Several years ago, when Congress changed the tax-rate structure for C corporations to a flat rate of 21% instead of the former graduated rates that topped out at 35%, they also came up with a new deduction for businesses that are not organized as C corporations. This tax break will be available only through tax year 2025 unless it is extended by Congress.
As a result, the current tax code provides a substantial tax benefit for most non-C-corporation business owners in the form of a deduction that is equal to 20% of their qualified business income (QBI). This deduction is most known as a pass-through income deduction because it applies to income from pass-through business entities such as partnerships and S corporations. This category also includes income from sole proprietorships, rentals, and farms; Real Estate Investment Trust (REIT) dividends; pass-through income from publicly traded partnerships; and cooperative dividends. The shorthand term for this deduction is the Sec 199A deduction, as 199A is the Internal Revenue Code section number for this provision. Let’s look at how this deduction works.
QBI – QBI is defined as the net amount of income, gains, deductions, and losses with respect to trades or businesses that are conducted within the United States.
QBI does not include:
- Capital gains or losses,
- Interest income,
- Dividends or payments in lieu of dividends,
- Annuity income not received in connection with a trade or business,
- Gain or loss from foreign currency transactions,
- Trade or business of being an employee,
- Reasonable compensation from an S-corporation, or
- Guaranteed payments from a partnership.
The pass-through deduction is not a business deduction; it is deducted on a taxpayer’s 1040 after the adjusted gross income is calculated. It is allowed regardless of whether the taxpayer claims the standard deduction or itemizes deductions. Since it is not a business deduction, it does not affect the computation of self-employment tax. Where QBI is less than zero, it is treated as a loss from a qualified business on the next year’s computation of QBI.
Complicated Computation - Congress ignored simplification when it created this deduction, which can be quite complicated, and which includes limitations at the entity level and for the combined deductions from all entities; furthermore, it is subject to a limitation based on the individual’s taxable income.
Thresholds & Caps – When determining the 20% of QBI deduction for each entity, the de-ductible amount may be reduced, phased-out or phased-in based on that year’s taxable income (without regard to the deduction itself). The 2021 thresholds for each limitation are $164,900 (170,050 in 2022) for individuals and $329,800 ($340,100 in 2022) for joint filers. The maximum of any phase-out or phase-in is $50,000 more than the threshold for individuals and $100,000 more for joint filers, so the maximums are $214,900 for individuals and $429,800 for joint filers ($220,050 and $440,100 for 2022). For those filing married separate, the 2021 threshold and cap amounts are $164,925 and $214,925, respectively, and for 2022, the amounts are the same as for individuals as noted above.
Specified Service Business – Special rules apply to specified service businesses, which are generally businesses that rely on the skill and reputation of the owners or employees. These include businesses focusing on health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and so on. This category specifically does not include engineering or architecture businesses and trades or businesses whose services consist of investment-type activities. For specified service businesses, if the taxable income is equal to or below the threshold, the entity’s deductible amount is the full 20% of QBI. When the taxable income is above the threshold, the deduction is pro-rata phased out between the threshold and the cap. Thus, a specified service business entity has no deduction when the taxable income exceeds $214,900 for individuals or $429,800 for joint filers ($220,050 and $440,100 for 2022) or $214,925 for 2021 and $220,050 for 2022 for married separate filers.
Wage Limitation – Before learning how the deduction is determined for other business entities, one must understand the wage limitation and how it is determined. An entity’s deduction is limited to the lesser of 20% of QBI or the wage limitation. The wage limitation is the greater of
- 50% of the W-2 wages from the business or
- 25% of the W-2 wages from the business plus 2.5% of the unadjusted basis of the business’s qualified property.
Other Businesses – Computing the deduction for other entities gets significantly more complicated depending upon the taxable income. The computations fall into three categories:
- Taxable income below the threshold amount described above,
- Taxable income above the threshold but less than the cap amount noted above, and
- Taxable income exceeding the cap.
Income below the threshold – The entity’s deductible amount is the full 20% of QBI.
Income above the threshold but less than the cap – This is the most complicated computation because the wage limit is phased-in between the threshold and the cap; it only applies to a pro-rata portion of the deduction.
Income above the cap – The deduction is equal to the lesser of the wage limitation or 20% of QBI.
Example: A married taxpayer with a taxable income of $500,000 is a shareholder in an S corporation. The K-1 from the S corporation shows pass-through income (QBI) of $300,000. The pro-rata share of that taxpayer’s wages that were paid by the corporation is $100,000, and the pro-rata share of the taxpayer’s qualified business property is $75,000. Because the taxable income is above the cap, the deduction for this business entity is the lesser of the wage limitation or 20% of the QBI. The wage limitation is the greater of $50,000 (50% of the $100,000 in wages) or $26,875 (25% of the $100,000 in wages plus 2.5% of the $75,000 in qualified business property). Thus, the wage limitation is $50,000. This is less than $60,000 (20% of the $300,000 in QBI), so the taxpayer’s deduction for this business is limited to $50,000.
With taxable income of $500,000, this taxpayer’s marginal tax bracket is 35%. This means that the $50,000 QBI deduction will save the taxpayer $17,500 of tax.
Aggregating Amounts – Once the deductions have been determined for each of a taxpayer’s business entities, they are combined in a rather complicated computation. First, the total deduction is added to 20% of the taxpayer’s REIT dividends and all the taxpayer’s publicly traded partnership income and cooperative dividends (after limitations). The final step is to compare this combined deduction amount to 20% of the taxpayer’s adjusted taxable income (i.e., taxable income minus capital gains); the lesser of the two becomes the actual deductible amount.
As you can see, this deduction provides a great tax benefit for business owners, but it can be quite complicated. Please contact this office with your questions and for assistance in determining your deduction.