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.
Taxpayers With Taxable Income From $315,001-415,000
The final group of taxpayers finds themselves only partially subject to the wage and fixed asset limit discussed above. This wage and fixed asset limit is phased in based on how much the taxpayers’ taxable income exceeds $315,000 until it is fully applicable at $415,000 of taxable income. Accordingly, the wages and/or fixed assets of the business do not need to be quite as high and are less likely to limit the 20 percent deduction.
Taxpayers Who Operate Specified Service Businesses
A taxpayer who operates a business in certain service fields (e.g., health, law, accounting, consulting, performing arts, athletics, financial services) is excluded from this deduction unless their overall taxable income is below the $415,000 threshold. Income from businesses in these services is eligible for the full 20 percent deduction if their taxable income is $315,000 or less. If income from the enterprise is between $315,000 and $415,000, the deduction may be partially limited based on the W-2 wage limitation discussed above.
Until a taxpayer applies his or her specific situation to the rules and limitations, it is difficult to determine what the benefits are. Even now, commentators and tax professionals are interpreting this new law differently so, until the IRS releases some regulations, there will continue to be some moving pieces in these calculations.
Additional items to watch for:
- Determining the unadjusted basis of fixed assets for the W-2 wage limitation.
- Treatment of REIT dividends and publically traded partnership income.
- Rules related to loss entities.
- Rules related to determining the deduction when multiple entities are involved.
- Rules related to agricultural and horticultural cooperatives.
We are expecting additional guidance on many of these items from the IRS in the coming months. If you have any questions about your specific situation, please feel free to contact your advisor.
Meet the Authors
Sara Northcutt, CPA
Aldrich CPAs + Advisors
Sara joined the firm in 2005 and has more than a decade of experience working on a wide range of clients, including financial lending, private equity, real estate, and other closely held businesses. Sara specializes in multi-state tax compliance. Sara received her Bachelor of Arts degree from Vanguard University of Southern California and did her post-baccalaureate…
- Closely-held businesses
- Certified Public Accountant
- Strategic tax planning and compliance
Tristen Cohen, JD, CPA
Aldrich CPAs + Advisors LLP
Tristen uses his combined training as a JD and a CPA to look holistically at medical practices’ tax and financial challenges. His diverse background gives him a unique perspective on the complexities healthcare practices face in the 21st century. He has over five years of public accounting experience focusing on advising business and individuals on taxation,…
- Tax planning
- Tax compliance
- Tax controversy
- Certified Public Accountant
- Juris Doctor