Layman’s version of Deduction for Qualified Business Income of an Individual under Sec. 199A
The Qualified Business Income tax deduction gives the owners of pass-through businesses like sole proprietors, partnerships, S corporations and real estate investors a deduction equal to 20% of qualified business income.
What is Qualified Business Income?
The qualified business income includes the profit from an active trade or business and then also rental income as long as you operate as a pass-through entity.
More specifically, this means your qualified business income includes the net income from an active trade or business as shown on the Schedule C and in box 1 of a partnership or S corporation K-1, the net rental or royalty income shown on Schedule E and in boxes 2 and 3 of a partnership or S corporation K-1, and then not the capital gains but rather the Sec. 1231 gains that may occur when a business sells assets used in the business.
Qualified business income also includes REIT dividends, qualified coop dividends and qualified publicly traded partnership income of the taxpayer.
What is not Qualified Business Income
Qualified business income amount does not include reasonable compensation paid to S corporation shareholders nor does it include guaranteed payments paid to partners.
For example, if you own and operate an S corporation making $150,000 before your shareholder-employee salary and then you pay yourself $50,000 in wages, you get the 20% deduction on $100,000 of profits.
The situation works the same way if you’re a partner receiving a guaranteed payment from the partnership. If your share of partnership profits equal $150,000 and you receive $50,000 as a guaranteed payment, you get the 20% deduction only on the remaining $100,000.
Qualified business income does not include foreign earned income.
Limitations on Sec 199A Deduction
The qualified business income deduction gets limited in a couple of situations.
A first limitation applies if you’re single and earn more than $157,500 or you’re married and earn more than $315,000. In this case, you can’t deduct more than the greater value of either 50% of the qualified business’s W-2 wages or the sum of 25% of the wages plus 2.5% of the depreciable property.
For example, if you have $1,000,000 of qualified business income and you’re potentially entitled to a $200,000 deduction. If your business’s wages equal $300,000 and you hold no depreciable property, you can only deduct $150,000 because 50% of $300,000 equals $150,000.
By the way, this wages-based limitation will mean that high income sole proprietors, partnerships and real estate investors without W-2 employees will miss out on the deduction.
You count as wages only amounts your business timely reports to the Social Security Administration.
A second limitation exists. You can’t deduct more than 20% of your taxable income after subtracting your net capital gains but before deducting the Sec. 199A deduction.
Say, for example, that you should theoretically get a $20,000 qualified business income deduction based on the qualified business income flowing out of a pass-through entity. If due to deductions your taxable income actually equals $80,000 and this $80,000 includes $30,000 of net capital gains, your deduction equals 20% of the net $50,000 ($80,000 taxable income minus $30,000 net capital gains), or $10,000.
Specified Service Trade or Business Disqualification
Not every pass-through entity gets to use the Qualified Business Income deduction.
The law, for example, disqualifies “specified service trades and businesses” including most of the traditional white collar professions (medicine, law, accounting, actuarial science, financial services and consulting) and then also performing artists and athletics and finally a vague catchall for any trade or business that relies on the “reputation or skill of one or more employees.”
Professional service firms with high-income owners, therefore, potentially don’t get to use the Sec. 199A deduction.
I say “potentially” because this disqualification doesn’t apply if you operate a specified service business and your taxable income falls under $157,500 or $315,000 if you’re married.
Furthermore, if your taxable income exceeds these thresholds ($157,500 or $315,000 in taxable income), the Sec 199A deduction doesn’t immediately zero out. The deduction phases out as you move from $157,500 to $207,500 in taxable income if you’re single (or from $315,000 to $415.000 if you’re married).
The deduction reduces your income subject to federal income taxes, but not self-employment taxes or alternative minimum taxes.
The New Deduction for Pass-Through Income In Detail
Generally for tax years beginning after Dec. 31, 2017, the Act adds a new section, Code Sec. 199A, “Qualified Business Income,” under which a non-corporate taxpayer, including a trust or estate, who has qualified business income (QBI) from a partnership, S corporation, or sole proprietorship is allowed to deduct:
- (1) the lesserof: (a) the “combined qualified business income amount” of the taxpayer, or (b) 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the sum of net capital gain for the tax year;
The “combined qualified business income amount” means, for any tax year, an amount equal to: (i) the deductible amount for each qualified trade or business of the taxpayer (defined as 20% of the taxpayer’s QBI subject to the W-2 wage limitation; plus (ii) 20% of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income of the taxpayer for the tax year.
QBI is generally defined as the net amount of “qualified items of income, gain, deduction, and loss” relating to any qualified trade or business of the taxpayer. If the net amount of qualified income, gain, deduction, and loss relating to qualified trade or businesses of the taxpayer for any tax year is less than zero, the amount is treated as a loss from a qualified trade or business in the succeeding tax year. QBI does not include: certain investment items; reasonable compensation paid to the taxpayer by any qualified trade or business for services rendered with respect to the trade or business; any guaranteed payment to a partner for services to the business or a payment to a partner for services rendered with respect to the trade or business.
The 20% deduction is not allowed in computing adjusted gross income (AGI), but rather is allowed as a deduction reducing taxable income.
Limitations. For pass-through entities, other than sole proprietorships, the deduction cannot exceed the greater of:
- (1) 50% of the W-2 wages with respect to the qualified trade or business (“W-2 wage limit”), or
- (2) the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Qualified property is defined as meaning tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.
For a partnership or S corporation, each partner or shareholder is treated as having W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages of the entity for the tax year. A partner’s or shareholder’s allocable share of W-2 wages is determined in the same way as the partner’s or shareholder’s allocable share of wage expenses.
However, the W-2 wage limit begins in the case of a taxpayer with taxable income exceeding $315,000 for married individuals filing jointly ($157,500 for other individuals), both indexed for inflation after 2018. The application of the W-2 wage limit is phased in for individuals with taxable income exceeding these thresholds, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals).
Thresholds and exclusions. The deduction does not apply to specified service businesses excluding engineering and architecture; and trades or businesses that involve the performance of services that consist of investment-type activities. However the service business limitation begins in the case of a taxpayer whose taxable income exceeds $315,000 for married individuals filing jointly ($157,500 for other individuals).The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals).