Can You Utilize the New QBI Deduction?
By David Kaplan, CPA
The Tax Cuts and Jobs Act (TCJA) that passed on December 22, 2017 created many changes for taxpayers that will come into play when they file their 2018 tax returns. One of the most talked about provisions is the implementation of the Qualified Business Income (QBI) Deduction, which was the TCJA’s way of giving a tax savings to business owners who don’t operate C Corporations. The QBI Deduction gives eligible taxpayers with domestic pass-through businesses or sole proprietorships the potential to claim a 20% deduction on their QBI. As with most tax laws, it’s not as simple as just a 20% deduction. There are many factors to consider in determining if the taxpayer can actually claim the 20% QBI Deduction:
Qualified Trade or Business – To be eligible to take a QBI Deduction, the trade or business must be actively conducted to produce income or profit, and must be engaged in with regularity and continuity. If you have a business that is considered a hobby, that business would not be eligible for the QBI Deduction. There are certain industries the law specifically designated that may get phased-out or excluded from taking the QBI Deduction. They are considered a “Specified Service Trade or Business” and are described in more detail below.
Many taxpayers question whether rental real estate activities would qualify for the deduction. The intent of the QBI Deduction had rental real estate in mind, and if the real estate activity meets the criteria of a trade or business as previously mentioned, it should be eligible for the QBI Deduction. A Rental Real Estate Safe Harbor was recently announced, that in a summarized form states: if 250 hours of rental services are performed, whether by the owners, or an employee/independent contractor paid by the owner, and you have the records to support this, the rental real estate activity will qualify for the QBI Deduction. If you have a rental real estate property that only receives monthly deposits (such as in a triple net lease) and the tenant handles all the maintenance and bill payments, then this activity would not qualify, as you are not engaged in the business with regularity and continuity.
Qualified Business Income (QBI) – QBI is the net income earned in the ordinary course of your trade or business. It does not include passive income such as interest income, dividends, and capital gains from sale of investments. It’s also important to note that a shareholder who receives a salary from the business, or a partner/member who receives a guaranteed payment cannot add his or her respective salary or guaranteed payment to the QBI amount on his or her personal tax return.
Specified Service Trade or Business – As previously mentioned, there are a handful of industries that may result in the individual owners being phased-out or not eligible for the QBI Deduction depending on their taxable income. These industries include: accounting, actuarial science, athletics, brokerage services, consulting, financial services, health, law, performing arts, services consisting of investing and investment management, trading or dealing in securities, partnership interests, or commodities, or a business whose principal asset is the reputation or skill of one or more of its employees or owners (such as endorsements, appearance fees, or receiving income for use of one’s likeness or image).
There may still be some exceptions within these industries that you should verify if you fall into one of those categories.
If you have a related business entity that is not a “Specified Service Trade or Business,” but receives a majority of its gross receipts from the related “Specified Service Trade or Business,” then the related entity may be subject to the same rules.
Taxable Income – If you determine that you may be eligible for a QBI deduction from a qualified business, then the next step is knowing your taxable income. For purposes of QBI, taxable income is the amount reported after you’ve reduced your adjusted gross income by either the standard deduction or itemized deduction.
If your taxable income is under $315,000 for married filing joint or $157,500 for all other filers, then the only limitation the QBI Deduction has is that QBI cannot be greater than 20% of taxable income. For purposes of the limitation only, taxable income does not include any long-term capital gains and qualified dividends (which get taxed at a lower rate already).
If your taxable income is in the range of $315,000-$415,000 for married filing joint or $157,500-$207,500 for all other filers, then you have to be concerned with whether you’re a “Specified Service Trade or Business” for which the deduction starts to phase out, as well as the phase in of limitations determining if you have enough wages and/or basis in unadjusted property to claim the full amount of QBI.
If you are a “Specified Service Trade or Business”, you will want to see if any tax planning can be done to get you under the taxable income amount of $315,000 for married filing joint or $157,500 for all other filers so that you can still get the full benefit of the QBI Deduction.
Once your taxable income exceeds $415,000 for married filing joint or $207,500 for all other filers, you are subject to limitations determining if you have enough wages and/or basis in unadjusted property to claim the full amount of QBI, and if you are a “Specified Service Trade or Business”, you’re not eligible for the QBI Deduction.
Limitations for Wages Paid and Depreciable Qualified Property – As mentioned in the taxable income section, once your taxable income exceeds $315,000 for married filing joint or $157,500 for all other filers, your QBI deduction may get limited based on whether the business has paid wages and/or has qualified property. The limitation is based on the greater of 50% of wages paid or the combination of 25% of wages paid plus 2.5% of unadjusted basis in qualified depreciable property. If your QBI Deduction is greater than this limitation, you may only deduct up to the limitation amount.
Wages include both those paid directly by the business that you issue a W-2 for, and also those paid through a professional employer organization or third-party payor that pays the wages to workers on behalf of your business.
The qualified property is depreciable tangible property that has been placed in, and remains in service within the last 10 years, or otherwise is still being depreciated, and is used to produce QBI. The amount used for purposes of calculating the limitation is the unadjusted basis immediately after acquisition, which usually will be your initial cost.
This topic has had CPAs spending countless hours in continuing education and training. We are also closely monitoring for any further guidance by the IRS on the many aspects open to interpretation. So, while we hope this article has given you some helpful information in understanding what the QBI Deduction is, it’s important to know that each taxpayer will be impacted differently, and ongoing discussions should be had with your preparer on how various transactions could impact your QBI.