the Lower Taxable Income Threshold
Calculation of the taxpayer’s QBI deduction when they fall below the lower taxable income threshold is straightforward. The taxpayer first calculates the deductible QBI amount for each qualified business, and then combines these values into a combined QBI amount. If the taxpayer has only one qualified business, the combined QBI amount is the deductible QBI amount for that business.
The taxpayer then applies the overall taxable income limitation to the combined QBI. Thus, the taxpayers QBI deduction is equal to the lesser of:
- The combined QBI amount, and
- The overall limitation (20% of the taxpayer’s taxable income in excess of any net capital gain).
Taxpayers A and B file a joint tax return. They report taxable income of $256,000, of which $5,000 is net capital gain and $200,000 is ordinary net income from taxpayer A’s interest in an S corporation. Taxpayer A and taxpayer B’s combined QBI is $40,000 (20% * $200,000). This is below the overall limitation of $50,200 (20% * [$256,000 taxable income – $5,000 net capital gain]), so taxpayers A and B’s QBI deduction for 2018 will be the $40,000.
Case B – Above the Higher Taxable Income Threshold
If the taxpayer has taxable income above the higher threshold amount, two issues arise in the calculation of the QBI deduction. First, a business of the taxpayer will not be treated as a qualified business – and the income of the business of the taxpayer will not be included in the QBI – if the business meets the definition of a specified service trade or business.
A specified service trade or business is 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 assets of such trade or business consist of the reputation or skill of 1 or more of its employees or owners. The QBI deduction will be denied in full for these specified services trades or businesses.
Second, if a business is a qualified business, the deductible QBI amount for the business is subject to a W-2 wage and capital limitation.
Taxpayers A and B file a joint tax return. They report taxable income of $550,000 of which $350,000 is ordinary income from taxpayer A’s interest in an S corporation. The S corporation is a specified service trade or business, and thus they will not receive the QBI deduction.
Taxpayers A and B file a joint return in which they report taxable income of $450,000, of which $300,000 is ordinary income from taxpayer A’s interest in an S corporation that is not a specified service trade or business. Taxpayer A’s allocable share of the business’s W-2 wages is $80,000, and her share of the business’s unadjusted basis in its qualified property is $600,000.
Taxpayers A and B’s wages and capital limitation is the greater of:
- 50% of W-2 wages, which is $40,000, and
- The sum of 25% of the W-2 wages ($20,000), plus 2.5% of the unadjusted basis of the qualified property immediately after its acquisition ($600,000 * 2.5% = $15,000) for a total of $35,000.
The amount of the wage and capital limitation is therefore $40,000.
A and B’s combined QBI is the lesser of:
- 20% of QBI ($60,000) or
- The wage and capital limitation of $40,000.
The Combined QBI is $40,000 before applying the overall limitation of $90,000 (20% of $450,000). Thus, taxpayers A and B’s QBI deduction for 2018 is $40,000.
How do I get help with my QBI tax deduction?
Calculating QBI is a complex task, as there are a range of different ways it is calculated depending on a taxpayer’s circumstances. This article only describes a brief overview of what QBI is and what it means for you, as well as the basic factors affecting its calculation.
It is important to have a professional prepare your tax return to ensure that you are receiving all the benefits and deductions to which you are entitled. At Ketel Thorstenson, LLC, we are here to help! We have the expertise and experience in tax planning and tax preparation to help you take full advantage of the QBI tax deduction. Get in touch with us today!
*”Pass-Through Entity.” InvestingAnswers.com, 6 Nov.2018, investinganswers.com/financial-dictionary/business-corporations/pass-through-entity-1119.