A Comprehensive Look at the New QBI Deduction

A Comprehensive Look at the New QBI Deduction

by Peter Desmond Hopkins, CPA, MS

Perhaps the most significant change enacted last December as part of what is commonly called the Tax Cuts and Jobs Act (TCJA) is the preferential treatment now afforded business income. Corporations saw their graduated rate structure that topped out at 35% replaced with a flat rate of 21%. While large multinationals with significant operations in the United States have since been in the news announcing bonuses, expansions and improved estimates of future profits, it is well known that closely held businesses are the lifeblood of the American economy and create millions of jobs in our country.

Congress is well aware of this, and that is why the business tax cut includes individuals who pay tax on the income of passthrough entities they own. Starting in 2018, individuals may be able to claim a qualified business income (QBI) deduction of as much as 20% of the income passing through from partnerships, limited liability companies (LLCs), S corporations and sole proprietorships. The QBI deduction will expire after 2025, without further Congressional action.

Types of income that qualify

In theory, all business income earned in the United States can qualify for a QBI deduction. However, the calculation is different, if the income is from a specified service business (SSB), and this can result in a reduced deduction or no deduction at all.

Any type of profit-seeking venture with the potential to create jobs or make capital investments in the United States is considered business income for the QBI deduction. This includes manufacturing, natural resources extraction, services, restaurants, hospitality, rental of real estate or personal property, retailing, wholesaling and farming. No industry is excluded, provided the income passes through and is reportable on an individual return. In addition, nonqualified ordinary dividends from real estate investment trusts (REITs) and patronage dividends from cooperatives are eligible for the QBI deduction. Compensation earned as an employee or as a guaranteed payment from a partnership is not counted as business income in calculating the QBI deduction.

QBI deduction for taxpayers below the threshold

Joint filers with taxable income before the QBI deduction of $315,000 or less ($157,500 for all other filers) will compute the QBI deduction in a few easy steps. First, they must determine the net taxable income from all their businesses. This includes all business income, gain, deductions and losses reportable on the return; it is not reduced by nondeductible expenses. Ordinary gains recognized from dispositions of interests in publicly traded partnerships (PTPs) are also included, even though these gains do not pass through from the PTPs. Items that are portfolio in nature such as dividends and capital gains are not included, even if they come from a passthrough entity.

Deductible net losses from individual businesses are not ignored, and a net loss from one business can reduce the QBI deduction that would have been available for another. Any QBI net loss carryforward (not yet possible in 2018) is treated as a loss from a business and will reduce the current year deduction. Of course, if a net loss is not deductible because of passive activity loss rules or for any other reason, it does not factor into the calculation.

If the cumulative net taxable income from all businesses is positive, 20% of the sum of the net business taxable income, nonqualified REIT dividends and PTP income represents the combined qualified business income amount (CQBIA). The CQBIA is compared with 20% of ordinary taxable income (excluding net capital gain) before the QBI deduction reduced by patronage dividends. The lesser of the CQBIA and the taxable income limitation is the tentative non-patronage portion of the QBI deduction.

Next, 20% of patronage dividends is compared with ordinary taxable income before the QBI deduction. The lesser of these two is the tentative patronage portion of the QBI deduction.

Finally, the sum of the tentative patronage and non-patronage portions of the QBI deduction is compared with ordinary taxable income before the QBI deduction. The lesser of these two amounts is the QBI deduction.

If the cumulative net taxable income from all businesses (not including PTPs) is negative, the net loss will carry forward and reduce any potential QBI deduction in the following year.

QBI deduction for taxpayers above the threshold

For taxpayers above the $157,500/$315,000 taxable income threshold, which will be indexed for inflation starting in 2019, the computation is a bit more complicated. This is where it becomes relevant to differentiate between SSBs and all other businesses. At this level, the QBI deduction is limited based on job creation and capital investment, and the calculation is more restrictive for SSBs.

