Deduction for Qualified Business Income For Non-Corporate Taxpayers

​One of the most talked about provisions of tax reform is the tax deduction for qualified business income for non-corporate taxpayers. While often referred to as the pass-through deduction, the new law will likely provide significant benefits to a broad base of taxpayers including partners in partnerships, members of LLCs taxed as partnerships, shareholders of S corporations, owners of single-member LLCs and sole proprietors not operating through any legal entity. It remains to be seen though whether the intended effect of creating parity with the corporate rate reduction will be achieved. Below is information regarding what income qualifies for the deduction, limitations on the deduction and related reporting matters. 

New Law

The net income of pass-through businesses - sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations - is not subject to an entity-level tax and is, instead, reported by the owners or shareholders on their individual or corporate income tax returns and subject to tax at the applicable tax rate. Generally for tax years beginning after December 31, 2017 and before January 1, 2026, the Tax Cuts and Jobs Act adds a new section, IRC §199A, “Qualified Business Income,” under which a non-corporate taxpayer (individuals, trusts, estates) who has qualified business income (“QBI”) from a partnership, S corporation, or sole proprietorship is allowed to deduct 20% of its QBI as an adjustment to taxable income.  

The 20% deduction is determined by a complicated formula and is subject to certain limitations as discussed below. In general, the deduction cannot exceed 20% of the excess of the taxpayer's taxable income over net capital gain. As clarified by the Conference Report, the deduction reduces taxable income after accounting for the standard or itemized deduction.

Qualified Business Income (“QBI”)

QBI is generally defined as the net amount of “qualified items of income, gain, deduction, and loss” relating to any qualified trade or business of the taxpayer to the extent these items are effectively connected with the conduct of a U.S. trade or business. In short, QBI can be thought of as the ordinary, operating income of the business. If the net amount of QBI is less than zero, the loss is carried over and will reduce QBI in the succeeding tax year.

Certain types of investment-related items are excluded from QBI, including capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). Employee compensation and guaranteed payments to a partner for services to the partnership are also excluded from QBI. Gains and losses from the sale of property used in the U.S. trade or business (IRC §1231 gains/losses) are presumably considered to be effectively connected to the U.S. business and therefore may be considered QBI.

Amount of Deduction

The amount of the deduction before any limitations are applied is 20% of QBI. In addition, the 20% deduction also applies without limitation to qualified REIT dividends, qualified publicly traded partnership income, and qualified cooperative dividends. The deduction is available to both passive and active investors.

Limitations on the Deduction

1. Taxable Income

For taxpayers whose 2018 taxable income is below $157,500 (filing single) or $315,000 (filing jointly) the only limitation on the 20% deduction is that it cannot exceed taxable income excluding net capital gain. It should be noted, however, net capital losses must be added back to taxable income and therefore the 20% deduction from QBI will be reduced. To the extent a taxpayer can manage the timing of capital losses, they may be able to maximize their QBI deduction.

For taxpayers with 2018 taxable income above $207,500 (filing single) or $415,000 (filing jointly) in addition to the taxable income limitation, further limitations regarding certain business activities and the amount of wages and assets are applied to the 20% deduction from Qualified Business Income. These limitations are phased in for taxpayers with 2018 taxable income between $157,500 - $207,500 (filing single) and $315,000 - $415,000 (filing jointly). As mentioned above, these additional limitations are not applied, to REITs, publicly traded partnerships, or cooperative dividends. 

2. Certain Businesses

For taxpayers with 2018 taxable income above $207,500 (filing single) or $415,000 (filing jointly), the QBI deduction is eliminated if the income is earned in the following service businesses: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

3. Wages and Assets

• 50% of W-2 wages OR
• The sum of 25% of W-2 wages plus 2.5% of the unadjusted (cost) basis of all qualified property

W-2 wages count towards the limit only if the wages relate to the qualified business and are timely reported to the Social Security Administration. Partners and S-Corporation shareholders generally include their allocable share of employee wages paid by the partnership or S-Corporation to their employees.

Qualified property is tangible depreciable property with respect to the qualified business. The full cost basis of the property is included in the limitation calculation for a minimum of 10 years or until the last full year of the applicable IRC §168 recovery period (under the General Depreciation System, without regard to ADS or MACRS). 

Both the wage and asset limitations are calculated separately for each source of QBI and taxpayers cannot combine attributes from one QBI source with another. 

K-1 Reporting

These changes will likely require additional Schedule K-1 footnotes by partnerships (and S-Corps). Among the likely information partners and shareholders will need includes the partner’s allocable share of partnership W-2 wages related to qualified business activities and their allocable share of qualified property. Partnerships may also need to provide such information separately stated by each qualified business activity.

This information is based on the statutes and guidance available as of the date of publication (January 2018) and is subject to change.