If you have income from a so-called pass-through business entity (sole proprietorship, partnership, LLC, or S corporation), the income is passed through to you and taxed on your personal return at the standard rates for individual taxpayers.
The Tax Cuts and Jobs Act (TCJA) adds a new wrinkle. For tax years beginning in 2018-2015, you can potentially claim a deduction based on your share of qualified business income (QBI) from a pass-through entity. This new write-off is available to individuals, estates, and trusts. It generally equals 20% of QBI, subject to restrictions that can apply at higher income levels and another restriction based on your taxable income. Here’s what you need to know.
QBI deduction basics
Your QBI deduction generally equals:
• 20% of QBI from a sole proprietorship (including a solely owned LLC treated as a sole proprietorship for tax purposes), a partnership (including an LLC treated as a partnership for tax purposes), or an S corporation plus
• 20% of qualified dividends from REITs, cooperatives, and publicly traded partnerships.
The deduction is effectively treated the same as an itemized deduction, but you need not itemize to benefit.
What counts as QBI?
Good question. QBI means your share of items of taxable income, gain, deduction, and loss from a qualified business conducted within the U.S. or Puerto Rico. Investment-related items like capital gains and losses, dividends, and interest income generally don’t count as QBI. However interest income collected by a qualified business does count and so do the aforementioned dividends from REITs, cooperatives, and publicly traded partnerships. Wages earned as an employee do not count as QBI. Ditto for guaranteed payments paid to you by a partnership (including guaranteed payments from an LLC treated as a partnership for tax purposes).
W-2 wage/capital investment limitation
Your QBI deduction is generally limited the greater of your share of: (1) 50% of amount of W-2 wages paid to employees by the qualified pass-through entity business during the tax year or (2) the sum of 25% of W-2 wages plus 2.5% of the cost of qualified property. The second limitation allows capital-intensive businesses to benefit from the QBI deduction. Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax yearend and used by that business during the tax year for the production of QBI.
Important Exception: The W-2 wage limitation/capital investment limitation does not apply until your taxable income (calculated before the QBI deduction) exceeds $157,500 or $315,000 if you are a married-joint-filer. Above those income levels, the limitation is phased in over a $50,000 taxable income range or a $100,000 taxable income range if you are a married joint-filer.
Example 1: W-2 Wage Limitation Applies
For 2018, you and your spouse file a joint return reporting taxable income of $355,000 (before the QBI deduction). You have $150,000 of net income from a qualified business. Your tentative QBI deduction is $30,000 (20% x $150,000). Your share of W-2 wages paid by the business is $40,000. The W-2 wage limitation is $20,000 (50% x $40,000). The $10,000 difference between the $30,000 tentative QBI deduction and the $20,000 W-2 wage limitation is 40% phased in [($355,000 – $315,000)/$100,000 = .40). So your QBI deduction is limited to $26,000 [$30,000 – (.40 x $10,000)].
Variation: Your taxable income is $300,000 (before the QBI deduction). Since your taxable income is below the $315,000 threshold for the phase-in of the W-2 wage limitation, you are unaffected by the limitation. So your QBI deduction is the full $30,000.
Service business disallowance rule
Income from specified service businesses generally does not count as QBI if your taxable income exceeds the applicable threshold. This disallowance rule potentially affects income from healthcare professions; law; accounting; actuarial sciences; performance arts; consulting; athletics; financial services; brokerage services; investing and investment management; trading or dealing in securities, partnership interests, or commodities; and any business where the principal asset is the reputation or skill of one or more of its employees. However, engineering and architectural service business are exempt from the disallowance rule (they evidently had really good lobbyists).
The disallowance rule is phased in once your taxable income (before the QBI deduction) exceeds the threshold amount of $157,500 or $315,000 if you are a married joint-filer. Above those income levels, the disallowance rule is phased in over a $50,000 taxable income range or a $100,000 taxable income range if you are a married joint-filer.
Example 2: Service Business Disallowance Rule Applies
For 2018, you file as a single taxpayer and report taxable income of $187,500 (before the QBI deduction). You have $125,000 of net income from a specified service business. Your tentative QBI deduction is $25,000 (20% x $125,000). Under the service business disallowance rule, you take into account only 40% of the service business income, or $50,000, because the service business disallowance is 60% phased in: [($187,500 – $157,500)/$50,000 = .60]; [$125,000 x (1.00 – .60) = $50,000]. So your QBI deduction is limited to $10,000 (20% x $50,000).
Variation: Your taxable income is $150,000 (before the QBI deduction). Since your taxable income is below the $157,500 threshold for the phase-in of the service business disallowance rule, you are unaffected by the rule. So your QBI deduction is the full $25,000.
Taxable income limitation
Finally, your QBI deduction is limited to 20% of your taxable income–calculated before the QBI deduction and not counting any net capital gain (meaning net LTCGs in excess of net short-term capital losses plus qualified dividends).
Example 3: Taxable Income Limitation Applies.
For 2018, you file a joint return reporting taxable income of $175,000 (before any QBI deduction and not counting any net capital gain). Assume that your tentative QBI deduction after considering the W-2 wage limitation and/or the service business disallowance rule is $40,000. Thanks to the taxable income limitation, your QBI deduction is limited to $35,000 (20% x $175,000).
Variation: Your taxable income is $225,000. Since your $40,000 tentative QBI deduction is less than 20% of your taxable income, you are unaffected by the taxable income limitation. So your QBI deduction is the full $40,000.
The bottom line
I’ve explained most of what you need to know about the new QBI deduction, but additional factors not covered here can come into play. I’m talking about how the W-2 wage/capital investment limitation interacts with the service business disallowance rule, how to calculate the QBI deduction if you own interests in several pass-through business entities, and how business losses affect the QBI deduction calculation. Your tax adviser can help you sort through the complexities and plan ahead to maximize your rightful QBI deduction.