An SSB is a business that performs services in the fields of accounting, actuarial science, athletics, brokerage, consulting, finance, health, law, performing arts, investing and investment management, trading, or dealing in securities, partnership interests or commodities. An SSB also includes any business whose principal asset is the reputation or skill of one or more of its employees or owners, except for architecture and engineering businesses.

For businesses other than SSBs, the job creation and capital investment limitation (JCCIL) is the greater of 50% of W-2 wages or the sum of 25% of W-2 wages and 2.5% of the unadjusted basis of qualified property. W-2 wages means gross compensation paid by the business subject to federal withholding plus any elective deferrals such as those under 401(k) plans, including any employer match. Those who are partners in partnerships or shareholders of S corporations will take into account their proportionate shares of these amounts in the same ratio as the related income tax deductions (i.e. for payroll expense and depreciation) pass through. Wages can only be counted, if they are reported on Forms W-2 filed with the Social Security Administration no later than 60 days after the deadline for reporting them, including any extension granted.

Qualified property is depreciable tangible property used in the business for the production of income that, by the end of the taxpayer’s tax year, has either not yet been in service for 10 years or has not yet reached the end of its regular tax recovery period for calculating depreciation.

Should 20% of the net income from a business exceed its JCCIL, all or a portion of the excess may be disallowed in computing the QBI deduction. The disallowance is determined by subtracting the applicable $157,500/$315,000 threshold from taxable income before the QBI deduction. That difference is divided by $100,000 for joint filers ($50,000 for all other filers) to determine the disallowance percentage, which is applied to the excess of 20% of the net income over the JCCIL. This percentage cannot be more than 100%. Therefore, joint filers with taxable income before the QBI deduction of $415,000 or more ($207,500 for all others) cannot have a QBI deduction from a business greater than that business’s JCCIL.

Nonqualified REIT dividends, income from PTPs and patronage dividends are not subject to a JCCIL.

Special limitation applicable to specified service businesses

To calculate the QBI deduction for an SSB, the amounts of income, W-2 wages and business property taken into account are themselves reduced for taxpayers above the $157,500/$315,000 threshold. The reduction is determined by dividing the excess of taxable income before the QBI deduction over the threshold amount by $100,000 for joint filers or $50,000 for all others. This percentage, which cannot exceed 100%, is used to reduce the income, W-2 wages and business property of the SSB that are taken into account in computing the QBI deduction. Effectively, joint filers with taxable income of $415,000 (or $207,500 for all others) or more cannot claim a QBI deduction for an SSB. Once the reduced amounts for the SSB are determined, the calculation of the QBI deduction is the same as for other businesses.

Other taxes and taxpayers

The QBI deduction is recomputed for alternative minimum tax (AMT). However, income from the businesses is not modified for adjustments and preferences taken into account in determining AMT income. Therefore, the only difference in calculation is the use of alternative minimum taxable income before the QBI deduction instead of regular taxable income before the QBI deduction.

The QBI deduction is available only for determining regular income tax and AMT. It does not reduce net earnings from self-employment or the amount subject to net investment income tax.

Estates and trusts calculate their QBI deductions in the same manner as individuals. However, to the extent the business income is distributed to beneficiaries, the elements that compose the QBI deduction computation also pass through to the beneficiaries. Therefore, a simple trust will not have a QBI deduction.

Conclusion and call to action

The QBI deduction is a significant change in how the business income of individuals is taxed. We anticipate the IRS will issue much needed guidance later this year. In addition, Congress may enact some technical corrections.

Since the computation of the QBI deduction can get rather involved, we have provided some examples from the simple to the comprehensive at the end of this article.

Those with significant investments in closely held businesses should reevaluate their choice of entity in light of the new QBI deduction as well as the new flat corporate tax rate of 21%, which also applies to personal service corporations. In some cases, it may be beneficial to convert a passthrough entity to a C corporation. In others, it may make sense to dissolve a C corporation or make an S corporation election for it and operate the business in a passthrough entity. Although liquidation of a C corporation often triggers taxable income, this may be mitigated, if the corporation has net operating losses it can use to shelter all or part of the tax. Further, the 21% tax rate may make a taxable liquidation of a C corporation more attractive.

