On December 22, 2017 President Trump signed H.R. 1 into law, bringing sweeping changes to tax law. This new law was known as the Tax Cuts and Jobs Act (TCJA) — that is, until a parliamentarian noticed that the bill needed to qualify as a reconciliation bill and thus could not have a fancy name. Nevertheless, we tax practitioners became attached to the name and acronym so we continue the convention here.
Below we offer insight on a single aspect of the TCJA known as the Qualified Business Income Deduction, aka the Small Business Deduction, the 20% Flow-Through Deduction and our favorite name — the Universal Employment for Tax Advisors Provision.
For those who appreciate simplicity, here is the minimum of what you need to know:
Many business owners (other than those in personal service industries) will receive a deduction equal to the lesser of: (i) 20 percent of their earnings from business operations, i.e., excluding investment gains and interest income, or (ii) 50 percent of W-2 wages paid.
The owners of most real estate businesses in which the income is taxed to the business owners (through partnerships, LLCs, etc.) will offset their taxable rental income by the lesser of (i) 20 percent of their earnings from operations, i.e., excluding investment gains and interest income, or (ii) the sum of (x) 25 percent of W-2 wages paid, plus (y) 2.5 percent times the cost of depreciable assets.
Taxpayers below certain income threshold amounts ($157,500 single; $315,000 joint) are entitled to deduct 20 percent of their business income without regard to the wage or asset-based limits described above and without regard to the nature of their business.
To determine whether and how the basic rules described above actually apply to a particular taxpayer,
a little more substance, and many more acronyms, are needed.
Business owners, including businesses owned as a sole proprietorship, partnership, limited liability company taxed as a partnership, S-corporation, estate or trust may be entitled to an income tax deduction equal to 20 percent of the owner’s qualified business income (“QBI” because no tax discussion is complete until you have mastered some acronyms). The question of personal eligibility for the QBI deduction turns on four questions:
New section 199A appears to incorporate a broad definition of trade or business that hopefully will allow most businesses to qualify as a QTB. However, until further guidance is provided by the IRS, there is an unanswerable question of when passive investment activities and passive real estate ownership constitutes a QTB. One of the authors is cynical and believes that passive triple net leased real estate, managed by a separate (and usually related) entity, will qualify as a QTB because that is how President Trump operates his real estate empire. The other author is more of a strict constructionist and expects that the definition of a QTB will be consistent with the general definition of a trade or business applied for federal income tax purposes.
QBI is basically income from operations, but its computation isn’t always straightforward. QBI starts with income, gain, and loss derived from U.S. qualified business and trade activity and includes qualifying REIT dividends and income from publicly traded partnerships. Wages and salary do not qualify as QBI. Investment interest, dividends, and capital gains also do not qualify as QBI. The QBI deduction as calculated cannot exceed the excess of the taxpayer’s taxable income less net capital gains. The calculation of the QBI recognizes that a taxpayer may have more than one trade or business and requires the separate determination of QBI and the limits separately for each trade or business. A parallel rule allows a “QBI” deduction under section 199A for income from an agricultural or horticultural cooperatives.
Section 199A limits the benefit of the QBI deduction for most businesses in any service industry (lawyers, accountants, doctors, and other professions in which the principal asset of the business is the reputation or skill of the businesses employees, but not architects and engineers). Taxpayers with QBI income from any of the specified service industries may still claim the QBI deduction but the deduction is phased out if the taxpayer’s taxable income exceeds $157,500 for single taxpayers (or $315,000 if the taxpayer is married filing joint returns). The phaseout of the QBI deduction is complete when the taxpayer’s taxable income exceeds $207,500 ($415,000 on joint returns).
Section 199A further differentiates taxpayers into three bands based on their taxable income, and the QBI deduction is calculated differently for each band.
Section 199A Deduction: Income Levels and Limitations
Most Service Businesses
Taxable income less than $315,000 (married, joint return)
Deduction = 20% of QBI (see statute for further refinements to the QBI deduction)
Taxable income greater than $415,000 (married, joint return)
Deduction limited to the greater of Wage Limit or Wage/Asset Basis Limit
Taxable income greater than $315,000 but less than $415,000 (married, joint return)
Deduction phased out ratably for income between $315,000 and $415,000
Wage Limit and Wage/Asset Basis Limit are phased in for income between $315,000 and $415,000
(For other taxpayers, the income phase-out ranges are $157,500 and $207,500)
All told, the QBI deduction represents a potentially significant tax reduction for owners of businesses, excluding only the shareholders of C Corporations from its scope. Of course, the new income tax rate of 21 percent for C Corporations is a significant tax reduction in itself. These competing tax reductions make choice of entity and other business structural decisions critical to taxpayers.
