The Tax Cuts and Jobs Act of 2017 brings with it many changes that will affect individual and business taxes for 2018. One of the more complex changes will be Section 199A or otherwise referred to as the Qualified Business Income Deduction (QBI). Section 199A in many ways is modeled after Section 199 or the Domestic Production Activities Deduction which no longer applies after 2017.
In simplistic terms, Section 199 provided a before adjusting gross income (AGI) deduction of 9 percent on individual tax returns based on certain business incomes. In comparison, Section 199A is an after AGI deduction equal to 20 percent of qualified business income subject to various limitations. So how does this all apply? First, let’s look at the breakdown on eligibility, eligible pass-through entities and specified services trades or businesses.
The QBI deduction is only available to individuals, estates and trusts with income from eligible pass-through entities. The deduction is available for tax years beginning in 2018 through 2025. The deduction will sunset after 2025 unless Congress extends it.
Eligible pass-through entities
The QBI deduction is available to income from pass-through entities subject to limitations. The pass-through definition includes sole proprietorships (Schedule C), disregarded entities (single member LLCs), real estate investors (Schedule E), partnerships and S-corporations.
Specified services trade or business
The QBI deduction is generally limited on certain service type businesses as the taxable income of the individual increases. Those businesses include those that have:
- Services performed in the fields of health, accounting, law, actuaries and consulting (not included are engineers or architects)
- Performing artists and paid athletes
- Services in the financial services or brokerage industries
- Any trade or business where the principal asset is the reputation or skill of the owner
So how does all this work together?
The first area to look at is the source of the income from the pass-through entity. If the taxable income before QBI deduction is less than $157,500 for an individual or $315,000 for a married couple, most of the limitations do not apply. Thus, you would generally be able to take a deduction on your individual return for 20 percent of the income from an eligible pass-through entity. This will even include the income from a specified service trade or business.
However, once the taxable income before the QBI deduction passes the thresholds of $157,500 for an individual and $315,000 for a married couple, the limitations are phased in and the income from specified service trades or businesses is phased out of the deduction calculation.
The second area to look at is the income from pass-through entities other than specified service trades or businesses. As noted above to the extent the taxable income before QBI is less than $157,500 for an individual and $315,000 for a married couple, the full 20 percent deduction will generally be allowed.
However, once the taxable income is in excess of these thresholds, there are other limitations put on the deduction. The deduction will be limited to 50 percent of the W-2 wages paid to employees from these pass-through entities or 25 percent of the wages and 2.5 percent of the cost basis of qualified property used in the pass-through entity. There are various complex rules related to the ability to aggregate businesses to satisfy these requirements that should be discussed with your tax professional.
The above overview of the qualified business income deduction is very much a high level summary. As with anything involving the IRS, there are many other limitations and complicated calculations that accompany this deduction. For the exact implication to your specific tax situation, consult your CPA or tax professional.