Other elements of the TCJA should also be taken into account. For example, a C corporation can fully deduct all its state and local income taxes, while an individual no longer can. The general reduction of the individual tax rates effectively makes the QBI deduction less valuable than it would have been for many taxpayers. The changes made to the AMT calculation mean that many individuals accustomed to paying this tax will no longer be subject to it, lowering their effective tax rates. However, the TCJA changes to AMT are scheduled to expire after 2025.

An after-tax cash flow projection can be used as a decision-making aid. Whether earnings will be distributed or reinvested in the business will have a significant impact on the results. State and local consequences may make a difference as well. The overall savings could be significant, and the best choice will not be the same for everyone. Our tax department can help you prepare a projection and interpret its results. Before making a final decision, it will be important to consider what future changes Congress might make to this new system it enacted rather quickly by a partisan vote, and that includes whether the QBI deduction will be extended beyond its 2025 expiration date. Contact us today, if you need help evaluating your choice of business entity and tax classification.

Example 1

Archie and Edith file a joint return that reports $75,000 of taxable income before any QBI deduction. Most of their income is from wages, but Archie moonlights as a self-employed New York City taxicab driver and reported net income from that business of $12,000. Since Archie and Edith are below the $315,000 threshold, their tentative QBI deduction is $2,400 ($12,000 x 20%). Their taxable income limitation is $15,000 ($75,000 x 20%). Therefore, Archie and Edith can claim a QBI deduction of $2,400, the lesser of those two amounts. Archie and Edith are in the 12% bracket, so their federal tax savings from the QBI deduction is $288 ($2,400 x 12%).

Example 2

Archie is a widower and the sole shareholder of an S corporation that operates a saloon. His only source of income is ordinary business income from the S corporation of $125,000. Archie’s niece, Stephanie, lives with him, and he files his return using head of household status. His standard deduction results in taxable income before any QBI deduction of $107,000. Since Archie is below the $157,500 threshold, his tentative QBI deduction is $25,000 ($125,000 x 20%). His taxable income limitation is $21,400 ($107,000 x 20%). Therefore, Archie can claim a QBI deduction of $21,400, the lesser of those two amounts. Archie is in the 24% bracket, so his federal tax savings from the QBI deduction is $5,136 ($21,400 x 24%).

Example 3

George and Louise file a joint return that reports taxable income before any QBI deduction of $350,000. George is the sole member of an LLC that operates a chain of dry cleaning stores from which he earns $400,000 of business income. George also invests in the stock market, and he reported a net long-term capital gain of $10,000. The W-2 wages paid by George’s business were $100,000, and the unadjusted basis of its qualified property was $2 million. Dry cleaning is not an SSB.

Since George and Louise are above the $315,000 taxable income threshold, they must calculate their QBI deduction by taking into account the JCCIL. Twenty percent of George’s net business income is $80,000 ($400,000 x 20%). Fifty percent of George’s W-2 wages is $50,000 ($100,000 x 50%). Twenty-five percent of George’s W-2 wages is $25,000 ($100,000 x 25%). Two and one-half percent of George’s qualified property is $50,000. The sum of 25% of the W-2 wages and 2.5% of the qualified property is $75,000 ($25,000 + $50,000). Since this is greater than 50% of the W-2 wages ($50,000), the JCCIL is $75,000. Twenty percent of George’s net business income exceeds the JCCIL by $5,000 ($80,000 – $75,000).

The excess of George and Louise’s taxable income before the QBI deduction over the threshold is $35,000 ($350,000 – $315,000). This excess divided by $100,000 equals 35%. This percentage multiplied by the excess of 20% of the net business income over the JCCIL is $1,750 ($5,000 x 35%), which represents the amount by which 20% of George’s net business income must be reduced in computing the QBI deduction. Therefore, the tentative QBI deduction is $78,250 ($80,000 – $1,750).

