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In 2017, the Tax Cuts and Jobs Act established IRS Code Section 199A, which provides a 20 percent deduction for eligible pass-through entities with qualifying business income (“QBI”). This new provision has the ability to reduce the maximum individual tax rate of 37% on pass-through income to approximately 29.6%, making it more equitable to the C corporation tax rate of 21%. However, the new law contains limitations that may reduce or eliminate the deduction for some business owners. These limitations and various calculations were a popular topic of conversation for tax professionals in 2019 due to their complexity and nuances. With the upcoming tax season approaching, this article will revisit the limitation rules and calculation procedures to correctly apply the QBI deduction for taxpayers in 2020.
Definitions of Section 199A
Qualifying Business Income (“QBI”): Ordinary income less ordinary deductions earned by a pass-through entity or sole proprietorship. Wages earned as an employee, dividends, interest, and capital gains and losses are not treated as QBI.
Qualified Trade or Business (“QTB”) vs Specified Service Trade or Business (“SSTB”): An SSTB is any trade or business in which the principal asset is the reputation or skill of at least one employee, with architects and engineers being the exception. Architects and engineers are an exclusion. The fields of healthcare, accounting, law, consulting, athletics, financial services, performing arts, actuarial science and investment management are all typically considered to be an SSTB. QTB is any business other than an SSTB. QTBs are not subject to the additional limitations that are placed on SSTBs.
Qualified Property: Tangible property that is used during the year for the production related to the QBI. The property must be depreciable and owned at year-end.
Limitations to the QBI Deduction
In its simplest form, the QBI deduction is calculated by taking 20 percent of the QBI. However, there are limitations that phase out or completely eliminate this deduction that must be considered every time the deduction is calculated:
Taxable Income Limitation: If the taxable income – not just QBI but all other income before the QBI deduction – is below $321,400 for a married filing jointly (“MFJ”) return or $160,700 for all others, there are no limitations on the QBI deduction. Once those taxable income levels are reached, there is a phase-out range until taxable income levels reach $421,400 for MFJ or $210,700 for all others. When taxable income is within the phase-out range or exceeds it, the W-2 Wage and Property Limitation must be assessed.
W-2 Wage and Property Limitation: When applicable, the QBI deduction is limited to either 50 percent of W-2 wages for the business – or – 25 percent of W-2 wages for the business plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of all qualified property, whichever amount is greater. In other words, the deduction is based on a calculation tied to the amount of wages paid to employees (including the taxpayer), as well as the cost of the property the business owns. The higher those figures are relative to the business’s income, the better the chances to partially or fully qualify for the QBI deduction.
SSTB Limitations: SSTBs have stricter guidelines than QTBs which result in quicker phase-outs of allowable deductions when the Taxable Income Limitations are reached or exceeded.
Scenarios for QTB at Various Taxable Income Levels:
Taxable Income below $321,400 for MFJ or $160,700 for all others: The taxpayer is not restricted by the Taxable Income Limitation or the W-2 Wage and Property Limitation; therefore, the taxpayer qualifies for the entire QBI deduction.
Taxable Income above $421,400 for MFJ or $210,700 for all others: Due to the Taxable Income Limitation being exceeded, the full W-2 Wage and Property Limitation applies. The taxpayer’s deduction will be limited to the greater of the two amounts previously stated in the “W-2 Wage and Property Limitation” paragraph.
Taxable Income within the phase-out of $321,400-$421,400 for MFJ or $160,700-$210,700 for all others: When taxable income is within the phase-out range, the full QBI deduction may or may not be taken depending on this following circumstances: First, if the tentative QBI deduction is below the W-2 Wage and Property Limitation then full deduction can be taken and no further calculations are required. However, if the tentative QBI deduction exceeds the W-2 Wage and Property Limitation, the excess amount of the tentative QBI deduction must be reduced on a pro rata basis. To determine the pro rata reduction, calculate the percentage of taxable income that is above the phase-out range base. For example, if an MFJ’s taxable income is $331,400, taxable income would be 10 percent above the phase-out range base. Once this percentage is calculated, multiply it by the excess QBI deduction above the W-2 Wage and Property Limitation to find the reduction amount. Finally, subtract the reduction amount from the tentative QBI deduction to arrive at the allowed QBI deduction.
Scenarios for SSTB at Various Taxable Income Levels:
Taxable Income below $321,400 for MFJ or $160,700 for all others: The taxpayer is not restricted by the Taxable Income Limitation, the W-2 Wage and Property Limitation, or any SSTB limitations; therefore, the taxpayer qualifies for the entire 20 percent of QBI deduction. The SSTBs are essentially treated like QTBs in this scenario.
Taxable Income above $421,400 for MFJ or $210,700 for all others: Due to the Taxable Income Limitation and the SSTB limitations, the entire QBI deduction is disallowed.
Taxable Income within phase-out of $321,400-$421,400 for MFJ or $160,700-$210,700 for all others: When taxable income is within the phase-out range, the full QBI deduction may or may not be taken depending on this following circumstances: First, determine the SSTB Limitation by calculating the percentage of taxable income that is above the phase-out range base. For example, if an MFJ’s taxable income is $331,400, taxable income would be 10 percent into the phase-out range. Subtract this percentage from 100 percent to arrive at the SSTB Limitation, which would be 90 percent in the example. The remaining calculations are the same as the QTB calculation stated previously with one major difference, the tentative QBI deduction and W-2 Wage and Property Limitation must first be multiplied by the SSTB Limitation percentage before proceeding with the calculation. In effect, this reduces the overall allowable QBI deduction for SSTBs significantly faster than it does for QTB.
To learn more about the QBI deduction, please consult your GBQ tax advisor to determine the impact on your business and how to maximize the benefit of this deduction.