Despite the fact that countless articles have been released that essentially reduce the latest “simplified” tax reform to mere bullet points, the law contains some pretty complex topics. One such complexity is the new 20 percent deduction available on “qualified business income” that has caught the attention of so many business owners.
This provision started out as something quite simple, but gradually morphed into something else entirely. It is filled with words that make you stop and wonder, “What exactly does that mean?” In addition to these trigger words, it seems that after every part of the code you could insert “subject to special rules and limitations.”
What does the deduction do for you?
If you are a shareholder in an S-corp, a partner in a partnership, or the owner of a sole proprietorship, this new deduction applies to you. Whether or not it actually benefits you depends on several factors. If your taxable income is $157,500 or less ($315,000 for joint filers), you will receive a new deduction.
If your taxable income exceeds the threshold amount, your deduction will be limited based on the amount of W-2 wages your company pays and how much property your company owns.
Businesses that provide the owner with high taxable income, own no property and pay no wages are in the worst-case scenario with regard to this new provision. These types of operations will receive no benefit from the new deduction. Sole proprietors will most commonly find themselves in this predicament.
What is qualified business income?
The definition of qualified business income is fairly straight forward. Qualified business income is ordinary income, less ordinary deductions, that a taxpayer earns from S-corporations, partnerships and sole proprietorships.
Not all income that is passed through qualifies as qualified business income. Capital gains and losses, dividends and interest income are all excluded from the definition of QBI.
It is important to understand that QBI does not include any wages or guaranteed payments received from any pass-through entities. In addition to this caveat, if an owner of an S-corporation does not take a wage but provides significant services to the company, they could, in the case of an IRS audit, be deemed to have taken a salary. The result of such an audit adjustment would be a decrease in QBI and ultimately a lower QBI deduction. Thus, taxable income would increase, resulting in a higher tax bill.
Recall from earlier, the QBI deduction is limited to the lesser of 20 percent of QBI or the greater of:
• 50 percent of the W-2 wages with respect to the business, or
• 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property.
With reference to the calculation of any taxpayer’s QBI deduction, the wages and property basis used are the partner or shareholder’s allocable portion, as opposed to the businesses entire amount.
That leaves one more big question: What does the “unadjusted basis of all qualified property” mean?
Qualified property is tangible property subject to depreciation. This means no inventory and no land.
The unadjusted basis is specifically defined in the code as the unadjusted basis (usually cost) immediately after acquisition.
Escaping the W-2 limitation
Now that we have all the definitions hammered out, let’s talk about the exception to the W-2 limitation. If a taxpayer’s taxable income (not adjusted gross income) is less than the threshold amount for the year, then the W-2 limitations simply does not apply. For 2018, the limitation is $315,000 for married filing joint and $157,500 for everyone else. Once the taxable income begins to exceed the threshold, the W-2 limitation phases in until the taxable income is $100,000 (for married individuals, $50,000 for everyone else) higher than the threshold.
John is a 30 percent shareholder of JKL Corp. from which he receives $230,000 of QBI. JKL Corp has $50,000 of unadjusted basis in qualified property and paid $250,000 in W-2 wages. Of the unadjusted qualified property basis, $15,000 ($50,000 x .3) is allocable to John and of the wages, $75,000 are allocable to John (250,000 x 30 percent). John is married to Mary, who earns $75,000 of W-2 income. John and Mary have taxable interest income of $5,000. Taxable income is $310,000.
If not for the provision allowing us to ignore the W-2 wage limitation, the calculation of John and Mary’s QBI deduction would be calculated as follows:
1. The lesser of:
• 20 percent of QBI (.20 x $230,000 = $46,000); or
• The greater of:
• 50 percent of the W-2 wages with respect to the business, (.50 x $75,000 = $37,500); or
• 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property ($18,750 (.25 x $75,000) + 375 (.025 x 15,000) = $19,125).
• 20 percent of qualified REIT dividends; and
• qualified publicly traded partnership income.
This would leave John and Mary with a deduction of $37,500.
However, since their taxable income is below $315,000 the W-2 limit is ignored and they are entitled to a deduction in the amount of $46,000.
Had their taxable income been higher than the threshold, the W-2 limit would gradually come into play. Once their taxable income reached $415,000 the W-2 limit would be in full effect and their deduction would be $37,500.
The Take Away
It is easy to see that the tax reform has not simplified things as much as Congress had hoped. To find out more about how this new deduction applies to your specific tax situation, reach out to a qualified tax adviser.
Brittany Flemming is a CPA and senior tax accountant at Brown Armstrong Accountancy Corp. Contact her at firstname.lastname@example.org or 661-324-4971.