George and Louise have ordinary taxable income of $340,000 ($350,000 – $10,000). Therefore, their taxable income limitation is $68,000 ($340,000 x 20%). Since the taxable income limitation is less than the tentative QBI deduction, George and Louise can claim a QBI deduction of only $68,000. The QBI deduction pushes George and Louise down from the 32% ordinary income bracket to the 24% bracket and saves them $18,320 in federal income tax, resulting in an effective value of the deduction of 27% ($18,320 ÷ $68,000).

Example 4

The facts are the same as Example 3 except George’s LLC operates a business through which George performs as an actor. Therefore, the business is an SSB. First, since George and Louise are above the $315,000 threshold, the elements used in the QBI deduction calculation must be reduced. George and Louise’s taxable income exceeds the threshold by $35,000 ($350,000 – $315,000). This excess divided by $100,000 results in a reduction percentage of 35%, or an allowance percentage of 65% (100% – 35%). Therefore, the elements used in the computation of the QBI deduction are net income of $260,000 ($400,000 x 65%), W-2 wages of $65,000 ($100,000 x 65%) and qualified property of $1.3 million ($2 million x 65%).

Twenty percent of the net income is $52,000 ($260,000 x 20%). Fifty percent of the W-2 wages is $32,500 ($65,000 x 50%). Twenty-five percent of the W-2 wages is $16,250 ($65,000 x 25%). Two and one-half percent of the qualified property is $32,500 ($1.3 million x 2.5%). The sum of 25% of the W-2 wages and 2.5% of the qualified property is $48,750. Since this amount exceeds 50% of the W-2 wages, the JCCIL is $48,750. Twenty-five percent of George’s net income exceeds the JCCIL by $3,250 ($52,000 – $48,750).

The excess of George and Louise’s taxable income before the QBI deduction over the threshold is $35,000 ($350,000 – $315,000). This excess divided by $100,000 equals 35%. This percentage multiplied by the excess of 20% of the net business income over the JCCIL is $1,138 ($3,250 x 35%), which represents the amount by which 20% of George’s net business income must be reduced in computing the QBI deduction. Therefore, the tentative QBI deduction is $50,862 ($52,000 – $1,138).

George and Louise have ordinary taxable income of $340,000 ($350,000 – $10,000). Therefore, their taxable income limitation is $68,000 ($340,000 x 20%). Since the tentative QBI deduction is less than the taxable income limitation, George and Louise can claim a QBI deduction of $50,862. The QBI deduction pushes George and Louise down from the 32% ordinary income bracket to the 24% bracket and saves them $14,209 in federal income tax, resulting in an effective value of the deduction of 28% ($14,209 ÷ $50,862).

Example 5 (Comprehensive)

Howard and Marian file a joint 2018 return and report taxable income before any QBI deduction of $325,000. Howard is the sole shareholder of an S corporation that operates a hardware store from which he earned $300,000 of taxable net business income. The W-2 wages paid by the hardware store were $150,000, and the unadjusted basis of its qualified property was $1 million. Marian owns a 50% interest in an LLC that operates a diner, which had taxable net business income of $100,000, W-2 wages paid of $80,000 and qualified property of $2 million. Marian also sings at live events in Milwaukee and Chicago. Her net profit from this sole proprietorship was $50,000, and she had no W-2 wages or qualified property. Marian is a member of a buying cooperative and received a patronage dividend of $5,000, based on purchases made through her diner. Howard and Marian have many investments. In 2018, they reported a net long-term capital gain of $7,000, taxable net business income from PTPs of $3,000 and ordinary gains from dispositions of interests in PTPs of $10,000.

Since Howard and Marian are above the taxable income threshold of $315,000, their QBI deduction needs to be computed with reference to the JCCIL. Twenty percent of Howard’s income from the hardware store is $60,000 ($300,000 x 20%). Fifty percent of the W-2 wages is $75,000 ($150,000 x 50%). Since this ensures that the JCCIL will be greater than 20% of the taxable net business income, we can conclude that the qualified business income amount (QBIA) for the hardware store is $60,000.

