One of the big wins of the Tax Cuts and Jobs Act (TCJA) for owners of pass-through entities is the creation of Section 199A, or the qualified business income deduction. While Section 199A did not create a simple flat tax for pass-throughs, as C Corporations now enjoy, it still provides a great opportunity for most business owners. However, unlike the corporate tax, the qualified business income deduction is complicated in terms of what sources of income qualify, how to calculate the deduction and what limitations may apply.
For tax years 2018 through 2025, business owners of partnerships, S Corporations, sole proprietorships, estates and trusts can take a maximum deduction of 20% of their qualified business income. However, for high-income taxpayers, wage limitations apply and certain industries are not eligible for the deduction if their taxable income is above a certain threshold.
The deduction is applied at the individual taxpayer level, not the entity level. Individual taxpayers determine their own deduction based on their allocable share of the entity’s income. Calculating the deduction for taxpayers with many sources of pass-through income will be tricky, as the deduction and limitations will be calculated on an entity-by-entity basis. This simply means that business owners can take a 20% deduction from each of their businesses, but cannot co-mingle businesses to share income and work around limitations. For a simplified chart outlining how this works, click here, or keep reading for more details.
Generally, qualified business income is the "net amount of income, gain, deduction and losses with respect to any qualified trade or business of the taxpayer." Additionally, qualified business income includes "20 percent of the aggregate amount of qualified REIT dividends and qualified publicly traded partnership income of the taxpayer."
While the general definition of qualified business income includes gains and losses, Section 199A specifically excludes items of short-term and long-term capital gains and losses, dividends and interest income (unless properly allocable to the trade or business) from business income.
Unfortunately, the qualified business income deduction applies to most pass-through entities, but not all. The TCJA excludes most "specified service" trades and businesses. The internal revenue code defines specified services to include entities providing services in the fields of:
- Actuarial science,
- Performing arts,
- Financial services,
- Brokerage services, or
- Any trade or business where its principal asset is the reputation or skill of one or more of its employees.
Typically, this code section includes the words “engineering” and “architectural.” However, Section 199A specifically excludes these two words from the definition — meaning income from engineering and architectural sources are in fact able to take the deduction. However, there is an exception to the exclusion of specified services: All business owners are allowed a deduction if their taxable income for the year falls below certain thresholds.
The "Simplified" Deduction
For taxpayers with taxable income under certain thresholds, the calculation of the deduction is rather simple. All business owners under this threshold are able to take advantage of the deduction, including even those deriving income from one of the excluded service areas listed above.
If taxable income is less than $157,500 ($315,000 for married filing jointly) the calculation of the qualified business income deduction is simply 20% of the lesser of the qualified income or the taxpayer's taxable income (less net capital gains).
These thresholds are not a hard cap, as taxpayers in excess of these amounts are subject to a phase-out deduction. After an additional $50,000 ($100,000 for married filing jointly) of taxable income, the phase-out is completely maxed out and taxpayers will be subject to a wage limitation on the deduction. Income from entities on the excluded “specified service” list will no longer be able to take the deduction once their income is greater than the top phase-out amount.
The Deduction for Everyone Else
For taxpayers with qualified business income in excess of the thresholds listed above, the calculation of the deduction is more complex. The deduction is the lesser of 20% of qualified business income deductions OR the greater of:
- 50% of wages paid to employees in qualified businesses, or
- 25% of wages paid to employees, plus 2.5% of the unadjusted basis of qualified property.
Let's ignore the property piece for a moment to first explain this limitation. The deduction is limited to the lower of 20% of qualified business income or 50% of wages paid in the qualified businesses. So, for example, a taxpayer with qualified income of $500,000 from a business that paid employee wages of $500,000 would be entitled to a $100,000 deduction (20% of $500,000). Another taxpayer with $500,000 of qualified business income but employee wages of only $150,000 would receive a deduction of $75,000 (50% of $150,000).
The second piece, regarding 2.5% of the unadjusted basis of qualified property, was added to the TCJA to benefit taxpayers with few employees but a large capital investment in property. Without this provision, many taxpayers in the real estate industry would receive little to no benefit from this deduction.
The unadjusted basis of property is determined immediately after purchasing the property, meaning accumulated depreciation taken against the property is not applied in the calculation. Qualified property is generally all tangible, depreciable property that is being used by the business in the current year and either is still being depreciated for tax purposes or was acquired by the business in the last 10 years.
For example, a taxpayer with qualified business income of $500,000 with no employee wages but $1 million in qualified property would receive a deduction of $25,000 (2.5% of the qualified property is less than 20% of the $500,000 of qualified business income).
In years with losses from a qualified business, Section 199A states that the loss should be carried over and treated as a loss against income in the next tax year. While we normally think of loss carryovers offsetting income down the road as a favorable provision, it actually will decrease the amount of qualified business income in the following year, reducing the amount of the potential deduction.
Combined with the reduction of the tax rate on the top bracket from 39.6% to 37%, the qualified business income deduction can create an effective tax rate of 29.6% for taxpayers whose deduction is not restricted by the wage limitations. While it might appear on paper that the corporate tax rate slash to 21% is the better option, entities that have been able to distribute cash and property to owners without tax implications would need to consider the corporate double tax. The qualified business income deduction may actually result in a better deduction and ultimate effective tax rate for many taxpayers than the flat tax rate offered by changing to a C Corporation.
As with all aspects of the new tax law, any considerations should be carefully vetted with your tax advisors.
Please contact a member of your service team, or contact David Charles at firstname.lastname@example.org or Mike Kolk at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.