Starting in 2018, the Tax Cuts and Jobs Act effectively allows business owners with pass-through entities (including partnerships, LLCs, S corporations, trusts, estates and sole proprietorships) to claim a deduction of up to 20% of their qualified business income (QBI).
QBI is defined as the net of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business. QBI is calculated separately for each eligible business, such that the partner/owner’s respective share of income and expenses can be calculated for each business.
Eligibility for this 20% deduction is subject to some income limitations; however, a retirement plan and/or other employee benefits plans can be a good tax planning tool to help mitigate the limitations.
QBI Deduction Exclusions and Limitations:
Investment-Related Income Exclusion
Eligibility for QBI deductions excludes capital gains, dividends and investment interest.
Wage and Guaranteed Payments Exclusion
Salaries to S corporation owners and guaranteed payments allocated to partners in a partnership or members of an LLC are excluded from QBI. In addition, the owner taxpayer must take wages that are considered reasonable for their position and industry.
W-2 Wage and Capital Limitation
If the owner’s taxable income is above $157,500 (or $315,000 for joint filers), then the QBI deduction is phased out. If the owner’s taxable income is above this threshold, then the QBI deductible amount is subject to a reduction based on W-2 wages and/or capital (the unadjusted basis of certain business assets in Sec. 199A(b)(2)(B)). The deductible QBI amount for the business is equal to the lesser of:
- 20% of the business's QBI, or
- the greater of: (a) 50% of the W-2 wages for the business, or (b) 25% of the W-2 wages plus 2.5% of the business's unadjusted basis in all qualified property.
Qualified property is defined as property that meets the following criteria:
- Tangible property that is subject to depreciation
- Held by, and available for use in, a trade or business at the close of the taxable year
- Used in the trade or business’s production of QBI
- The depreciable period has not ended before the close of the taxable year
Where QBIs are concerned, the depreciable period for most property is the longer of the useful life or 10 years. Real estate, for instance, may have a depreciable period of up to 39 years.
For example, a company purchases a piece of machinery on November 18, 2014. The machinery is used in the business and depreciates over five years. Even though the depreciable life of the asset is only five years, the company’s owners will be able to take the unadjusted basis into consideration for purposes of the QBI limitation for 10 full years, from 2014 through 2023. Consider the same facts, only the asset is a non‐residential rental building that is depreciated over 39 years. The owners will be able to take their share of the building’s basis into consideration from 2014 through 2052.
Specified Service Trade or Business (SSTB) Limitation
In addition to the wage and capital limitation, there is an additional limit based on specified service trades or businesses. Specified services defined under IRC Section 1202(e)(3)(A) include:
- Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one (1) or more of its employees,
- Any banking, insurance, financing, leasing, investing, or similar business,
- Any farming business (including the business of raising or harvesting trees),
- Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
- Any business of operating a hotel, motel, restaurant, or similar business.
The specified service trade or business limitation may apply if taxable income exceeds certain thresholds. QBI deductions based on income begin to be phased out when an SSTB owner’s taxable income (calculated before any QBI deduction) exceeds $157,500, or $315,000 for a married joint-filer. Phaseout is complete when the owner’s taxable income exceeds $207,500, or $415,000 for a married joint-filer.
If the owner’s taxable income exceeds $207,500 (or $415,000 for a married joint-filer), none of the owner’s QBI, W-2 wages or qualified property for any SSTB can be counted. Therefore, no QBI deduction can be claimed for income from any SSTB. If the SSTB owner’s taxable income (calculated before the QBI deduction) is below the phaseout threshold listed above, the allowable deduction from the SSTB is simply 20% of QBI from the SSTB.
Additional Deduction from REIT Dividends or PTP Income
Dividends from a real estate investment trust (REIT) or publicly traded partnership (PTP) income are eligible for up to an additional 20% deduction, which gets added to the QBI deduction. This deduction is not limited by W-2 wages or qualified property, but the amount of PTP income that qualifies may be limited if the PTP is engaged in a specified service trade or business as discussed above.
The deduction is limited to the lesser of the QBI component plus the REIT/PTP component or 20% of the taxable income minus net capital gain. The deduction is available regardless of whether an individual itemizes their deductions or takes the standard deduction.
How Employee Benefits Can Help Maximize a QBI Deduction
Pre-tax deductions for a retirement plan or certain employee benefits can help reduce the taxable income below the exclusion thresholds mentioned above.
That’s because deductions from an employee’s pay for things like employer-sponsored retirement plan contributions, such as 401(k) contributions, flexible spending accounts, dependent care, parking (if tax-exempt) and medical premiums end up reducing W-2 wages.
Work with a Professional to Maximize Your QBI Deduction
With all the exclusions and limitations, determining your QBI deduction can certainly cause headaches. Working with a financial professional can help save you time and hassle while they help to make sure you’re maximizing your deduction potential.
MBA, CFP® AIF®, CPA, Life & Health Insurance License Chris has more than 30 years of experience in the financial services industry in the areas of accounting and financial planning. He is well-versed in the financial challenges faced by most individuals. Chris has also authored articles on financial planning, divorce and the financial markets. In addition, for those going through divorce, has appeared as a subject matter expert on a number of media outlets, as well as presented...Read More