The Tax Cuts and Jobs Act (TCJA) was signed into law by President Trump on December 22, 2017 and it is the largest overhaul of the Internal Revenue Code since 1986. Many of the provisions of the TCJA took effect as of January 1, 2018 and they are set to expire on December 31, 2025.
One of the most widely talked about changes that took effect is the new Section 199A deduction for qualified business income (QBI) of pass-through entities. The deduction applies to all entities other than C corporations. This includes sole proprietors, S-corporations, partnerships and LLCs. Taxpayer’s can now deduct up to 20% of their QBI on their tax return, effectively taxing only 80% of the income from the business.
In this article, we will focus on how the QBI deduction applies to “specified service trade or businesses” and the its effect on various entity structures. Additionally, we will discuss tax planning strategies and opportunities available for those businesses that may not qualify for the full 20% deduction due to limitations.
Section 199A allows for a deduction for each taxable year equal to the lesser of:
20% of qualified business income, or
20% of taxpayer’s taxable income
Business owners with taxable income that falls below the following threshold amounts will be able to qualify for the full 20% deduction:
$157,500 for single, married filed separately and head of households
$315,000 for married filing joint
In the case that taxable income falls below the above thresholds, the taxpayer will receive the full 20% QBI deduction without regard to the type of business generating the income. The business does not have to have W-2 wages paid or depreciable assets to qualify for the deduction.
A lawyer, who is single, operates as a sole proprietor and earns $140,000 from her law practice. She also has interest and dividend income. Taxable income after her standard deduction amounts to $150,000. In this case, she would take the lesser of 20% of QBI (20% x $140,000 = $28,000) or 20% of taxable income (20% x $150,000 = $30,000). Her QBI deduction would be $28,000, the lesser of the two amounts.
Business owners who derive their income from a specified service trade or business and whose taxable income exceeds the applicable thresholds ($157,000 single/$315,000 MFJ), will be subject to a phase-out of the QBI deduction.
A specified service trade or business means any business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, performing arts and athletes. Any business where the principal asset of the business is the reputation or skill of one or more employees or owners is deemed a specified service trade or business.
The phase-out of the QBI deduction begins when taxable income exceeds $157,500 for single and $315,000 for all other filers. The phase-out range for single and all other filers is $50,000 and $100,000, respectively. Once taxable income reaches $207,500 for single and $415,000 for all other filers, you are completely phased-out of claiming the QBI deduction. This means that even if your taxable income is only $1 over the phase-out amounts, and you are considered a specified service trade or business, then your deduction is zero.
Service business owners whose taxable income exceeds the lower limit of the phase-out ($157,500/$315,000) can still qualify for a partial QBI deduction. The deduction is computed as the lesser of:
20% of qualified business income, or
The greater of (a) 50% of W-2 wages paid by the qualified trade or business or (b) the sum of 25% of W-2 wages paid by the qualified trade or business plus 2.5% of the unadjusted basis of qualified property immediately after its acquisition
When computing the QBI deduction for a specified service trade or business, the business owner takes into account the applicable percentage of qualified business income, allocable W-2 wages and qualified property. The applicable percentage is computed as 100% minus the percentage equal to the ratio of taxable income of the taxpayer in excess of the threshold amount, $50,000 or $100,000, depending on filing status.
An example would be a veterinarian practice owner, who is married, with taxable income of $385,000. The practice earns $220,000 after paying wages of $150,000 to employees. The veterinarian has an applicable percentage of 30% (1-(($385,000 – $315,000) / $100,000)). We would now apply the 30% applicable percentage in determining our QBI income as well as allocable W-2 wages and qualified property.
When computing the QBI of the business, you would use the applicable percentage of 30% of business income totaling $66,000 ($220,000 x 30%). To determine includible W-2 wages, apply the 30% to W-2 wages paid to arrive at $45,000 ($150,000 x 30%). Now you calculate your deduction by using the lesser of 20% of $66,000 ($13,200) or 50% of $45,000 ($22,500). The deduction is $13,200, the lesser of the two amounts.
Example of W-2 Wage Limitation:
Let’s examine a situation when the W-2 wage limitation comes into play. Remember, the wage limitation only applies when the business owner’s taxable income exceeds the lower limit of the phase-out ($157,500/$315,000).
Miles, a business advisory consultant who is married, owns 100% of his advisory business and is set up as an LLC. The net income from the business is $345,000 and the total W-2 wages paid by the company amount to $110,000. The unadjusted basis (not reduced by depreciation deductions) of qualifying property (QP) owned by the business equals $50,000. Miles has no other investment or business income or losses. Taxable income after his $24,000 standard deduction amounts to $321,000.
Since taxable income exceeds the $315,000 lower limit of the phase-out, we must first compute the applicable percentage of qualified business income, allocable wages and qualifying property to use in our calculation. The applicable percentage is 94%, computed as follows (1-(($321,000 – $315,000) / $100,000)).
We compute the QBI, allocable W-2 wages and qualifying property unadjusted basis by using the applicable percentage:
QBI - $64,860 ($345,000 x 94%) x 20%
50% of Wages - $51,700 ($110,000 x 50%) x 94%
25% of Wages + 2.5% QP- $27,025 ($110,000 x 25% + $50,000 x 2.5%) x 94%
Next, we take the lesser of the QBI deduction ($64,860) or the greater of the allocable W-2 wages ($51,700) or allocable qualifying property ($27,025). Because the W-2 wages computed ($51,700) is greater than the qualifying property, we compare that to the QBI deduction of $64,860 and use the lower amount, the $51,700 of wages.
