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One of the more publicized changes under The Tax Cuts and Jobs Act (TCJA) is the Section 199A deduction – commonly known as the Qualified Business Income Deduction. This deduction was designed to keep the tax rate on passthrough entity income competitive with the new lower corporate tax rate of 21% by providing a deduction on an individual's tax return of up to 20% of income from a qualifying passthrough entity. Businesses structured as partnerships, S corporations, and sole proprietorships can qualify for the deduction. Rental property owners can also qualify in some cases. At first glance, this seems like an easy calculation, but in fact, there are several thresholds and limiting factors that must be accounted for. Careful tax planning with your trusted tax advisor will maximize the benefit.
Qualified business income (QBI) is determined separately for each business and includes items of gross income, deduction, gain, and loss to the extent the amounts are related to the activity's trade or business. It does not include non-trade or business interest income, dividends, or capital gains.
The deduction may be limited or disallowed depending on the individual's taxable income for the year. The tax code provides thresholds as follows:
Below $315,000 married filing joint (MFJ) ($157,500 all other taxpayers)
Between $315,000 - $415,000 MFJ ($157,500 - $207,500 all other taxpayers)
Above $415,000 MFJ ($207,500 all other taxpayers)
Additional calculations are also necessary to compute the deduction for qualified REIT dividends and qualified publicly traded partnership income, but that is beyond the scope of this article.
Our discussions below will assume an MFJ filing status.
If taxable income is below $315,000, the deduction is generally 20% of total QBI. However, this is limited to 20% of the taxpayer's overall taxable income, excluding capital gain income.
If taxable income is above $315,000, determining the deduction becomes even more complicated. Additional calculations are necessary and further limiting factors include:
If taxable income is above $415,000 and the activity is non-SSTB, the 199A deduction is calculated as follows:
If taxable income is between the $315,000 and $415,000 thresholds, the deduction limitations are phased-in, meaning the taxpayer will receive a partial deduction.
Income from certain service businesses is ineligible for the QBI deduction, depending on the individual business owner's overall taxable income. If taxable income is below $315,000 for taxpayers married filing joint (MFJ) or $157,500 for everyone else, there is no limitation other than the 20% of overall taxable income limitation. However, the QBI deduction related to SSTB income will face a phased-in limitation if taxable income is between $315,000 and $415,000 MFJ. If taxable income for married taxpayers is above $415,000 (or $207,500 for everyone else), none of the SSTB income is qualified.
An SSTB is any trade or business involving the performance of services 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 assets of such trade or business is the reputation or skill of 1 or more of its employees. Architecture and engineering services specifically do not fall into this classification. While many taxpayers may be impacted by this limitation, there are numerous tax planning opportunities. Be sure to consult your tax advisor if this situation applies to you.
When an activity generates negative QBI, the taxpayer must first consider whether the net applicable QBI from all activities is a loss. If so, no 199A deduction is available in the current year and the net loss carries over to the next year and is treated as a separate activity. Any associated W-2 wages or UBIA are not carried over. If the net applicable QBI for all activities results in income, then the activity with an applicable QBI loss in the current year is allocated proportionately among the other activities with QBI income. The new net QBI income for each activity is then used in the calculation outlined above.
When a taxpayer has multiple qualifying businesses and taxable income is above the $315,000 MFJ threshold, it could be advantageous for taxpayers to elect to aggregate activities to benefit from W-2 wages and UBIA allocations (if one business has no wages, for example). Only certain activities can be aggregated and once the election is made it applies to all subsequent years. This is yet another area which holds a lot of tax planning opportunity.
Sec 199A provides an opportunity for rental income to qualify for the QBI deduction. To qualify, the rental activity must rise to the level of a trade or business, which requires careful consideration and planning. The taxpayer generally needs to be involved in the activity with continuity and regularity, but there are other factors to consider. Assuming the rental rises to the level of a trade or business, the full 20% QBI deduction may still be limited for most rental activities due to lack of W-2 wages. However, the 2.5% unadjusted basis immediately after acquisition of all qualified property (UBIA) limitation can provide a significant benefit.
As you have seen by now, determining the 199A deduction can be much more complicated than calculating a simple 20%. Taxpayers with qualified domestic passthrough entity income should consult with their tax advisor to ensure their deduction is optimized and tax planning opportunities are not missed. Delap is here to help.
Delap LLP is one of Portland’s largest local tax, assurance, wealth advisory, and information security consulting firms, located in Portland & Lake Oswego, Oregon.
Co-authored with Holly Huddleston