As part of its tax reform effort, Congress made significant amendments to the Internal Revenue Code and reduced the federal income tax burden of many taxpayers. One of the most important tax reduction tools included in this new legislation, referred to as the Tax Cuts and Jobs Act (TCJA), is the new deduction under section 199A (the QBI deduction).
The new deduction could reduce tax liabilities for businesses operated through partnerships, S corporations, and sole proprietorships—allowing them a deduction equal to 20% of their qualified business income (QBI). Where applicable, the QBI deduction significantly decreases a taxpayer’s effective tax rate.
For example, if the TCJA’s top individual income tax rate of 37% otherwise applies, the QBI deduction lowers the individual’s effective tax rate on his or her QBI to 29.6%. However, computing the deduction under the new rules can be complex.
The QBI deduction only applies to non-C corporation taxpayers, meaning it may benefit businesses operated through partnerships, S corporations, and sole proprietorships. While these pass-through entities don’t enjoy the same low 21% tax rate granted to C corporations under the TCJA, the QBI deduction provides a meaningful tax benefit to pass-through businesses.
Although the QBI deduction may provide a significant tax reduction for many pass-through businesses, it doesn’t represent the same type of across-the-board rate cut given to C corporations. Instead, in creating the QBI deduction, Congress enacted a new set of complex rules that introduce additional uncertainty into the tax law by favoring certain types of businesses over others. Accordingly, taxpayers should carefully consider how section 199A applies to their particular facts and determine what steps they can take to benefit from the QBI deduction.
Applying Section 199A
The general concept behind section 199A is to grant non-C corporation taxpayers a deduction equal to 20% of their QBI from a qualified trade or business. However, a series of complex definitions and limitations make the application of this general concept difficult.
To navigate section 199A, it’s helpful to break the statute into a series of steps used to calculate the QBI deduction.
Step 1: Determine whether the taxpayer’s trade or business is a qualified trade or business.
Step 2: Determine the QBI earned through each of the taxpayer’s qualified trades or businesses.
Step 3: Apply the applicable W-2 wage and qualified property limitations to each of the taxpayer’s qualified trades or businesses.
Step 4: Determine the taxpayer’s combined QBI amount.
Step 5: Apply the taxable income limitation to the taxpayer’s combined QBI amount to arrive at the QBI deduction.
Details to Note
Before further explaining each of these steps, taxpayers may want to consider a few additional preliminary details. With respect to a business operated by a partnership or an S corporation, the QBI deduction under section 199A is applied at the partner or shareholder level, rather than at the partnership or S corporation-level.
Also, the QBI deduction only applies for purposes of chapter 1 of the Internal Revenue Code. This means that, while it may provide a significant benefit with respect to the general income tax, it doesn’t provide a similar benefit for other taxes, such as taxes on self-employment income under section 1401 or on investment income under section 1411.
Step One: Qualifying Trade or Business Determination
The starting point in applying the QBI deduction is determining whether the business is a qualified trade or business. A qualified trade or business is any trade or business other than a specified service trade or business (SSTB), or a trade or business of preforming services as an employee.
An SSTB is a trade or business involving health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its owners or employees.
SSTBs also include businesses that perform services consisting of investment and investment management, trading, or dealing in securities, partnership interests, or commodities. At this time, there’s significant uncertainty regarding the scope of the SSTB definition, especially concerning the circumstances under which the reputation or skill of owners or employees will be considered the principal asset of a trade or businesses.
Taxpayers with Multiple Businesses
Adding to this uncertainty is the premise that section 199A largely applies on a business-by-business basis, meaning most of the relevant computations and limitations are applied separately to each trade or business of the taxpayer. However, it’s unclear how to determine the scope of each trade or business engaged in by the taxpayer.
For instance, it’s unclear if a taxpayer who’s primarily engaged in manufacturing but performs some related financial services work should be treated as engaged in a single manufacturing business, or as engaged in a manufacturing and financial services business. If the activities are viewed as one manufacturing business, the entire business would be a qualified trade or business. If the activities are viewed as separate businesses, only the manufacturing business would be considered a qualified trade or business because the financial services business would be an SSTB.
Exception for Small Businesses
Although an SSTB generally can’t be a qualified trade or business, an exception applies for certain small businesses. If a taxpayer’s pre-QBI deduction taxable income doesn’t exceed a threshold amount of $315,000 for joint-return filers or $157,500 for other filers, an SSTB is treated as a qualified trade or business.
If the taxpayer’s pre-QBI deduction taxable income doesn’t exceed the threshold amount by more than $100,000 for joint-return filers or $50,000 for other filers, the SSTB may continue to be a qualified trade or business, but the QBI deduction will become subject to certain phaseout rules.
