Article written by:
Tyler Gabalski, CPA, Tax Senior and
Hannah Henderson, Tax Staff
The Qualified Business Income Deduction under Code Section 199A has brought significant changes to the way that pass-through entities are taxed under the Tax Cuts and Jobs Act. Before considering any limitations, it is a deduction for 20% of qualified business income (QBI) of pass-through entities. QBI is the net amount of qualified items of income, gain, deduction and loss with respect to a qualified trade or business in the US. Compensation, guaranteed payments and investment activities are the major items excluded from QBI. Although this deduction seems simple on the surface, there are limitations based on industry, wages and property. This article will focus on the wage and property limitations.
The 20% deduction is limited to the greater of:
- 50% of your allocable share of the W-2 wages paid by the business, or
- 25% of your allocable share of the W-2 wages paid by the business plus 2.5% of your allocable share of the unadjusted basis, immediately after acquisition, of all qualified property of the business
W-2 wages are the sum of wages subject to wage withholding, elective deferrals and deferred compensation paid by the business during the calendar year ending during the tax year.
For this purpose, qualified property is generally defined as tangible property subject to depreciation that is available for use in the qualified trade or business at the tax year end, is used at any point during the year for the production of qualified business income and the depreciable period has not ended before the tax year end. For property with a recovery period under 10 years, the cost would be taken into account for the 10-year period after it is placed in service (assuming it is used in a qualified business for each of those years).
To demonstrate these limitations, let’s look at three scenarios:
- Entity 1 is a sole proprietorship, does not pay W-2 wages and does not own any significant qualified property. The taxpayer’s deduction generally would be zero under the W-2 limitation.
- Entity 2 is an S corporation with multiple shareholders. Shareholder 1 is allocated $250,000 of income and $80,000 in W-2 wages. The S corporation does not own any significant qualified property. Before limitations, the taxpayer’s deduction would be $50,000 (20% of $250,000). However, the taxpayer’s deduction would be limited by wages to $40,000 (50% of $80,000).
- Consider the same scenario as number 2. However, the S corporation also owns a building with adjusted basis allocated to Shareholder 1 of $1,000,000. In this case, the taxpayer’s deduction would be limited to $45,000 (25% of $80,000 plus 2.5% of $1,000,000).
Taxpayers should also be mindful of the taxable income thresholds for when these limitations will be applicable. If taxable income is under $157,500 (single filers) or $315,000 (married filing jointly), the limitations mentioned above do not apply. Further, the limitations are phased in for taxable income up to $207,500 (single) or $415,000 (joint). Said differently, taxpayers with taxable income below the $157,500 and $315,000 thresholds will not be subject to any limitations, while taxpayers above the top range ($207,500 or $415,000) will be fully subject to the wage and property limitations discussed above. For those taxpayers in between the thresholds ($157,500 – $207,500 or $315,000 – $415,000), the limitations are phased in using a sliding scale approach.
The Qualified Business Income Deduction offers plenty of opportunity for owners of pass-through entities. Please consult your GBQ tax advisor to determine the impact on your business and how to maximize the benefit of this deduction.