Marian’s share of the net business income from the diner is $50,000. Her share of the W-2 wages and qualified property are $40,000 and $1 million, respectively. Twenty percent of Marian’s net business income from the diner is $10,000 ($50,000 x 20%). Fifty percent of her share of W-2 wages is $20,000. Since this ensures that the JCCIL will be greater than 20% of the taxable net business income, we can conclude that the QBIA for the diner is $10,000.

Marian’s performing arts business is an SSB. First, since she and Howard are above the $315,000 threshold, the elements used in the QBI deduction calculation must be reduced. Howard and Marian’s taxable income exceeds the threshold by $10,000 ($325,000 – $315,000). This excess divided by $100,000 results in a reduction percentage of 10%, or an allowance percentage of 90% (100% – 10%). Therefore, the net business income used in the computation of the QBI deduction is $45,000 ($50,000 x 90%). Since her W-2 wages and qualified property are both zero, the JCCIL for this business is zero.

Twenty percent of the net income is $9,000 ($45,000 x 20%). All of this represents an amount in excess of JCCIL.

The excess of Howard and Marian’s taxable income before the QBI deduction over the threshold is $10,000 ($325,000 – $315,000). This excess divided by $100,000 equals 10%. This percentage multiplied by the excess of 20% of the net business income over the JCCIL is $900 ($9,000 x 10%), which represents the amount by which 20% of Marian’s net business income must be reduced in computing the QBI deduction. Therefore, the QBIA for the performing arts business is $8,100 ($9,000 – $900).

Howard and Marian have taxable income from PTPs of $13,000 ($3,000 + $10,000). Since PTP income is not subject to JCCIL, the QBIA from the PTPs is $2,600 ($13,000 x 20%).

Howard and Marian have a CQBIA of $80,700 ($60,000 + $10,000 + $8,100 + $2,600). Ordinary taxable income reduced by patronage dividends is $313,000 ($325,000 – $7,000 – $5,000), and 20% of this amount is $62,600. Since the CQBIA exceeds the taxable income limitation, the tentative non-patronage portion of the QBI deduction is limited to $62,600.

Twenty percent of Marian’s patronage dividends is $1,000 ($5,000 x 20%). This is less than taxable ordinary income of $318,000 ($325,000 – $7,000). Therefore, the tentative patronage portion of the QBI deduction is $1,000.

The tentative QBI deduction is $63,600 ($62,600 + $1,000). Since this is less than taxable ordinary income of $318,000, the QBI deduction is $63,600. The QBI deduction pushes Howard and Marian down from the 32% ordinary income bracket to the 24% bracket and saves them $16,064 in federal income tax, resulting in an effective value of the deduction of 25% ($16,064 ÷ $63,600).

In 2019, tragedy strikes Marian’s diner in the form of a fire. As a result, the LLC operating the diner has a net business loss of $750,000. Marian gets a job as a substitute teacher to supplement the family’s income. The S corporation operating the hardware store passes through another $300,000 of taxable net business income to Howard, and Marian earns another $50,000 singing. The cooperative pays Marian a $4,000 patronage dividend. Howard and Marian sell some securities at a loss to raise cash and report a $2,000 net capital loss. They have $5,000 of taxable net business income passing through from the PTPs and $2,000 of ordinary gain from disposition of interests in PTPs. Howard and Marian report $100,000 of taxable income before any QBI deduction on their joint return.

We will assume there was no inflation in 2018, so all 2019 thresholds and tax brackets are unchanged.

Marian’s share of the loss from the diner is $375,000 ($750,000 x 50%). This results in a cumulative net business loss of $25,000 ($300,000 + $50,000 – $375,000). Therefore, Howard and Marian’s QBIA from their three businesses is zero.

Howard and Marian have taxable income from PTPs of $7,000 ($5,000 + $2,000). Since PTP income is not subject to JCCIL, the QBIA from the PTPs is $1,400 ($7,000 x 20%). Since they had a net business loss, this is their entire CQBIA. Ordinary taxable income reduced by patronage dividends is $96,000 ($100,000 – $4,000), and 20% of this amount is $19,200. Since the CQBIA is less than the taxable income limitation, the tentative non-patronage portion of the QBI deduction is $1,400.