Under the phaseout rules, a taxpayer may only take into account the applicable percentage of QBI, W-2 wages, and qualified property from the trade or business. The applicable percentage equals 100% minus the percentage obtained by dividing (a) the pre-QBI deduction taxable income of the taxpayer in excess of the applicable threshold amount by (b) $100,000 for joint-return filers or $50,000 for other filers.
For instance, assume that a married couple filing a joint return operated an SSTB, and that the couple’s pre-QBI deduction taxable income equaled $400,000. In determining the couple’s QBI deduction, the couple’s pre-QBI deduction taxable income in excess of the $315,000 threshold amount would be $85,000 ($400,00 - $315,000). This means the couple’s applicable percentage would be 15% (100% - $85,000 / $100,000). Accordingly, in computing the QBI deduction, the couple would only be allowed to take into account 15% of the QBI, W-2 wages, and qualified property with respect to the trade or business.
Step Two: QBI Calculation
Once a taxpayer has established the existence of a qualified trade or business, the taxpayer must determine the QBI earned by the trade of business. QBI is the net amount of qualified items of income, gains, deductions, and losses with respect to a qualified trade or business. The qualified items of a qualified trade or business are items that are considered effectively connected with the conduct of a trade or business in the United States and that are otherwise taken into account within the taxable year. Qualified items, however, don’t include any of the following:
- Capital gains or losses
- Dividends or dividend-equivalent amounts
- Interest income that isn’t properly allocable to a trade or business
- Certain commodity and foreign currency-related items
- Certain items from notional principal contracts
- Income from annuities not received in connection with a trade or business
- Any items of deduction or loss that’s properly allocable to the above listed items
QBI also doesn’t include reasonable compensation paid to a taxpayer by a qualified trade or business, guaranteed payments paid to partners for services rendered to the trade or business, or to the extent provided in the regulations, certain other payments to partners for services rendered to the trade or business.
When the qualified trade or business is operated through a partnership or S corporation, the QBI deduction is generally determined at the partner or shareholder level. In determining the QBI of a partner or an S corporation shareholder, each partner or shareholder takes into account the partner’s or shareholder’s allocable share of each qualified item of income, gain, deduction, and loss.
If the net amount of QBI from all of a taxpayer’s qualified trades or businesses is less than zero, a loss carryover rule provides that the net loss is treated as a loss from a qualified trade or business in the next taxable year. When that loss is applied in the next taxable year, it will generally decrease both the taxpayer’s QBI and QBI deduction for the next taxable year.
Taxpayers with Multiple Businesses
While the determination of QBI appears relatively straightforward if a taxpayer operates only a single trade or business, the statute doesn’t provide meaningful guidance to taxpayers operating multiple trades or businesses. In particular, section 199A doesn’t explain how a taxpayer who has multiple qualified trades or businesses should determine QBI or the QBI deduction if some of the businesses produce income while others produce losses. Similarly, it doesn’t explain how a section 199A loss carryover should be applied when the taxpayer has multiple trades or businesses producing income in the year the loss is applied.
Presumably, some netting of these income and loss amounts should occur, but the statute contains no express instruction regarding how this should be done. Accordingly, taxpayers face additional uncertainty in determining their QBI and QBI deduction in these cases.
Step Three: Apply W-2 Wage and Qualified Property Limitations
After calculating the QBI for each qualified trade or business, the taxpayer must determine how much QBI from each business will be included in the combined QBI amount. With respect to each qualified trade or business, the taxpayer is allowed to include in the combined QBI amount the lesser of (a) 20% of the QBI with respect to the qualified trade or business or (b) the greater of the following:
- 50% of the W-2 wages with respect to the qualified trade or business, or
- 25% of the 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 with respect to the qualified trade or business (the preliminary QBI deduction amount).
For purposes of this limitation, qualified property is any tangible depreciable property that meets the following criteria:
- It’s held by, and available for use in, the qualified trade or business at the end of the taxable year
- It’s used to produce QBI at some point during the taxable year
- Its depreciable period doesn’t end before the close of the taxable year
The depreciable period begins when property is placed in service and ends on the later of (a) the date that’s 10 years after the property is placed in service or (b) at the end of the qualified property’s recovery period for depreciation purposes.
In determining the preliminary QBI deduction amount, if the qualified trade or business is operated through a partnership, a partner takes into account W-2 wages of the partnership based on the partner’s allocable share of the partnership’s wage expenses. A partner also takes into account qualified property of the partnership based on the partner’s allocable share of the partnership’s depreciation expense. Similar rules apply with respect to a shareholder of an S corporation.
