Complex Qualification Rules and Calculations Lie Ahead
The Tax Cuts and Jobs Act has introduced into tax law the opportunity for an individual taxpayer to take a 20% deduction related to their qualified trade or business income from a partnership, S-corporation, or sole proprietorship. Determining this deduction is not as easy as just multiplying your qualified business income by 20% because there are limitations that must be considered when calculating your income deduction.
What’s Not Included in the Act’s Definition of a Qualified Trade or Business?
First, it is important to understand what is not included in the definition of a qualified trade or business.
Qualified trades or businesses do not involve the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any trade or business where the principal asset of the business is the reputation or skill of one or more of its employees. The Tax Cuts and Job Act specifically includes engineering and architecture services as qualified trades or businesses.
However, if your business is excluded under this provision, you still may qualify for benefits if your taxable income is below the thresholds defined below.
Limitations on the 20% Pass-Through Deduction
In general, you can deduct the lesser of: 20% of taxable income or 20% of the qualified business income (QBI), defined as the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business. Qualifying items are those that were taken into account when determining taxable income for the year and relate to a trade or business within the United States.
Wage limitations on the qualified business income deduction will apply when your taxable income exceeds the threshold amount of $157,500 ($315,000 in the case of a joint return). The limitation is fully phased in when your taxable income is the threshold amount plus $50,000 ($100,000 in the case of the joint return).
The 20% deduction is limited to the greater of: 50% of the W-2 wages related to the qualified business or the sum of 25% of W-2 wages with respect to the qualified business plus 2.5% of the unadjusted basis of all qualified property related to the qualified business. These limitations only affect you if your taxable income is over the threshold amount. When the wage limitation is fully phased in, your qualified business income will be the lesser of: 20% of your qualified business income, 20% of taxable income, or the greater of (1) 50% of W-2 wages or (2) 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property with respect to the qualified trade or business.
Three Examples of Calculating a Qualified Business Income Deduction
Example 1: assume you file a joint tax return, have taxable income of $420,000, and qualified business income of $75,000.
Your share of W-2 wages related to the qualified business is $20,000. Taxable income has caused the wage limitation to fully phase in, as a result, the qualified business deduction will be the lesser of the following:
| Taxable Income: | $420,000 x 20% = $84,000 |
| Qualified Business Income: | $75,000 x 20% = $15,000 |
| 50% W-2 wages: | $20,000 x 50% = $10,000 |
| QBI Deduction | $10,000 |
This calculation becomes slightly more complicated when your taxable income falls within the phase in limits of $157,500 - $207,500 ($315,000 - $415,000 in the case of a joint return). When 50% of the W-2 wages are greater than 20% of the qualified business income, there is excess qualified business income. In this case, a wage limit percentage will need to be calculated by reducing your taxable income by the threshold amount divided by $50,000 ($100,000 in the case of a joint return). The excess qualified business income is then multiplied by the wage limit percentage to determine the qualified business income limit. The qualified business income deduction is then found by reducing 20% of the qualified business income by the qualified business income limit.
Example 2: assume you file a joint tax return, have taxable income of $400,000, and qualified business income of $75,000.
Your share of W-2 wages related to the qualified business is $20,000. Since taxable income is over the threshold amount you will be subject to a wage limitation. The qualified business deduction would be calculated as follows:
| Taxable Income: | $400,000 x 20% = $80,000 |
| Qualified Business Income: | $75,000 x 20% = $15,000 |
| 50% W-2 wages: | $20,000 x 50% = $10,000 |
Calculation of the Wage Limit:
|
Taxable Income ($400,000) – Threshold Amount ($315,000) ______________________________________________________ $100,000 |
= 85% |
| Qualified Business Income | $15,000 |
| Less: 50% W-2 Wages | $10,000 |
| Excess Qualified Business Income | $5,000 |
| Wage Limit Percentage | 85% |
| QBI Limit | $4,250 |
| 20% Qualified Business Income | $15,000 |
| Less: QBI Limit | $4,250 |
| QBI Deduction | $10,750 |
As stated above, the limitation based on W-2 wages and capital begins when your taxable income is above the threshold amount of $157,500 ($315,000 in the case of a joint return). This limitation is the greater of (1) 50% of W-2 wages related to the qualified business or (2) 25% of W-2 wages related to the qualified business plus 2.5% of the unadjusted basis of qualified property related to the qualified business. Qualified property is tangible property that is subject to depreciation.
Example 3: assume you are filing a joint return, have taxable income of $450,000, qualified business income of $80,000, your share of qualified property related to the qualified business is $100,000, and and there are no W-2 wages.
Since taxable income is over the threshold amount you will be subject to the greater of the wage or wage and capital limitation.
| Taxable Income: | $450,000 x 20% = $90,000 |
| Qualified Business Income: | $80,000 x 20% = $16,000 |
The wage limit is the greater of the following:
| 50% W-2 Wages: | $0 x 50% = $0 |
or
| 25% W-2 Wages: | $0 x 25% = $0 |
| Plus: 2.5% of Capital: | $100,000 x 2.5% = $2,500 |
| Total: | $2,500 |
| QBI Deduction | $2,500 |
It is important to note that the qualified business income deduction is determined by looking at the facts of each entity separately. If you invest in more than one pass-through entity, the qualified business income deduction will be determined on an entity by entity basis.
Freed Maxick’s Tax Team Can Help You Cut Through Tax Reform Complications
Determining your qualified business income pass-through deduction can become very complicated.
Not only are you subject to various limitations, you must be sure your investment is included in the definition of qualified service trade or business. Although doing the analysis and calculating your QBI deduction can be tricky, our tax professionals are available for a no cost review of your situation.
To set up an appointment with the Freed Maxick tax team, call us at 716.847.2651 or click here to schedule an appointment, today.