I was doing some planning for my estimated tax payments over the past few months and therefore started sifting through the nuances of the Tax Cuts and Jobs Act (TCJA) of 2017. Yes I am that big of a nerd, so hopefully my clients don't have to be. The TCJA refers to various changes in tax laws that are effective beginning in the filing year 2018. Due to these changes, many individuals and businesses will more than likely be changing the way they file starting with 2018 returns. Paycheck withholdings should also be reviewed after a few months into 2019 because of the new tax brackets and potential changes in the way you file (i.e. standard deduction vs. itemizing). One of the biggest changes included in the tax code is the new "199A Deduction" aka "Qualified Business Income Deduction" (QBID) that a lot of business owners/professionals may be able to take advantage of. If you are a small-business owner or a professional service provider such as a: doctor, attorney, accountant, actuary, athlete, performer, etc., then keep reading!
What is the 199A Deduction or QBID?
One of the more unique additions to the tax code is the IRC 199A deduction for pass-through entities (S-Corp Shareholders, Sole Proprietors, Partners in a Partnership, Members of an LLC, Real Estate Investors, Certain Trusts and Estates). Essentially what the deduction gives the business owner is up to a 20% deduction of the Qualified Business Income (QBI) generated by their pass-through entity (or sum of QBI from all entities). QBI is the net domestic business taxable income, gain, deduction, and loss with respect to any qualified trade or business. The purpose of the deduction is to try and put pass-through entities on the same playing field as C-Corporations. The TCJA lowered the tax rates for C-Corps down to a flat 21% tax rate. With pass-through entities, the net income generated by the business "passes through" to the business owner and is taxed at their personal rate which could be much higher than 21%. The new 199A deduction aims to alleviate this inconsistency. The deduction is complicated, and is not available in all instances since there are limitations and other qualifications to satisfy (who would have thought?).
UPDATE: The 2018 tax forms are now available. You can use our tax resource center to access any applicable forms and publications you may need. The Qualified Business Income Deduction is on line 9 of the 2018 1040. You can access a link to the official IRS publication regarding the deduction at the end of this article (See "The Bottom Line").
What Is A Qualified Trade Or Business?
A qualified trade or business is any trade or business, with two exceptions:
Specified service trade or business (SSTB), which includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. This exception only applies if a taxpayer’s taxable income exceeds $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers.1 This means that if you fall in any of those previously mentioned service categories and have taxable income that is less than those amounts (based on your filing status), you will be able to take a section 199A deduction without limitation. In other words, when personal taxable income is below the previously mentioned amounts, your SSTB income is "treated" as "qualified business income". If an individual with an SSTB has taxable income over those limits, limitations apply and the deduction may be lost entirely.
Performing services as an employee.
Limitations and Calculations
The deduction is a "below-the-line" deduction or from Adjusted Gross Income (for our fellow nerds out there). Whether a tax payer itemizes deductions or uses the new higher standard deduction ($12,000 Single, $24,000 Married Filing Jointly (MFJ)), will not affect whether or not you can utilize the Code section 199A deduction. The calculation is actually very complex because it depends on so many factors (it always "depends" when it comes to taxes).
For taxpayers with taxable income that exceeds $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers, the deduction is subject to limitations such as the type of trade or business (SSTB as previously mentioned), the taxpayer’s taxable income, the amount of W-2 wages paid by the qualified trade or business, and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business.1
These limitations are phased-in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500. The threshold amounts and phase-in range are for tax-year 2018 and will be adjusted for inflation in subsequent years.1
If your business is an SSTB and you file single with taxable income over $207,500 in 2018, then you will NOT get any Code section 199A deduction.
If your business is not an SSTB and you file single with taxable income over $207,500 in 2018, then you may get some deduction amount as long as you have some QBI. In this case the deduction for QBI may be limited by the amount of W-2 wages paid by the qualified trade or business and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business.1
NOTE: The proposed regulations define "Qualified Business Income" (QBI) as the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business within the United States. The (reasonable) compensation that an S-Corporation pays to a shareholder-employee is included in the W-2 wage limitation for determining the Code section 199A deduction, and those wages are not included in QBI to the shareholder.2
If taxable income is below the threshold ($157,500 / $315,000) the deduction is the lesser of:
The net "combined qualified business income" (QBI) amount + 20% of your qualified REIT dividends and qualified PTP income or,
- 20% of your taxable income (from the 1040) minus your net capital gains (you would add back capital losses if applicable)
Let's compare a single shareholder S-Corporation vs. a taxpayer taxed as a Sole Proprietor.
Let’s assume that QBI before wages to the shareholder is below the threshold of $315,000 (MFJ). The Code section 199A deduction will be the lesser of 20% of QBI or 20% of tentative taxable income (less capital gains).2
In this case, the Sole Proprietor comes out ahead of the single shareholder S-Corp.2
If taxable income is above the threshold ($207,500 / $415,000) the deduction is the lesser of:
20% of the business owner’s “qualified business income” (QBI) or,
The greater of:
50% of the W-2 wages paid or,
25% of the W-2 wages paid + 2.5% of the unadjusted tax basis in property of the business (UBIA).
Again we will use a single shareholder S-Corporation vs. a taxpayer taxed as a Sole Proprietor.
Neither one of them has any other employees or qualified property, and neither is an SSTB. Each taxpayer’s tentative taxable income is over the Code setion 199A threshold of $415,000 (MFJ). The deduction will will follow the rules above.2
In this example the single shareholder S-Corp comes out ahead of the Sole Proprietor.2
The Bottom Line
The new 199A deduction can get quite complicated and make your head spin but it is most certainly something to consider. Small-business owners and other professionals should consult their tax advisors regarding this deduction to see what changes they may need to make to help maximize their potential deduction. Click here to access the IRS Pub. 535 regarding the deduction (see chapter 12). The Code section 199A deduction is one example of why tax planning vs. simply getting your taxes done each year is key.
Cameron Valadez is a CFP® Practitioner located in Riverside, CA.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
Waddell & Reed and its representatives do not provide tax advice. This is meant for educational purposes only. It should not be considered legal, tax or investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with your professional advisors regarding your personal situation prior to making any financial related decisions. 02/19
2(Anne Meagher, JD, CLU®, ChFC®; Proposed regulations: guidance for pass-through business owners)