In December 2017, Congress passed a new tax bill known as the Tax Cut and Jobs Act (TCJA). This is one of the most complex changes to the tax code since 1986. The following summary of this new qualified business income deduction is meant to be a brief and simple (as possible) summary of a very complex item in the TCJA. This article does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors (or make an appointment with us) concerning the application of tax laws to their particular situations.
For tax years beginning after December 31, 2017 and before January 1, 2026, Qualified Small Business which includes sole proprietorship, partnership, or S corporation generally qualify for a deduction of 20% of qualified business income (QBI) known as the qualified business income deduction (QBID). This new tax benefit to individuals is intended to create some parity with the reduced corporate tax rates.
The deduction is subject to complicated restrictions and limitations, but the rules that apply to individuals with taxable income below certain thresholds are simpler and more permissive than the ones that apply above those thresholds.
The deduction is generally available to taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers. The deduction is generally equal to the lesser of 20% of the taxpayer’s QBI plus 20% of the taxpayer’s qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, or 20% of taxable income minus net capital gains. Deductions for taxpayers above the $157,500/$315,000 thresholds may be limited; the application of those limits is described in the proposed regulations.
Of course, no new tax bill is that simple. There is a limitation for:
The term “combined qualified business income amount” for the taxable year means the sum of the deductible amounts determined for each qualified trade or business carried on by the taxpayer plus 20% of the taxpayer’s qualified REIT dividends and qualified publicly traded partnership income.
The deductible amount for each qualified trade or business is the lesser of:
a) 20% of the taxpayer’s qualified business income with respect to the trade or business, or
b) The greater of 50% of the Form W-2 wages with respect to the trade or business or the sum of 25% of the Form W-2 wages with respect to the trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. This paragraph does not apply if the taxpayer’s taxable income is below the threshold amount.
A threshold amount applies for both a limitation on specified service businesses and a wage limit. These limitations are phased in when the taxpayer’s taxable income exceeds $157,500 ($315,000 MFJ). The phase-in range is $50,000 ($100,000 MFJ). Thus, the full specified service business and wage limitations apply once taxable income exceeds $207,500 ($415,000 MFJ). The threshold amount is indexed each year for inflation.
Taxpayers between the taxable income thresholds and who are not in a specified service trade or business are subject to only a partial wage and capital limitation. The deductible QBI amount for a business of a taxpayer with taxable income between the thresholds is 20% of QBI, less an amount equal to a "reduction ratio" multiplied by an "excess amount."
Domestic business. Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States.
Qualified trade or business. A qualified trade or business means any trade or business other than a specified service trade or business, and other than the trade or business of being an employee. However, the specified service trade or business exclusion from the definition of a qualified trade or business is phased-in for taxpayers that exceed the threshold amount. It does not apply to taxpayers below the threshold amount.
Specified service business. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, 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 one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. The new law specifically excludes engineering and architecture services from the definition of a specified service trade or business.
Limitation based on Form W-2 wages and capital. For taxpayers with taxable income above the threshold phase-in range, the deduction is limited to the greater of:
a) 50% of the Form W-2 wages paid with respect to the qualified trade or business, or
b) The sum of 25% of the Form 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.
The above limitation is phased-in if the taxpayer’s taxable income is above the threshold amount but within the phase-in range. If the taxpayer’s taxable income is below the threshold amount, the limitation based on Form W-2 wages and capital does not apply.
There are many other provisions in TCJA which will potentially benefit small businesses. We are only highlighting this item because it is new and will impact a large number of small business owners.