Qualified Business Income deduction offers significant tax break for small business owners – FAQs
The Tax Cuts and Jobs Act (the act) added Section 199A to the Internal Revenue Code (the code). Code section 199A, entitled “Qualified Business Income,” provides a deduction from adjusted gross income (AGI) for purposes of calculating a non-corporate taxpayer’s taxable income. The deduction from AGI is what tax professionals refer to as a “below the line” deduction, as opposed to an adjustment to gross income to arrive at AGI (an “above the line” deduction).
The base deduction under code section 199A is equal to 20 percent of “net qualified business income” (subject to phase-out rules for higher-income taxpayers, discussed below), and excludes business income earned by certain professionals in excess of the income limitations. Thus, if a married taxpayer’s net qualified business income is $200,000, 20 percent of that amount, or $40,000, would be deducted from the taxpayer’s AGI. At the 24 percent marginal income tax rate, the taxpayer would pay $9,600 less in federal income taxes, which is a nice result for qualifying pass-through business owners.
In addition, the deduction is limited to 20 percent of the taxpayer’s taxable income, if such taxable income is less than “net qualified business income” (which could be the case if the taxpayer itemizes deductions to reduce taxable income below qualified business income). For example, if a taxpayer has $100,000 of qualified business income but reports $75,000 of taxable income on his or her return due to other deductions (such as itemized deductions), the section 199A deduction would be $15,750 (20 percent of $75,000), because the section 199A deduction is limited to 20 percent of the lesser of $100,000 (qualified business income) or $75,000 (taxable income).
The favorable tax consequences resulting from code section 199A have resulted in inquiries from business owners who intend to take advantage of the new deduction. The remainder of this article answers some of the frequently asked questions we have received since the act was enacted on December 22, 2017.
Question: Do I need to form a limited liability company or a corporation to take advantage of the qualified business income pass-through deduction?
Answer: No. The following organizational structures will generate pass-through business income that will qualify for the section 199A qualified business income deduction:
- Sole proprietorship (Schedule C to Form 1040)
- Single-owner LLC disregarded for Federal income tax purposes (Schedule C to Form 1040)
- Real estate investment/ownership (Schedule E to Form 1040)
- Multiple-owner LLCs taxed as partnerships (Schedule K-1 (1065))
- LLCs and corporations taxed as S corporations (Schedule K-1 (1120-S))
- Trusts and estates
- REIT’s and qualified agricultural and horticultural cooperatives
Question: Should I revoke my corporation’s S-election and become a C corporation so I can take advantage of the reduced tax rate on C corporation earnings (21 percent)?
Answer: Small business owners who currently pay their personal expenses from corporation earnings and profits should generally maintain their S corporation status. The tax rate on qualifying C corporation dividends (distributed to taxpayers who own shares of C corporation stock) continues to apply in addition to the C corporation tax rate. Combining the C corporation tax rate with the qualifying dividend tax rate generally results in higher overall taxes for business owners who operate with C corporations, when compared to taxes from S corporation earnings passed through to the owners and subject to the 20 percent qualified business income deduction under code section 199A. This is generally true even when one considers the application of the ordinary income tax rates on a reasonable portion of W-2 wages paid to the owner(s) from S corporation earnings and associated payroll taxes on such wages. Thus, owners of C corporations who intend to distribute all or a substantial portion of corporate earnings to the shareholders should, instead, be considering effectuating S-elections to take advantage of the code section 199A deduction for qualified business income.
Question: Does my professional services business qualify for the Section 199A deduction?
Answer: Section 199A excludes from the definition of “qualifying trade or business” certain “specified service trade or business” activities. “Specified service trade or business” is defined as:
- Service professionals such as doctors, lawyers, accountants, actuaries and consultants
- Performing artists
- Professional athletes
- Professionals who work in the financial services or brokerage industries
- “Any trade or business where the principal asset is the reputation or skill of one or more employees or owners”
Notably, the exclusion of income from specified service trade or business activities is only relevant when taxable income of such professionals exceeds the income limits on deductibility that are also imposed by the act (discussed below). Thus, for example, a single dentist with $150,000 in qualifying pass-through income may be entitled to the entire Section 199A deduction because the $150,000 is below the $157,500 income limit for single persons.
