Is your business income eligible for the new 20% tax deduction?
Do you own a business? Then you may be eligible for a tax deduction of up to 20% of your business income.
A brand new income tax deduction was created in the 2017 Tax Cut and Jobs Act (“Tax Act”) and became effective January 1, 2018. Individuals who report Qualified Business Income, or “QBI”, on their personal tax return Form 1040 may be eligible in 2018 for a deduction of up to 20% of that QBI income.
For example, a business owner with $300,000 in Qualified Business Income in 2018 could potentially be eligible for a $60,000 deduction against taxable income, translating into approximately $20,000 in income tax savings (depending on your tax bracket).
Sounds great for business owners, right? Yes, a 20% QBI deduction is a helpful benefit for those who qualify. However, many taxpayers will see their QBI deduction (and thus their tax savings) lowered or eliminated by the Byzantine rules implementing this provision. As a result, a relatively narrow subset of business owners will receive benefit from this new deduction, and some business restructuring of compensation and employment arrangements may be needed to take advantage of the new rules.
This is complicated stuff. Efforts to author a simple analysis of a taxpayer’s QBI can quickly dissolve (or devolve) into a multi-page, multi-step process of definitions, tests, and complex calculations. Calculating QBI requires a complete analysis of a taxpayer’s income sources, business types, and certain facts about what those businesses own and how they operate. It gets confusing very fast.
Instead, we are finding that each taxpayer requires a step-by-step analysis of how these new rules will impact their individual situation. Part of the challenge is that no rules (regulations) currently exist to establish IRS positions on the fine details where the plain language of the law doesn’t give us a clear answer. Some situations are simple, but most are not. What follows is only a general guide to determine if you might qualify this year for some or all of the 20% QBI deduction. To truly find out how the facts of your individual case may impact your eligibility for a QBI deduction and its amount, please give us a call or send us an email. We will be happy to discuss how these new rules may impact your specific situation.
Key Questions and Tests for the New 20% QBI Deduction:
- Do you report business income for tax purposes as a sole proprietor, a disregarded entity LLC, as an S corporation, or Partnership? Do you get a Form K-1 from a Trust or Partnership that reports income to you?
- If yes, you might have QBI and need to test further for deduction eligibility.
- If no, you do not have QBI, but maybe there is an opportunity to convert your salary income to QBI? We can discuss, but this is an area where regulatory guidance is very much needed.
- Note: business income generated by C Corporations is not eligible for the QBI deduction.
- What qualifies as Qualified Business Income (or QBI)? Qualified Business Income is defined by the Tax Act by what it is not. There are many businesses who don’t fit neatly in the existing definitions, and some will face difficult classification decisions without any regulatory guidance. The Tax Act treats a business as a Qualified Trade or Business (thus eligible for the QBI deduction) except for:
- One involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services;
- One where the business’s principal asset is the reputation or skill of one or more of its employees or owners;
- One involving the performance of services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities; and
- The trade or business of performing services as an employee (earning W-2 wages).
These general definitions leave a lot of unanswered questions, as paragraph 2b would seem to encompass nearly any business. While not a perfect test, consider whether or not you report your business income to the State of Washington in the “services” category. If so, there is a good likelihood that your business would be considered a service business for QBI purposes.
** Special Note: a specific “carve-out” in the Tax Act excludes architects and engineers from the definition of Specified Service Trade or Business (thus making them eligible for the QBI deduction). The only explanation given is that such services are integral to the construction of real property and thus should not be limited by the Specified Service Trade or Business classification.
- Your taxable income reported for 2018 will have a big impact on whether or not you are eligible to claim the 20% QBI deduction. First consider how much 2018 taxable income you expect to report and where you fall in the following taxable income levels:
Single Married Filing Jointly QBI Deduction? A. less than $157,500 less than $315,000
- 20% Deduction Likely
B. $157,501 to $207,500 $315,001 to $415,000
- Service Business Income? Then phase out likely applies; likely to qualify for a QBI deduction of 1% to 19%.
- Non-service Business Income? Then 20% deduction possible.
C. Over $207,501 Over $415,001
- Service Business Income? Then no deduction.
- Non-service Business Income? Then 20% deduction possible.
What’s clear is that the Tax Act treats service businesses differently than non-service businesses. Income from a service business typically “flows through” the business and is reported on an individual owner’s personal tax return (Form 1040). Income from any businesses is eligible for the 20% QBI deduction if the owner’s taxable income from all sources comes below the limits shown in category 3A above. If a taxpayer’s income is higher than those specified in category 3C above, those taxpayers get no QBI deduction from a business if that business is a service business. For those taxpayers whose business is a service business and their income falls in the “Messy Middle” of 3B above will face a proportionate limit to the 20% deduction. Finally, for those taxpayers with total taxable income above the limits shown in 3A, if the businesses they own are not service businesses, then those taxpayers should be eligible for the 20% QBI deduction against their business income.
- With all the limitations on eligibility, the question becomes, “Who is left to otherwise qualify for the QBI deduction?” There seem to be a few clear winners:
- Real estate professionals who are not required to treat rental real estate income as “passive”.
- “Flow-through” businesses operating as sole proprietorships, disregarded entities, S corporations or partnerships that make, distribute or sell tangible property (manufacturing and distribution, retail and wholesale, for example).
Businesses less clearly eligible for the 20% QBI deduction include restaurants or building contractors, where it is arguable that “the principal asset is the reputation or skill of one or more of its employees or owners”.
Summary and Next Steps
This post really only scratches the surface of the incredible complexities of the new 20% QBI deduction, but the new rules represent a real potential for tax savings to those eligible to claim the deduction. There will be opportunities to determine how much salary and how much business profit results in the maximum deduction, and restructuring of business operations may be appropriate in some cases.
Please let us know if we can help you determine if the 20% QBI deduction might be available to you.