The New Qualified Business Deduction: A Key Feature of the Tax Law Changes in 2018Added by Richard G. Smith in Articles & Publications, News, Tax Law on February 14, 2018
It is now well-accepted that the tax bill signed into law on December 22 does not accomplish simplification of the tax code. Instead, the Tax Cuts and Jobs Act brought reductions in tax rates and wholesale changes in deductions, credits and many other provisions affecting individuals and businesses alike. This article will focus on perhaps the most revolutionary of the changes – the “qualified business deduction” targeted for small businesses. This provision, contained in section 199A of the Code, introduces an entirely new concept into the tax law – a “phantom” deduction that requires no investment and is intended solely to grant a sort of parity to non-corporate taxpayers compared with those taxed as corporations.
One of the widely publicized changes in the new tax law is the reduction of the corporate tax rate from 35% to 21%. In order to grant small businesses a comparable benefit, the new law allows a deduction for up to 20% of a taxpayer’s “qualified business income” (QBI). There are complex limitations on the amount of the deduction, many of which are beyond the scope of this article. Many details regarding the implementation of the deduction are left to regulations that hopefully will be forthcoming soon in temporary form.
But it is important to develop as soon as possible a basic understanding of this deduction, because it may affect a business owner’s tax planning and even hiring or capital expenditure decisions in 2018. This article will introduce some of the new law’s key provisions that the reader should discuss with his or her tax professional.
Many important features of the new deduction were uncertain until the final version of the bill emerged from the conference committee created to reconcile the House and Senate bills. One of those provisions was the identification of who would be eligible for the deduction. In the final version, all non-corporate entities are eligible for the deduction, including individuals and also trusts and estates that conduct or own an interest in a business. This presents an interesting and as-yet-unanswered question of how tiered entities will take advantage of the deduction. Consider the following:
- If an individual owns a small business as a sole proprietor, he or she will be able to deduct up to 20% of the QBI of that business (subject to the limitations inherent in the definition of that term).
- If an individual owns an interest in a partnership, LLC or S corporation, he or she will be able to deduct 20% of his or her share of the QBI of that business.
- If an individual owns an interest in a partnership, LLC, or S corporation, and that entity owns an interest in another non-corporate operating entity, the QBI presumably will flow through from the operating entity to the intermediate entity and then to individual based on the applicable ownership percentages in each entity. That same flow-through should apply to the wage and capital limitations discussed below.
Not all small businesses are treated equally under the new law. Certain “specified service trades or businesses” are more limited than others in their ability to take the deduction. These are professions such as medicine, accounting and the law (but not engineering or architecture), and others “where the principal asset … is the reputation or skill of one or more of its employees.”
Here is a summary of the limitations on all businesses, with a specific discussion of the additional limitations on these professions. It is important to note for planning purposes that the limitations can be avoided or mitigated by the hiring or characterization of employees and by the capital expenditures of the business.
- For all taxpayers, if the taxable income on a joint return is less than $315,000 ($157,500 for single filers), there are generally no limitations on the 20% deduction.
- For all taxpayers, there is a potential limit on the deduction for incomes over $315,000, based on the amount of W-2 wages paid by the business and based on the original cost of property owned by the business at the end of the year. The formula for calculating this potential limit is complex, but if the amount of wages or property is sufficiently high, there is no limit on the 20% deduction.
- For all taxpayers, the wage/property limitations are phased-in between $315,000 and $415,000 in taxable income, so there should still be a reduced deduction at the higher income level even if the business has no wages and owns no property. But in general, for taxable incomes over $315,000 the deduction will be reduced if W-2 wages or property are not high enough to avoid the limitation.
- The limitation is the greater of (i) 50% of the W-2 wages of the business, or (ii) 25% of W-2 wages plus 2.5% of the original cost of property. For example, assume a taxpayer had $500,000 of business income (QBI) and $600,000 of taxable income on a joint return. The business, of which he is the sole owner, had $100,000 in W-2 wages and $2,000,000 in the original cost of property still used in the business. The 50% wage limit would be $50,000 (50% of $100,000). The 25%/2.5% limit would be 25% of the $100,000 in wages, $25,000, plus 2.5% of the $2,000,000 of property, $50,000, for a total of $75,000. The overall limit would be $75,000, the higher of those two calculations. Without these limits, the 20% deduction would have been $100,000. Another $100,000 in wages would have removed the limitation, but of course would have cost the taxpayer more in labor costs. Another $1,000,000 in property investment also would have removed the limitation, but the wisdom of that investment would depend on the productivity of the equipment.
- For the “specified” professional businesses, there is an additional
limitation that is phased in between $315,000 and $415,000 of joint taxable income, with no additional deduction available at higher incomes even if the W-2 wage and property limitations would have allowed such deductions.
There are some other features of this calculation that are important to note:
- QBI is similar to ordinary income, but without considering interest or dividend income or capital gains or losses. If a business has losses in a given year, those losses are carried forward to reduce QBI in future years, and thus reduce the deduction.
- QBI does not include wages paid to the taxpayer. For instance, if an S corporation pays wages to its owner, the owner could not take a 20% deduction on the wages he or she receives. This may affect the common practice of setting up S corporations in order to minimize employment taxes (i.e., paying a low salary with the remaining S Corp income available to the shareholder but not subject to employment tax). That practice is subject to IRS attack under current law if the compensation is not reasonable, but under the new law, what “reasonable compensation” is paid will not be eligible for the 20% deduction. In contrast, other pass-through entities (such as LLCs) can flow through and distribute money that will fully eligible for the 20% deduction (subject to the other limits described here) without considering whether amounts paid to owners are reasonable.
- Since wages are a factor in calculating the deduction at income levels above $315,000, there may be less incentive to characterize workers as independent contractors.
- The fact that property is a factor in calculating the deduction makes the deduction available for rental property owners. This was a late change in the bill, in the conference committee process.
In conclusion, this newly enacted section opens an entirely new chapter of analysis and planning for business owners and those professionals advising them. It is important for owners or managers of these businesses to consult with their tax advisers as soon as possible to determine whether there are planning opportunities available to take full advantage of this important deduction.
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