Taxpayers with Multiple Businesses
It’s important to emphasize that the limitations computed based on W-2 wages and qualified property are determined separately for each of the taxpayer’s qualified trades or businesses. As a result, a taxpayer can’t use excess W-2 wages or qualified property from one qualified trade or business to increase the limitation with respect to a second qualified trade or business. However, it’s unclear how to determine the scope of each trade or business engaged in by the taxpayer, and this will create uncertainty regarding the application of the W-2 wage and qualified property limitations.
Exception for Small Businesses
The W-2 wage and qualified property limitations don’t apply if a taxpayer’s pre-QBI deduction taxable income doesn’t exceed the threshold amount of $315,000 for joint-return filers or $157,500 for other filers. In addition, the limitation is phased-in over the first $100,000 of pre-QBI deduction taxable income over the threshold amount for joint filers, or over the first $50,000 of pre-QBI deduction taxable income over the threshold amount for other filers.
If a taxpayer is subject to the phase-in, the deduction is partially limited and the taxpayer must first determine the amount by which 20% of the QBI from the qualified trade or business exceeds the applicable W-2 wage or qualified property limitation that would apply if the phase-in rule didn’t exist. This difference is known as the excess amount.
Next, the taxpayer multiplies the excess amount by a percentage determined by dividing (a) the taxpayer’s pre-QBI deduction taxable income in excess of the applicable threshold, by (b) $100,000 in the case of joint return filers or $50,000 in the case of other filers (the reduction amount). The taxpayer then decreases the 20% of QBI that would otherwise enter into the combined QBI amount by the reduction amount to arrive at the amount of QBI that will enter into the taxpayer’s combined QBI amount.
Example of Taxable Income Between Thresholds
Assume a married couple filing a joint return operates a qualified trade or business, that 20% of the QBI with respect to the qualified trade or business equals $50,000, and that the couple’s pre-QBI deduction taxable income equals $400,000. Assume further that there were $60,000 of W-2 wages with respect to the qualified trade or business and $0 of qualified property with respect to that business.
Although 20% of the couple’s applicable QBI is $50,000, the couple would generally be subject to a W-2 wage limitation of $30,000 ($60,000 x 50%). However, because the couple’s pre-QBI deduction taxable income isn’t greater than the applicable threshold amount of $315,000 plus $100,000, the W-2 wage limitation is phased in.
Under the phase-in rule, the couple’s excess amount equals $20,000 ($50,000 - $60,000 x 50%), and its reduction amount equals $17,000 ($20,000 x ($400,000 - $315,000) / $100,000). This means the couple would have a preliminary QBI deduction amount of $33,000 ($50,000 - $17,000) to include in its combined QBI amount with respect to the qualified trade or business.
Step Four: Determine the Combined Qualified Business Income Amount
Once the taxpayer has applied the W-2 wage and qualified property limitations to each of the applicable qualified trades or businesses, the taxpayer can determine the combined QBI amount. The combined QBI amount equals the aggregate of the preliminary QBI deduction amount for each qualified trade or business, plus 20% of the taxpayer’s aggregate qualified REIT dividends and qualified publicly traded partnership income. A detailed discussion of qualified REIT dividends and qualified publicly traded partnership income is outside of the scope of this summary.
Step Five: Apply Taxable Income Limitation
After working through each of the above steps, the taxpayer is finally prepared to compute the QBI deduction. The taxpayer’s QBI deduction equals the lesser of (a) the taxpayer’s combined QBI amount or (b) 20% of the taxpayer’s pre-QBI deduction taxable income minus any net capital gains.
For instance, if the combined QBI amount for a married couple is $70,000, and the couple’s pre-QBI deduction taxable income less net capital gains is $300,000, the deduction is limited to 20% of $300,000, or $60,000.
The new QBI deduction may provide a significant benefit to taxpayers who own and operate businesses through pass-through entities. However, unlike the reduction in corporate tax rates provided by the TCJA, the QBI deduction is a complex and uncertain calculation that favors certain businesses over others. This means taxpayers holding pass-through entities should carefully consider how the new deduction will apply to their particular facts and circumstances.
In particular, taxpayers operating businesses with any of the following characteristics may find it difficult to benefit fully from the QBI deduction and should consider what steps they can take to better align themselves with the section 199A requirements:
- Service providers may not be able to qualify an SSTB as a qualified trade or business.
- Businesses with international operations won’t be able to treat income that isn’t effectively connected with a trade or business conducted in the United States as QBI.
- Businesses employing significant financial or intangible assets relative to labor and tangible assets may face limitations related to a lack of W-2 wages and qualified property.
We’re Here to Help
The Treasury Department is expected to draft extensive regulations in the near future addressing a number of the uncertainties related to the QBI deduction. We’ll keep you up-to-date on these important developments.
For more information on how the QBI deduction could affect you or your business, contact your Moss Adams professional or visit our dedicated tax reform webpage.