Question: Is the Section 199A deduction phased out at higher income levels?
Answer: Yes. The deduction phases out based on taxable income from all sources (not only business income). For purposes of the phase-out rules, the income limits correspond to the highest income level subject to the 24 percent marginal tax bracket. Thus, phase-out of the deduction for single taxpayers starts at $157,500, and the deduction completely phases out at $207,500. The phase-out of the deduction for married taxpayers filing jointly starts at $315,000, and the deduction is completely phased out at $415,000. Both of the top-end deduction limits will be adjusted for inflation after the 2018 tax year.
Question: Does the Section 199A deduction apply to W-2 compensation and guaranteed payments from partnerships?
Answer: No. Section 199A specifically excludes from the definition of “qualified business income” guaranteed payments appearing on Schedule K-1 and reasonable compensation appearing on Form W-2 (typically paid by an S corporation to justify return of some or all of the remaining S corporation earnings to the shareholders as S corporation distributions for self-employment taxable income planning purposes). For many business owners who are used to taking guaranteed payments (such as management fees in real estate investment companies), creative drafting should be considered to treat such fees as distributions instead of guaranteed payments on Schedule K-1.
Question: What if I operate more than one qualifying trade or business?
Answer: All qualifying trade or business activities will be aggregated to result in a “combined qualified business income amount” for purposes of calculating the deduction under section 199A. For example, if a taxpayer operates four rental properties, with three generating $25,000 and one generating a loss of $25,000, these income amounts would be aggregated: ($25,000 x 3) - $25,000 = $50,000. The section 199A deduction would be 20 percent of $50,000, or $10,000.
Question: What if one or more of my qualifying trade or business activities involves payment of W-2 wages to employees?
Answer: For taxpayers who exceed the income limitation amounts (e.g., high-income taxpayers), the code section 199A deduction is the lesser of 20 percent of the qualified business income or 50 percent of the W-2 wages of the qualifying trade or business. (For taxpayers who do not exceed the income limitation amounts, W-2 wages are not factored in determining the section 199A deduction.) For example, if a single taxpayer operates a technology company from an S corporation that pays $100,000 in W-2 wages and generates $300,000 in net qualified business income, the taxpayer (having taxable income in excess of the $157,500 income limitation for single taxpayers) will only be able to take the section 199A deduction equal to 50 percent of the $100,000 in W-2 wages (thus, the deduction would be $50,000, rather than $60,000, which is 20 percent of the $300,000 in net qualified business income).
The imposition of the 50 percent of W-2 wages limitation for high-income taxpayers presents a planning opportunity for business owners who are not used to paying such wages. For example, if a business owner operates as a sole proprietor or a multi-owner LLC and receives $400,000 in qualified business income but pays no W-2 wages, the code section 199A deduction would be limited to 50 percent of such W-2 wages ($0). If, instead, the business owner formed a corporation or an LLC and elected to be taxed as an S corporation, then paid W-2 wages of $100,000 and distributed the remaining $300,000 in S corporation distributions, the code section 199A deduction would be available, in the amount of $50,000 (which is 50 percent of the $100,000 in W-2 wages and which is less than $60,000 (20 percent of the $300,000 in qualified business income)).
There is an alternative method of calculating the section 199A deduction for high-income taxpayers, which is apparently designed to protect capital-intensive businesses that do not pay W-2 wages, such as real estate development businesses. Under this alternative method, a qualifying business owner can take the section 199A deduction based on the lesser of qualified business income or the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property. (We will address this alternative calculation method more extensively in a forthcoming client alert summarizing the impact of the act on the real estate industry.)
The qualified business income deduction is among many provisions of the act which sunset after the year 2025. Unless Congress extends the effectiveness of section 199A, business owners should take steps to optimize their business structure to take full advantage of the deduction for the next eight years.