The Qualified Business Income (QBI) deduction is a new tax deduction for individuals that was created as part of the tax overhaul. The changes to the tax law drastically reduced the corporate tax rate and the QBI deduction was added as a way to include small businesses owners in that tax cut.
QBI is net income from a Schedule C business, Schedule F farming activity, S-corporation, partnership, trust, or LLC taxed as partnership or S-corporation. Rental income on Schedule E can be QBI under certain circumstances.
Because of the way the deduction is calculated, business owners should carefully consider their options for entity type, officer compensation, and pass-through income. These factors can be optimized to maximize your QBI deduction. And, since the QBI deduction can be up to 20% of your taxable income, the impact can be huge.
The QBI deduction is a below-the-line deduction, meaning it does not reduce your adjusted gross income (AGI); it reduces your taxable income.
As with many tax deductions, the QBI deduction phases out once your AGI reaches certain limits. For 2018 tax filings, the phaseout ranges are $315,000 – $415,000 if your filing status is Married Filing Joint, and $157,500 – $207,500 if you are using any other filing status. Since the deduction is calculated differently depending on where your AGI falls relative to that phaseout range, reference the flow chart to determine how to calculate your QBI. In all cases, the resulting QBI deduction cannot exceed 20% of your taxable income.
Below the phaseout range, the deduction is simply 20% of the lesser of QBI or taxable income after reduction for any net capital gains.
If your AGI is above the bottom of the phaseout range, you will need to know whether your business falls into the “specified service trade or business” (SSTB) category. SSTBs are treated less favorably than other businesses. Why? Ask Congress; it seems like a pretty arbitrary distinction to me.
Your business falls into the SSTB category if the primary business activity is providing services in the following areas: investing, health, law, accounting, consulting, or any other area where the reputation or skill of one or more employee is a principal business asset.
If your AGI is above the top of the phaseout range and your business is a SSTB, you cannot take the QBI deduction. For any other type of business, if your AGI is above the phaseout range, the QBI deduction is limited by the amount of wages paid to employees in your business. The wages limitation is the greater of 50% of all W-2 wages or 25% of all W-2 wages plus 2.5% of the unadjusted basis of all the depreciable assets owned by the business. In plain English, that usually means 2.5% of the purchase price of the business’ assets.
If your AGI is within the phaseout range, calculate your phaseout percentage. The phaseout percentage is (AGI-315k)/100k if you file MFJ or (AGI-157.5k)/50k for all other filing statuses. From there, the calculation gets a little complicated; reference the flow chart for the full equation. And of course, contact our office to learn more about how we can help you maximize this powerful new tax deduction.