Are you eligible for a 20 percent business income deduction this year?
The qualified business income (QBI) deduction is one of the most intriguing elements of the Tax Cuts and Jobs Act (TCJA) passed late in 2017. It creates a deduction for taxpayers who meet certain requirements for business structure, income, and business type.
That sounds fantastic, doesn’t it? But it’s complicated. If you’re a business owner, you may feel overwhelmed by this deduction’s complexities. I’d like to offer you cheat sheet to help you figure out how this new deduction will affect your business. I’ll provide an overview of the QBI deduction, but I will do my best to stay out of the weeds. This way you can feel empowered going into discussions with your accountant, tax preparer and financial advisor without feeling overwhelmed with complicated info.
What is the QBI deduction?
The QBI deduction allows a deduction for up to 20 percent of qualifying business income from partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships. So if you own a company that is one of those types of businesses or entity, you may be entitled to a nice tax deduction come next April. While the 20% deduction is seemingly straightforward, the calculation includes multiple steps.
The first step involves determining QBI. QBI is the net amount of income, gains, deductions, and losses generated by any qualified business belonging to the taxpayer. In short, it’s your net income from the business. For sole proprietors, LLCs you find that amount on Schedule C line 31. And for S Corps and Partnerships you can look on your K-1 (line 1).
QBI does not include salary paid to you (i.e., W-2 wages) or guaranteed payments to a partner for services rendered to a business. This nuance will become especially helpful when planning for how to maximize the deduction for S corps and partnerships. In these cases, some of the income qualifies as QBI and some does not. That’s not necessarily a nuance you need to unpack right now — even if you’re structured as an S Corp or partnership. Just keep it on your radar.
Your 20 percent deduction can be limited in a couple of ways. First, it’s limited to 20 percent of your taxable income in excess of any net capital gain. Additionally, the amount may be reduced or limited based on (1) by a wage and capital limitation and/or (2) when the business is a specified service trade or business (SSTB).
My cheat sheet
Glazing over yet? I understand. I threw a lot at you in that last paragraph. But we’re going to take a step back, and I’ll give you a few questions to simply your approach to figuring out how the deduction affects you.
Question 1: Am I qualifying business?
First, the deduction only applies to pass-through entities like sole proprietorships, partnerships, LLCs and S-Corps. If you’re one of the ones mentioned above, congrats! You’re one step closer to getting your deduction.
Step 2: Do I have qualifying income?
Your deduction is based on net profit. And for owners of an S-Corp, the wages you pay yourself don’t count; only the profit that is leftover after you pay yourself after a reasonable salary. Same with partnerships that pay partners guaranteed payments.
This leaves many S-Corp owners asking whether it makes sense to become a partnership, LLC or sole proprietorship in order to qualify more of their income for QBI. In other words, since sole proprietors, LLCs (taxed as either a sole proprietor or partnership) and S-Corps don’t have to pay a “reasonable salary”, all of their net profit can qualify the deduction. The challenge for you and your advisor is to figure out if the increase in QBI deduction will make up for the increase in self-employment tax that you have to pay out of the company profits.
Step 3: Am I a SSTB?
The last question you need to ask yourself is if you’re an SSTB or a specified service or trade business. According to the TCJA, an SSTB includes businesses that provide services in in field of:
“…any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.”
That’s a pretty broad list plus a catch all at the end. The new proposed regulations provide a lot more clarity around what roles within the 13 fields count as specified. For example, “accounting” includes “enrolled agents, return preparers, financial auditors, and similar professionals.” You can have your financial professional dig into your specific field.
This definition is important because the type of business you are affects how you must deal with the income thresholds:
- below a lower taxable income $157,500 for a single filer, or $315,000 if filing a joint return
- above a higher taxable income threshold $207,500 or $415,000 if filing a joint return, or
- between the lower and higher taxable income thresholds.
Note that this is taxable income (what used to be line 43 on your 1040). Meaning, the income that is left after your standard, itemized or any other deductions you’re entitled to.
If you’re an SSTB and have above the highest taxable income threshold, your deduction is completely eliminated. If you’re in the middle, your deduction gets reduced. If you’re below the threshold you get to deduct 20% of your QBI for each business that you have.
If you’re not a SSTB and fall in the middle or higher thresholds, you still can have your deduction limited, but you may get some of it back depending on if your QBI deduction is equal to or less than the greater of 50% of W-2 wages with respect to your trade or business or the sum of 25% of W-2 wages + 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property.
Unadjusted basis…..yaaawwwwnn. As the business owner, and likely not doing the calculation yourself, I think it’s best to just know what it is and when it applies. You can discuss the specific calculation with your tax preparer and/or financial advisor.
Some planning opportunities
Now that you know the basic rules, let’s talk some tax strategies. We’ll just cover these in general terms. If it sounds like they’d work for you, ask your accountant, tax preparer or financial advisor to go over the details with you.
For SSTBs within the income ranges, you can employ income-shifting strategies like accelerating expenses and or pushing income (or the opposite if you’re well below the threshold). You can also look into reducing your income by contributing to tax deferred retirement accounts (solo 401k, SEP IRA, SIMPLE, etc) and/or your HSA. You can also see what itemized deductions you can increase (charitable contributions?) to help reduce your income. Lastly, you could look into whether it’s actually more profitable for you to file Married Filing Separately (MFS) if your spouse’s income is pushing you over the income limits and limiting your deduction.
For those of you way above the income levels, you may look into changing the type of business from an SSTB to a non-SSTB. Say your business has both SSTB and non-SSTB income streams— just as an example, say you’re a financial advisor (SSTB) who earns income from insurance sales (non-SSTB). It may be worth separating the businesses and operate them independently. There are a lot of messy rules here, but you can ask your advisor about the gross revenue tests and “incidental-to-STTB” rules, if you’re having this discussion.
Here’s another situation where entity selection can be important. At incomes below the cut-off threshold, it may make more sense to structure your business as a sole proprietorship, a partnership or a single-member LLC, rather than an S-Corp in which you have to pay yourself a reasonable salary. You and your tax advisor should look for the best balance of maximizing your QBI deduction while also limiting payroll taxes.
Lastly, for people who may be employees at the moment and can’t take advantage of the deduction (they aren’t a pass-through entity), think about becoming an independent contractor. Your employer will save on payroll tax, and you can take advantage of the QBI deduction and business expenses that will reduced your overall tax. Before you choose this route, make sure you qualify as an independent contractor. You need to be able to demonstrate that your employer doesn’t have control over how, when and where your work gets done.
One last word of caution: it’s best to really think through your decision before you make and drastic changes to your business. The details of this new law are still being worked out. Also, remember, this may all go away after 2025. In any case, I hope this gives you a sense of the issues involved and the questions you should ask the next time you need with your tax professional.