Overview of the Qualified Business Income Deduction
The reduction in the corporate tax rate under the 2017 tax act would have, without additional action, resulted in an inequity in the taxation of pass through entity income as individuals will generally have a higher income tax rate than the 21% corporate tax rate. To remedy the situation the new tax law provides individuals a deduction from income taxes for qualified business income (QBI). While the change to the corporate income tax rate is permanent, the deduction for QBI expires on December 31, 2025, unless extended by Congress.
Determining whether a taxpayer qualifies for this deduction is not an easy task. This article provides only a general overview of the requirements and will ignore REITs and qualified publicly traded partnerships and cooperatives. For a more in-depth analysis of the law I invite you to refer to my article “Navigating the New Deduction for Qualified Business Income” published in the March 19, 2018 issue of Tax Notes magazine,https://www.taxnotes.com/tax-notes/2018-03-19.
To make it as easy as possible, I have posed a series of questions which will hopefully enable you to determine whether you will qualify for the QBI deduction.
1. Is your business a regular corporation?
Yes: STOP. You do not qualify for the QBI deduction.
No: Go to question 2. The law applies to flow through entities and sole proprietorships, not regular corporations.
2. Is the business income US based?
Yes: Go to question 3.
No: STOP. You do not qualify for the QBI deduction.
3. Is the business income investment income or compensation paid to the taxpayer for services performed for the business?
Yes: STOP. You do not qualify for the QBI deduction.
No: Go to question 4.
4. Is the business involved in performing services in law, health, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading, or dealing in securities, partnership interests or commodities or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners?
No: All the business income is QBI. Go to question 5.
Yes: Whether you qualify for the QBI deduction depends on your taxable income which includes your income from all sources (capital gains, dividends, etc.) less the standard/itemized deduction. For joint filers, taxable income includes the income of your spouse. Proceed to (a) through (c) below.
(a) Is your taxable income $157,500 or less (single filer) or $315,000 or less (joint filer)?
Yes: Good news. All the business income is QBI. Go to question 5.
No: Go to question 4(b) below.
(b) Is your taxable income more than $157,500 but less than $207,500 (single filer) or more than $315,000 but less than $415,000 (joint filer)?
Yes: Good news. A portion of the business income qualifies as QBI. Go to question 5.
No: Go to question 4(c) below.
(c) STOP. Since your taxable income is more than $207,500 (single filer) or more than $415,000 (joint filer) you do not qualify for the QBI deduction.
5. Once you have determined the business’ QBI you have to determine how much of the QBI is combined QBI (CQBI). Note that the calculations below apply to all businesses, not just professional service businesses.
(a) Is your taxable income $157,500 or less (single filer) or $315,000 or less (joint filer)?
Yes: The business’ CQBI is 20% of the QBI.
No: Go to 5(b) below.
(b) Is your taxable income more than $157,500 but less than $207,500 (single filer) or more than $315,000 but less than $415,000 (joint filer)?
Yes: You are required to make an additional calculation.
(i) Take the greater of: (1) 50% of the W-2 wages paid by the business or (2) 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of the business’ qualified property.
(ii) Is the amount in (i) less than 20% of QBI.
Yes: The CQBI of the business is only a portion of 20% of QBI. The reduction to QBI is based on a formula beyond the scope of this article.
No: The business’s CQBI is 20% of the QBI.
(c) If your taxable income is more than $207,500 (single filer) or more than $415,00 (joint filer) then CQBI is the lesser of:
(iii) 20% of QBI OR
(iv) the greater of 50% of W-2 wages paid by the business OR 25% of the W-2 wages plus 2.5% of the unadjusted basis of the business’ qualified property.
6. If you have gotten this far, then congratulations! Your business has CQBI and you qualify for the QBI deduction. The amount of the QBI deduction is the lesser of:
(a) the CQBI or
(b) 20% of [taxable income MINUS (net capital gain plus qualified cooperative dividends)]
PLUS the lesser of:
(c) 20% of qualified cooperative dividends or
(d) Taxable income MINUS net capital gain
In no event can the QBI deduction exceed the taxable income reduced by the net capital gain. The deduction is allowed to taxpayers who do not itemize and is not considered an itemized deduction.
CONCLUSION
There is always uncertainty surrounding a new law. The above is a simplification and there are unresolved issues which I have not discussed. It is anticipated that the Department of the Treasury will issue proposed regulations or notices later this year. When this will happen, and what issues will be covered is not known.