Complicated? Sure. But now that you have mastered the rules, the flow chart on the following page will walk you through the determination of whether a taxpayer can benefit from this legislative largess. Thereafter, we explain the formula for computing the amount of the deduction in a way that should make sense in the overwhelming majority of situations.
For taxpayers with income over the phase out amount, the deduction is applied to the sum of
(1) + (2):
(1) The lesser of
(A) Combined Qualified Business Income (CQBI), or
(B) 20 percent of the excess of taxable income over the sum of net capital gain plus qualified co-op dividends
(2) The lesser of
(A) 20 percent of qualified coop dividends, or
(B) Taxable income determined without regard to net capital gain
CQBI, per 199A(b)(1), equals the sum of
(A) The deductible amount (DA) for each QTB
(B) 20 percent of qualified REIT dividends and qualified publicly traded partnership income
The DA per 199A(b)(2) for each QTB is the lesser of:
(A) 20 percent of the taxpayer’s QBI with respect to such QTB,
(B) The greater of:
(i) 50 percent of wages paid by the QTB,
(ii) 25 percent of such W-2 wages, and 2.5 percent times the unadjusted basis in tangible (i.e., not IP) depreciable (i.e., not inventory) property (for assets with depreciable life of 10 years or less) or for the regular (not ADS) depreciation life for real property — even if the asset is immediately deductible under the new IRC 179 rules or capital cost recovery acceleration rules).
QBI thus excludes net Capital G/L, all other dividends, interest and other investment related income and losses.
QBI excludes amounts paid as reasonable compensation to shareholders as W-2 salary or guaranteed payments paid to members (and, only to the extent provided in regulations reasonable compensation that would otherwise be payable to a partner in exchange for services).
This rule means that the amount of a particular taxpayers Section 199A deduction can be materially different depending on the form of business through which the QTB is conducted. For example, assume an architect (not an SSTB but filing a single income tax return) earns $500,000 of QBI by modifying and selling homes she designed long ago. Her QTB has no W-2 employees but her QBI is determined after paying $100,000 to a half dozen independent contractors. She is over the phase-out limit so the math should be easy, right? If the taxpayer is a sole proprietor then she can’t pay herself a wage so her IRC 199A deduction is zero because of the 50 percent Wage Limit.
If this taxpayer is well advised, she might hire those same independent contractors as part time employees (reducing the hourly IC amounts to reflect the added employment taxes imposed on employers), in which case she would be entitled to a $50,000 section 199A deduction ($100,000 of wages*50 percent is less than $500,000 QBI*20 percent). If she doesn’t want to deal with employees, her tax advisor could recommend that she operate the identical QBI through an S corporation and pay herself a reasonable salary of $140,000, leaving $360,000 of QBI. She is well above the phase-out threshold for taxpayer’s filing a single return. In that case, she is entitled to a $70,000 tax deduction (50 percent of her $140,000 of wages is slightly less than 20 percent*of her $360,000 of QBI). Alternatively, she could operate via an S corporation with the same $140,000 of reasonable compensation, and convert those ICs into employees, and thereby increase her section 199A deduction to $72,000 (20 percent*360,000 is less than 50 percent of $240,000 of wages).
And if this same taxpayer operates through a partnership and her share of partnership income was the exact same amount but she receives $140K of guaranteed payment because partners are not allowed to be employees? The guaranteed payment is excluded from QBI which reduces her QBI to $360,000 but in the absence of any wages the deduction is again zero.
Of course, if our architect is employed by a company in which she is not an owner, then she gets no deduction. What if our architect had instead gone to law school and earned the exact same amounts under the exact same structures? She would get no deduction because law is one of the SSTBs — those specified trades or business described in small print in the middle of that complicated flow chart above — that are not eligible for the deduction unless their income is below the phase out amount.
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We know we threw a lot at you. If you have any questions regarding the new tax law, please do not hesitate to contact a member of our Tax Team.
 For clarity, the definition of CQBI has nothing to do with income at all — it is the sum of certain deductions for each QTB.
 Tony Nitti’s recent article in Forbes does a wonderful job demonstrating the absurd consequences of this rule. Nitti, T., The New “Qualified Business Income Deduction” varies Based on Your Business Type – or Does It?, Forbes, Jan. 4, 2018.
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