Unfortunately, the computation doesn’t stop there. There is one more step required to further limit the deduction. Under IRC Section 199A(b)(3)(B), when 20% of the taxpayer’s qualified business income exceeds the allocable W-2 wages or qualifying property, you must reduce the QBI deduction by taking:
20% of the QBI less
the excess of the 20% deduction over W-2 wages or qualifying property, multiplied by
the amount by which the taxpayer’s taxable income exceeds the threshold amount and divided by the phase-out amount of $50,000 or $100,000, depending on filing status
So, in this scenario, we take our 20% QBI deduction of $64,860, compute the excess of the deduction over wages/property ($64,860 - $51,700 = $13,160) and multiply that by the excess of taxable income over the threshold amount divided by $100,000 (($321,000 - $315,000) / $100,000 = 6%).
We apply the 6% reduction to our excess amount of $13,160. The total reduction of $790 ($13,160 x 6%) is applied to our original QBI deduction and adjusts our deduction down to $64,070 ($64,860 - $790). Because Miles has taxable income of $321,000, which is slightly over the applicable threshold of $315,000, the reduction of the QBI deduction is minimal. Any increase to taxable income, once over the lower limit of the phase-out, will cause a direct reduction in the QBI deduction.
Example of Capital Limitation:
Now let’s assume that Sonny, a pediatrician who is married, operates his practice as a sole proprietor. He has 7 exam rooms and uses the latest technology, continuously buying the most innovative medical equipment. Sonny’s business income is the same as Miles, $345,000. However, he only pays wages of $50,000 for part-time team staff, and his unadjusted basis in the medical equipment is $750,000.
The applicable percentage of 94% remains the same, as qualified business income and taxable income did not change.
In computing the QBI, allocable W-2 wages and qualifying property unadjusted basis we use the following:
QBI - $64,860 ($345,000 x 94%) x 20%
50% of Wages - $23,500 ($50,000 x 50%) x 94%
25% of Wages + 2.5% QP- $29,375 ($50,000 x 25% + $750,000 x 2.5%) x 94%
We now use the lesser of the QBI deduction ($64,860) or the greater of the allocable W-2 wages ($23,500) or allocable qualifying property ($29,375). Because the qualifying property computed is greater than the allocable W-2 wages, we compare that to the QBI deduction of $64,860 and use the lower amount of $29,375.
As we saw in our previous example, the 20% QBI deduction is required to be reduced further when it exceeds the W-2 wage or QP allocable amounts. In Sonny’s case, the 20% deduction of $64,860 exceeds the QP allocable amount of $29,375. We must first take the QBI deduction and compute the excess of it over allocable QP ($64,860 - $29,375 = $35,485). Then we multiply that by the excess of taxable income over the threshold amount divided by $100,000 (($321,000 - $315,000) / $100,000 = 6%).
The excess of the QBI deduction over allocable qualifying property is multiplied by 6%, giving us a reduction of $2,129 ($35,485 x 6%). We now reduce our initial QBI deduction of $64,860 by the $2,129, and the result is a final QBI deduction of $62,731.
It is extremely important to work proactively with your CPA to take full advantage of the QBI deduction with income reducing strategies and business planning opportunities.
Consider Hiring Employees
Business owners should consider switching independent contractors to employees. There may be substantial tax savings available by converting independent contractors to employees. Take, for instance, a financial advisor that earns $395,000 from their business, pays W-2 wages of $25,000, pays $125,000 to independent contractors and has taxable income of $371,000. The QBI deduction available to them is only $18,374. Now, if the advisor hired full time employees in place of paying independent contractors, converting the $125,000 to W-2 wages, the QBI deduction increases nearly 84% to $33,774!
Maximize Retirement Plan Contributions
Contributing to a retirement plan has always been an effective way of reducing your tax bill. But now, more than ever, the tax savings of contributing to a retirement plan while taking full advantage of the QBI deduction can be very substantial.
Consider a business owner that earns $405,000 from their LLC, which is considered a specified service trade or business. After deducting their standard deduction and one-half of self-employment tax, the taxable income amounts to $367,616. This is well above the lower limit of the phase-out of $315,000. Therefore, the QBI deduction for the would only be $18,186.
Now assume that the owner implemented a simplified employee pension (SEP) plan during the year. The maximum contribution that can be made into a SEP for 2018 is $55,000. If the owner takes advantage of maximizing their SEP, their taxable income decreases from $367,616 to $312,616. Since taxable income is now below the lower limit of the phase-out ($315,000), the owner qualifies for the full 20% QBI deduction. In this case, the QBI deduction amounts to $62,523!
By contributing $55,000 to their retirement plan, the business owner ends up with an additional QBI deduction of $44,337. The QBI deduction plus the $55,000 deduction for the SEP contribution decreases taxable income by $99,337! The decrease in taxes of $26,596 produces tax savings at a marginal rate of 48%, and the savings can even be used to fund the retirement plan contribution.
As you can see, the Section 199A deduction is one of the more complex provisions of the new tax law. There are multiple tax planning strategies and opportunities available which will allow you to take full advantage of the new law. Proper planning is essential to ensure that you are maximizing the strategies mentioned in this article.
Please feel free to contact me with any additional questions that you may have on the section 199A deduction. I’m happy to answer any other tax related questions so please don’t hesitate to ask!