One of the most talked about aspects of the Tax Cuts and Jobs Act is a new deduction for individuals who own their own businesses called the qualified business income deduction, also known as the pass-through deduction. It is one of the more significant changes to tax law that we have had in recent times. The basic premise of this deduction is that a taxpayer will be able to exclude 20 percent of the qualified business income from being taxable on their return. If someone has $100,000 of business income, only $80,000 will be taxed. This may seem straightforward, but there are multiple limitations that can affect the actual amount of the deduction.
In order to maintain some sense of order and organization in the chaos of the new tax law, we’ll discuss how the deduction affects four groups of people: taxpayers with taxable income below $315,000, taxpayers with taxable income from $315,001-$415,000, taxpayers with taxable income above $415,000, and taxpayers who own certain specified service businesses. As a side note, the mentioned taxable income thresholds are for taxpayers who are married filing jointly. For all other taxpayers, the threshold is half that amount.
Taxpayers With Taxable Income Below $315,000:
Taxpayers who find themselves below this threshold only need to have qualified business income in order to take the deduction. Qualified business income (QBI) includes net income from any businesses owned by the taxpayer and operated through a partnership, S corporation, or a sole proprietorship. The income excludes capital gains, dividends and most other types of income besides basic operating income. In order to determine the amount of the deduction, the taxpayer makes two calculations. The first is to add up the aforementioned sources of QBI and multiply the sum by 20 percent. The second is to calculate overall taxable income less any capital gain and multiply that by 20 percent. The taxpayer then takes the lower of those two amounts as a deduction.
It’s worth noting that qualified business income does not include any amounts treated as a salary to the business owner. We expect the forthcoming IRS regulations to better define what amounts are treated as salaries, but, generally speaking, these are wages from an S corporation and guaranteed payments from a partnership.
Taxpayers With Taxable Income Above $415,000:
Taxpayers above this threshold are subject to the W-2 wage limitation. There are two ways to calculate the W-2 wage limitation, and the taxpayer uses the greater of the two limitations. The first is to take 50 percent of the taxpayer’s allocable share of W-2 wages from the business. The second is to take 25 percent of the taxpayer’s allocable share of W-2 wages plus 2.5 percent of the taxpayer’s allocable share of the unadjusted basis of qualified property. This limitation is calculated for each business flowing to the taxpayer separately. The deduction then equals the lesser of 20 percent of QBI or the greater of the two W-2 wage limitations.