Decoding "Qualified Business Income" for Flow-Through Entities

Decoding "Qualified Business Income" for Flow-Through Entities

Thomas J. Kleinhans, CPA
Posted by Thomas J. Kleinhans, CPA on Jul 31, 2019 10:00:00 AM

ChoiceFor the first time since the Reagan Administration, the U.S. Government has implemented a tremendous shift to the tax code creating major adjustments that have affected millions of taxpayers. To name a few changes, the child tax credit and threshold have increased, the standard deduction has doubled, and the state and local tax deduction has been limited for many taxpayers. Among the significant adjustments to the tax code includes a qualified business income (QBI) deduction for business owners of a flow-through entity. Flow-through entities include LLCs, sole-proprietorships, partnerships, s-corporations, and more. This article will describe the composition of the deduction and who was able to benefit the most from the deduction in 2018 and for years to come.

What is the Qualified Business Income Deduction?

Congress wanted to find a way to give small business owners a similar tax break they were offering to large corporations. For the large corporations, the Tax Reform reduced the tax rate from 35% to a flat tax rate of 21% for entities taxed as a C Corporation. Many small businesses are set up as flow-through entities, meaning the income from these businesses is taxed at the owner of the business’s tax rate instead of taxed separately. As a result, individuals could potentially be paying a 37% tax on their business income if they are set up as a partnership, s-corporation, etc. To even the playing field between C Corps and other business entities, Congress developed the Section 199a Qualified Business Income Deduction. The qualified business income deduction (QBI), also known as the “20% pass-through deduction,” was passed by Congress as Section 199A under the Tax Cuts and Jobs Act, which was implemented on January 1, 2018.

How it Works

Unsurprisingly, calculating the “20% pass-through deduction” is not as easy as it sounds. To make this as simple as possible, we will create six categories individual taxpayers will fall into;

 

TAXABLE INCOME (2018 TAX BRACKETS)

Married File Joint (MFJ) < 315,000 Others < 157,500

MFJ 315,000 < but < 415,000 Others 157,500 < but < 207,500

MFJ > 415,000
Others > 207,500

Specified Service?

N

See Section 1

See Section 2

See Section 3

Y

See Section 4

See Section 5

See Section 6

 

In order to determine an individual’s category, one must know the definition of specified service. A specified service trade or business (SSTB) means any trade or business involving the performance of service in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of an employee. Before jumping to conclusions, please consult a tax professional to determine if your entity is an SSTB.

Section 1- If a person falls into section 1 on the table, they have the simplest calculation for the QBI deduction.  First, take the profits and gains related to the business (excluding guaranteed payments and w2 wages), subtract deductions related to the business (half of self-employment tax and health insurance deduction), and multiply the total by 20%. Next, take the taxable income, subtract capital gains and qualified dividends, and multiply this total by 20%. The smaller of these two totals will be the deduction.

  • Lesser of;
    • Qualified Business Income x 20%
    • (Taxable Income – (Capital Gains + Dividends)) x 20%

Section 2- If a person falls into Section 2, they must read section 3 first. Section 2 will be a weighted average of Section 1 and Section 3. The closer the taxable income is to falling into Section 1, the closer the deduction will be to Section 1. Vice versa if the taxable income falls closer to Section 3. This is the most intricate calculation of the sections.

Section 3- Section 3 is the same as section 1 except there one additional criterion to add to the equation. First, take 50% of w-2 wages to employees, and compare the total to 25% of w-2 wages plus 2.5% of UBIA qualified property. UBIA is the acquisition cost of qualified business property, which is tangible property subject depreciation that has not been fully depreciated or is not older than 10 years. Take the greater of these numbers and compare to the first number calculation in Section 1. Take the lesser of these numbers and compare to the second number calculation in Section 1. The smaller of the two numbers will be the qualified business income deduction.

  • Greater of; (Step 1)
    • 50% of W-2 wages
    • 25% of W-2 wages plus 2.5% of UBIA qualified property
  • Lessor of; (Step 2)
    • Qualified Business Income x 20%
    • Number from Step 1
  • Lessor of; (Step 3)
    • (Taxable Income – (Capital Gains + Dividends)) x 20%
    • Number from Step 2

Section 4- Same as Section 1

Section 5- Same as section 2, except you will be using the weighted average calculation from section 4 and section 6

Section 6- You do not qualify for the deduction

Who can Benefit

Anybody with a flow-through entity could potentially reap the benefits of the QBI deduction. For example, if a person who owns a construction company generates a QBI of $100,000, and their spouse makes $45,000 of w-2 wages, the individual would receive a $20,000 QBI deduction, which would save this married couple over $4,500 in tax dollars. When a taxpayer owns multiple flow-through entities, the calculations become more intricate, but the deduction has saved numerous taxpayers thousands and thousands of dollars. On the other hand, there are several taxpayers who thought they were going to see a tax break with the Tax Cuts and Jobs Act, yet they fall into a category that disqualifies them from the QBI deduction. If a taxpayer is a single veterinarian who has qualified business income over $160,000, they would not see a single tax dollar saved from the QBI deduction. After its guinea pig year, tax professionals and their clients will be capable of proper planning to maximize their use of the QBI deduction along with other tax savings opportunities the Tax Cuts and Jobs Act has introduced.

If you are looking for a more extensive explanation and examples of the QBI deduction, feel free to check out some of the references below. Evidently, this provision set to expire in 2026, so by the time you become the 199a expert, its material may become useless knowledge!

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References

LaBrecque. (2019). New Code Section 199A Pass-through Qualified Business Income Deduction. MICPA Special Task Force on Tax Law Changes, 1-3.

Legal Information Institute. (2018, January). 26 U.S. Code § 199A. Qualified Business Income. Retrieved from Cornell Law School: https://www.law.cornell.edu/uscode/text/26/199A

Nitti, T. (2019, January 19). IRS Publishes Final Guidance On the 20% Pass-Through Deduction: Putting It All Together. Retrieved from Forbes: https://www.forbes.com/sites/anthonynitti/2019/01/19/irs-publishes-final-guidance-on-the-20-pass-through-deduction-putting-it-all-together/#5f1c451ed9f0

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