Key Considerations of the Qualified Business Income Deduction
One of the most discussed aspects of the 2017 Tax Act is the ability of individuals to claim the new 20% qualified business income deduction. As is the case with many of the individual tax provisions, the deduction only applies for tax years beginning after December 31, 2017 and before January 1, 2026.
An individual may generally deduct 20% of qualified business income from a partnership, limited liability company taxed as a partnership (LLC), S corporation, sole proprietorship, trust or estate. The deduction is not applicable to C corporations or to a person providing services as an employee. Special rules apply to agricultural and horticultural cooperatives, as well as, to REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.
Qualified business income is income that is effectively connected with the conduct of a trade or business in the US, meaning that the income must relate to US-based activities as opposed to foreign-based activities. Certain investment income, such as capital gain, dividends, interest, annuities, and transactions involving commodities, foreign currencies, and notional principal contracts, are not eligible for the deduction. In addition, compensation paid to an individual or guaranteed payments received from a partnership/LLC are not treated as qualified business income for purposes of the deduction.
Specified Service Businesses
Much of the discussion about the 20% deduction relates to the limitations applicable to a “specified service trade or business.” A specified service trade or business is any trade or business (excluding engineering and architecture services) in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, and investment management trading, as well as businesses that are dealers in securities, partnership interests or commodities, and any business where the principal asset is the reputation or skill of one or more employees or owners.
Income from a specified service trade or business is actually eligible for the 20% deduction as long as the taxable income of the taxpayer (based on all income, not just qualified business income) does not exceed a threshold amount, which is $157,500, or $315,000 in the case of a joint return. These amounts are indexed for inflation starting after 2018. There are phase out rules that eliminate the 20% deduction once taxable income exceeds $207,500, or $415,000 in the case of a joint return.
As noted above, the general rule is that the deduction is based on 20% of qualified business income. However, the rules are very complicated and in order to determine the amount of the deduction you need to calculate various amounts and compare these amounts to each other.
We first start with 20% of qualified business income and add to that amount 20% of qualified REIT dividends and 20% of qualified publicly traded partnership income. However, if 20% of qualified business income exceeds an amount based on a W-2 wages and business investment (for this purpose we use the greater of 50% of W-2 wages with respect to the qualified business or 25% of such W-2 wages plus 2.5% of the tax basis of certain depreciable property), we use the lower amount based on W-2 wages and business investment. The addition of the wages/business investment component was designed to prevent a qualified business from paying low wages and driving up the qualified business income in order to maximize the 20% deduction. To further complicate the calculation, the W-2 wages/business investment component is phased in only after the $157,500/$315,000 threshold amounts are reached.
The qualified business income deduction, as calculated above, is subject to a further limitation rule. The deduction cannot exceed the taxpayer’s taxable income less the amount of net capital gain and qualified cooperative dividends. This further limitation is designed to make sure that a taxpayer cannot use losses from other investments to decrease taxable income and then use the qualified business income deduction to create a loss that is carried over to the following tax year. Tax simplification was certainly not a factor when determining the qualified business income deduction.
There are a variety of special rules related to the deduction. First, if there is a net loss for a year, the net loss carries over to the following tax year. Second, the deduction is available regardless of whether an individual claims itemized deductions or the newly expanded standard deduction. Finally, the deduction is treated as a deduction for purposes of computing taxable income, but not for purposes of computing adjusted gross income (AGI). There are many limitations in the Internal Revenue Code that are a function of the amount of AGI and the qualified business income deduction does not impact the AGI calculation.
The principal benefit of the 20% deduction will be for individuals who receive income from US-based businesses that are not engaged in the specified service business category. While there is some benefit for specified service income, the phase out rules will effectively limit the overall benefit. For other businesses, the key will be how much US-based operating income will be generated (since passive income is ineligible for the deduction) and whether the limitations based on W-2 wages/business investment will lower the deduction. We expect that businesses will use significant modeling to determine the breakpoint for avoiding the W-2 wages/business investment limitation.
For questions, information, or guidance, please feel free to contact John Eagan (firstname.lastname@example.org; 212.868.4835), Kevin Koscil (email@example.com; 215.864.6827) or another member of our Tax and Estates Group.