This year, tax season took a leaf from the TV playbook, with a rerun in October. Now that the Tax Cuts and Jobs Act of 2017 (TCJA) has come into effect, taxpayers and tax professionals have struggled with challenges posed by the new law, which caused a record 15 million taxpayers to file an extension in 2019. New rules needed to be learned and implemented. Many are still in the making. However, the TCJA brought benefits as well as a whole lot of bother. Importantly, it included a deduction – the section 199A deduction – that will probably apply to you if your enterprise is structured as a “pass-through entity”; as are over 90 percent of businesses in the United States. A pass-thru entity is an entity that passes its income, loss, deductions, or credits to its owners.
The pass-through provision is a novel provision that allows owners of “pass-through entities” to write-off part of their “qualified business income.” Set out in section 199A of the TCJA, the provision, known as “the deduction for qualified business income,” allows sole proprietorships, partnerships, trusts and S corporations to deduct up to 20 percent of their qualified business income. Qualified business income includes domestic income from a trade or business but excludes employee wages, capital gains, interest and dividend income.
Eligible taxpayers were able to claim it for the first time on their 2018 federal income tax return, regardless of whether they itemized or took the standard deduction. The deduction is “equal to the lesser of 20 percent of their qualified business income plus 20 percent of their qualified real estate investment trust dividends and qualified publicly traded partnership income or 20 percent of taxable income minus net capital gains.” To get the full deduction of 20 percent, an individual must not have overall taxable income greater than $157,500; the threshold for a married couple filing jointly is $315,000.
The deduction is based on ownership interest. For example, if you own half of an S-corporation, only 50 percent of the corporation’s income can be applied to your return. Here’s how that might work.
Scenario 1
Jack and Jill own Hill Enterprises, in equal shares, which had net income of $100,000 in 2018. Jack’s share of that income would be $50,000. He also has income from other sources equaling $100,000. And so his total taxable income is $150,000, which makes him eligible for the full 20% percent deduction. Thus, only $40,000 of the income from Hill Enterprises, will appear as taxable income in Jack’s return.
Here’s how it works:
There are two separate metrics involved. The first is Jack’s total taxable income (TTI), which is made up of $50,000 from the pass-through entity and “income from other sources,” which could be, perhaps, investments in securities, or even wages. The second is the qualified business income (QBI) deduction, which only applies to the pass-through income of $50,000.
Jack’s TTI, since it is less than $157,500, determines that he is eligible for the full QBI of 20%.
The QBI of 20% is then applied to his pass-through income of $50,000, reducing pass-through taxable income by $10,000.
QBI is 20% of $50,000 = $10,000. $50,000 – $10,000 = $40,000.
If there are no tax breaks on the $100,000 of non-pass-through income, Jack’s TTI would now be $140,000.
There are phase-out rules that reduce the percentage of income that escapes tax, reaching zero for individuals with a taxable income exceeding $207,500 ($415,000 for couples), while the provision itself is set to expire after 2025.
Unfortunately, not all service businesses are eligible for this deduction. Businesses excluded are those performing “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 one or more of its employees or owners.”
For non-service businesses, some additional rules, a wage test, may apply.
Scenario 2
Jill now owns a dress shop, which had net income, in 2018, of $200,000, plus she earned another $50,000 from her partnership with Jack. The dress shop business paid wages of $20,000. Jill’s total taxable income is now $250,000, which is above the pass-through threshold. However, Jill could still be eligible for the deduction. She applies the two wage tests:
First, 50% of the company’s W-2 wages: 50% x $20,000 = $10,000.
Second, 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property
(25% x $20,000) + (2.5% x 0) = $5,000.
Jill chooses the greater deduction, so her total QBI deduction is $10,000.
Scenario 3
Consider if Jill’s business had been the same as before, except that she had added $250,000 in qualified property.
First, 50% of the company’s W-2 wages: 50% x $20,000 = $10,000.
Second, 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property
(25% x $20,000) + (2.5% x $250,000) = $5,000 + $6,250 = $11,250
Once again. Jill chooses the greater deduction, so her total QBI deduction amounts to $11,250.
To find out if you qualify for the Qualified Business Income Deduction, please contact MBAFAS at (800) 576-5746.
