Federal income tax rates for C corporations have been reduced to a flat 21%, starting in 2018 under the Tax Cuts and Jobs Act (TCJA). But what about pass-through businesses?
Congress devised a special tax break for pass-through businesses to help achieve parity between the reduced corporate income tax rate and the tax rates for business income that pass through to owners of sole proprietorships, partnerships, S corporations and limited liability companies (LLCs), which are treated as sole proprietorships or partnerships for tax purposes.
But not every pass-through entity is eligible for the break — and it isn’t always 20%. Here’s an overview of how much this deduction can amount to and which types of income count as qualified business income (QBI) under the new tax law.
How Much Is the Deduction?
Under prior law, net taxable income from pass-through business entities was simply passed through to owners and taxed at the owners’ level at the standard rates.
For tax years beginning after December 31, 2017, the TCJA establishes a new deduction based on a non-corporate owner’s QBI. This break is available to individuals, estates and trusts. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels and another restriction based on taxable income.
A non-corporate owner’s deduction generally equals:
- 20% of QBI from a partnership (including an LLC treated as a partnership for tax purposes), S corporation, or sole proprietorship (including a single-member LLC that is treated as a sole proprietorship for tax purposes), plus,
- 20% of aggregate qualified dividends from REITs, cooperatives and qualified publicly traded partnerships (special rules apply to specified agricultural and horticultural cooperatives).
The QBI deduction isn’t subtracted in calculating the non-corporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction. However, you don’t need to itemize to claim the QBI deduction.
Which Types of Income Count as QBI?
QBI is defined as the non-corporate owner’s share of items of taxable income, gain, deductions and loss from a qualified business. It includes interest income that’s properly allocable to a business, along with the aforementioned qualified dividends from REITs, cooperatives and publicly traded partnerships.
Investment-related items — such as capital gains and losses, dividends and interest income — don’t count as QBI. In addition, employee compensation and guaranteed payments from a partnership to a partner (including an LLC member who’s treated as a partner for tax purposes) don’t count as QBI.
Qualified items of income, gain, deductions and loss must be effectively connected with the conduct of a business within the United States or Puerto Rico.
Finally, QBI is calculated without considering any adjustments under the alternative minimum tax (AMT) rules.
Important: The QBI deduction and the applicable limitations are determined at the owner level. Each owner takes into account his or her share of qualified items of income, gain, deductions and loss from the pass-through entity and his or her share of W-2 wages paid by the entity.
Are There Any Restrictions?
In addition to being limited to 20% of your taxable income — calculated before the QBI deduction and before any net long-term capital gains (LTCGs) and qualified dividends that are eligible for preferential federal income tax rates — the QBI deduction is subject to two other limitations.
1.W-2 wage limitation. The QBI deduction generally can’t exceed the greater of the non-corporate owner’s share of:
- 50% of amount of W-2 wages paid to employees by the qualified business during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of QBI.
Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 taxable income range or over a $100,000 taxable income range for married joint-filers.
2. Service business limitation. Income from specified service businesses generally doesn’t count as QBI if the owner’s taxable income (not counting any potential QBI deduction) exceeds the applicable level. This limitation potentially affects income from such professions as:
- Health care,
- Actuarial science,
- Performance art,
- Financial and brokerage service,
- Investing and investment management,
- Trading or dealing in securities, partnership interests or commodities, and
- Any business where the principal asset of the business is the reputation or skill of one or more of its employees.
Engineering and architectural service business are specifically excluded from this limitation.
The service business limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the service business limitation is phased in over a $50,000 taxable income range or over a $100,000 taxable income range for married joint-filers.
Calculating the QBI Deduction: It’s All Relative
To illustrate how the qualified business income (QBI) deduction works, let’s suppose you and your spouse file a joint tax return for 2018, reporting taxable income of $300,000 (before considering any QBI deduction or any long-term capital gains (LTCGs) or qualified dividends). Your spouse has $150,000 of net income from a qualified pass-through business that isn’t a specified service business.
Your preliminary QBI deduction is $30,000 (20% x $150,000). Since your joint taxable income is below the $315,000 threshold for the phase-in of the W-2 wage limitation, you’re unaffected by the limitation. So, your QBI deduction is the full $30,000.
Alternatively, let’s suppose your brother and his wife file a joint tax return for 2018, reporting taxable income of $355,000 (before considering any QBI deduction or any LTCGs or qualified dividends). Your brother is an architect with $150,000 of net income from a qualified pass-through business.
His preliminary QBI deduction is $30,000 (20% x $150,000). Your brother’s share of W-2 wages paid by the business is $40,000. So, his W-2 wage limitation is $20,000 (50% x $40,000). The $10,000 difference between the $30,000 preliminary QBI deduction and the $20,000 W-2 wage limitation is 40% phased in [($355,000 – $315,000) ÷ $100,000]. Therefore, your brother’s QBI deduction is limited to $26,000 [$30,000 – (40% x $10,000)].
Now let’s turn to your sister, who works as an investment broker. She files as a single taxpayer for 2018, reporting taxable income of $187,500 (before considering any QBI deduction or any LTCGs or qualified dividends). Her income includes $125,000 of net income from selling investments, a specified service business.
Her tentative QBI deduction is $25,000 (20% x $125,000). For simplicity, let’s assume she’s unaffected by the W-2 wage limitation. However, under the service business limitation, she can take into account only 40% of her service business income, or $50,000 (40% x $125,000). That’s because the service business limitation is 60% phased in at your sister’s taxable income level [($187,500 – $157,500) ÷ $50,000 = 60%]. Therefore, her QBI deduction is limited to $10,000 (20% x $50,000).
Important: If your sister’s taxable income (before considering any QBI deduction or any LTCGs or qualified dividends) was below the $157,500 threshold for the phase-in of the service business limitation, she would qualify for the full QBI deduction of $25,000.
Calculating the QBI deduction can be complicated. This article explains the basics, but additional factors may come into play, such as how business losses affect the QBI deduction calculation and how the deduction is calculated if you have income from several pass-through entities.
While the QBI deduction is beneficial, in some circumstances, it could make more sense to operate your business as a C corporation, which would be taxed at the flat 21% corporate income tax rate. Your tax advisor can help you sort through the complexities and find the best tax-smart strategies for your specific personal and business circumstances.