Posted by Fred Lake

How Qualified Business Income Deduction Can Reduce Your Tax Bill by 20%

How Qualified Business Income Deduction Can Reduce Your Tax Bill by 20%

One of the latest tax rules entrepreneurs should know about is the Qualifying Business Income (QBI) Deduction. The deduction, also known as Section 199A, is a 20% deduction available to qualifying pass-through companies, such as sole proprietorships, S corporations, and partnerships (non-corporations). Like many tax rules, this deduction is more complicated than it first appears, so let's start with the basics and then dig a little deeper for those who want to take a closer look at the potential savings.

Here are some things you need to know about the pass-through deductions and what it applies to.

  • It is not based on the representation of business income that most of us are used to. Instead, it uses "Qualifying Business Income" (QBI) to calculate the deductions to which you would be entitled.

  • The amount of the deduction is limited according to income.

  • Certain types of activities, called Specified Services Trade or Business (SSTB) in the new tax legislation, can no longer benefit from the deduction once certain income limits have been reached.

Let's take a look at each of these rules that apply to an independent business:

IRS Point of View

The QBI, from the IRS's point of view, is equal to the income you earn from your pass-through business, less any net short-term gains or losses. (A pass-through company is a company whose income is reported and taxed in the owner's tax return.) Additionally, the QBI does not include pass-through income from W-2 wages received from an S Corp or guaranteed payments from a partnership.

The amount you can deduct is also subject to limits of 50% of the wages your business pays employees or 25% of the wages plus 2.5% of the qualifying business ownership basis, whichever is higher than the other. These calculations should be compared to 20% of the QBI so that you can deduct the lower amount. This limit also gradually includes the same category of taxable income of $321,400 and $421,400 for co-taxpayers.

Non-Corporate Taxpayers

The income-based limit applies to unincorporated taxpayers who exceed the income limit of $321,400. If you own a personal service business (called a special service business), the QBI amount is proportionately eliminated when your total taxable income reaches $421,400. With this level of income and more, you are no longer entitled to the 20% deduction. Businesses that are not specific service businesses can still benefit from the deduction.

Specific Service Trade or Business (SSTB)

A specific service trade or business (SSTB) defined by the IRS is any business or trade that provides services in the areas of health, law, accounting, actuarial, performing arts, consulting, sports, financial services, brokerage services, and other sectors. . Also included are all stock exchanges or activities involving investments and the management of investments, dealing or trading in securities. Architects and engineers are not defined as a particular commercial or service enterprise and are therefore excluded from this limitation.

Capital Intensive Companies

The new law took into account capital-intensive companies, with an increase in the salary cap to include a calculation of ownership. According to the IRS, a qualifying business is a depreciable property that your business uses to obtain the QBI. These deductions can be made based on your individual performance, and the calculations will apply to each business you run separately.

So how should business owners calculate the 20% QBI pass-through deduction?

First, you need to determine if your business is SSTB, as mentioned above. The first two illustrations below assume that your company is not an SSTB. In all cases, you must calculate the qualifying business income (QBI) of your business. It is simply the net income of your business, excluding any wages, salaries, or payments made to you as the owner. If you own individual property, this will be your income on Schedule C.

  1. If your business is below the income phase-out threshold described above, calculate 20 percent of the income transferred from your business and make the deduction, provided it is less than 20 percent of your taxable income, with the exception of net capital gains.

  2. If your business is not SSTB and exceeds the income limit, the calculation will be more complex to allow for the phasing out of the deduction.

You will need to determine what percentage of income you can have over the limit of $160,700 for a single taxpayer and $321,400 for married taxpayers filing jointly.

Also, note that if your taxable income is $210,700 (a single taxpayer) or $421,400 (a married filing jointly taxpayer), the QBI deduction is limited to 50% of your W-2 salary for that business or the amount of 25% of W-2 wages from the business plus 2.5 percent of any qualifying property. So then, using the income limit above and the phase-out amount of $210,700/$421,400 to calculate the limit on a prorated basis.

Here is an instance of how to do this assuming:

  • You have $425,000 in taxable income (married filing joint return), including $300,000 in QBI earned through a non-SSTB business.

  • You paid two employees a total of $100,000 in W-2 salaries.

  • You own the building where your office is located, which has an unadjusted purchase basis of $250,000.

Given this hypothetical situation, your maximum transfer deduction is 20% of your QBI of $300,000, which equals $60,000. Since your taxable income is greater than $421,400, any necessary pass-through deduction is limited to the greater of 

(i) 50% of the W-2 salary paid to your employees or 

(ii) 25% of the W-2 wages plus 2.5% of the $250,000 basis of your office building. 

(i) is $100,000 (50% x $100,000) = $50,000; (ii) is (2.5% x $250,000) + (25% x $100,000) = $31,250. Since (i) is greater than (ii), you would consider the amount to be less than $31,250 as a pass-through deduction.

A non-specified service trade or business

An unspecified business or service enterprise would calculate the deduction as follows:

For our example, suppose:

  • You are a consultant (one of the categories of contractors subject to elimination limits) and a single taxpayer with a taxable income of $233,015.

  • Your taxable income is $72,315 or 45% above the taxpayer's income limit.

  • You paid your employees $60,000 in wages.

To find out, multiply the deduction before the phase-out; in this case, it is limited to 50% of the W-2 salary you paid because there is no qualifying asset. This equates to $30,000 (50% x $60,000 W-2 wages = $30,000). With the phase-out percentage of 45%, you will get 55% of the total deduction, which equals 55% x $30,000 = $16,500.

This new pass-through deduction can provide significant tax savings for your business, but it's also a little tricky. Could it save you 20%? Perhaps – It depends on how the specific rules for this deduction apply to your situation. Here it may be helpful to hire a tax professional to do some math and plan your taxes. Whether you choose to work with a tax professional or on your own, it is worth considering whether this tax deduction will affect your tax account this year.



Fred Lake
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