Twenty percent of Marian’s patronage dividends is $800 ($4,000 x 20%). This is less than taxable income, all of which is ordinary, of $100,000. Therefore, the tentative patronage portion of the QBI deduction is $800.

The tentative QBI deduction is $2,200 ($1,400 + $800). Since this is less than taxable ordinary income of $100,000, the QBI deduction is $2,200. Howard and Marian are in the 22% bracket, and the deduction saves them $484 in federal income tax.

In 2020, Howard’s S corporation earns him another $300,000 in the hardware business. The S corporation has $150,000 of W-2 wages and qualified property of $1 million. The diner reopens, and the LLC reports $50,000 of taxable net business income. The LLC also has W-2 wages paid of $80,000 and qualified property of $2.5 million. Marian earns another $50,000 as a singer. Her performing arts business has no W-2 wages or qualified property. The cooperative pays Marian a $5,000 patronage dividend. Howard and Marian report $6,000 of net capital gain. Taxable net business income passing through from PTPs is $5,000, and ordinary gain from dispositions of PTPs is $10,000. Howard and Marian invest in REITs during the year and receive $8,000 of nonqualified REIT dividends. On their joint return, Howard and Marian report taxable income before any QBI deduction of $350,000.

We will assume there was no inflation in 2019, so all 2020 thresholds and tax brackets are unchanged.

Since Howard and Marian are above the taxable income threshold of $315,000, their QBI deduction needs to be computed with reference to the JCCIL. Twenty percent of Howard’s income from the hardware store is $60,000 ($300,000 x 20%). Fifty percent of the W-2 wages is $75,000 ($150,000 x 50%). Since this ensures that the JCCIL will be greater than 20% of the taxable net business income, we can conclude that the QBIA for the hardware store is $60,000.

Marian’s share of the net business income from the diner is $25,000. Her share of the W-2 wages and qualified property are $40,000 and $1.25 million, respectively. Twenty percent of Marian’s net business income from the diner is $5,000 ($25,000 x 20%). Fifty percent of her share of W-2 wages is $20,000. Since this ensures that the JCCIL will be greater than 20% of the taxable net business income, we can conclude that the QBIA for the diner is $5,000.

Marian’s performing arts business is an SSB. First, since she and Howard are above the $315,000 threshold, the elements used in the QBI deduction calculation must be reduced. Howard and Marian’s taxable income exceeds the threshold by $35,000 ($350,000 – $315,000). This excess divided by $100,000 results in a reduction percentage of 35%, or an allowance percentage of 65% (100% – 35%). Therefore, the net business income used in the computation of the QBI deduction is $32,500 ($50,000 x 65%). Since her W-2 wages and qualified property are both zero, the JCCIL for this business is zero.

Twenty percent of the net income is $6,500 ($32,500 x 20%). All of this represents an amount in excess of JCCIL.

The excess of Howard and Marian’s taxable income before the QBI deduction over the threshold is $35,000 ($350,000 – $315,000). This excess divided by $100,000 equals 35%. This percentage multiplied by the excess of 20% of the net business income over the JCCIL is $2,275 ($6,500 x 35%), which represents the amount by which 20% of Marian’s net business income must be reduced in computing the QBI deduction. Therefore, the QBIA for the performing arts business is $4,225 ($6,500 – $2,275).

Howard and Marian have taxable income from PTPs of $15,000 ($5,000 + $10,000). Since PTP income is not subject to JCCIL, the QBIA from the PTPs is $3,000 ($15,000 x 20%).

Howard and Marian have nonqualified REIT dividends of $8,000. Since REIT dividends are not subject to JCCIL, the QBIA from the REITs is $1,600 ($8,000 x 20%).

Howard and Marian have a QBI net loss carryforward of $25,000 from 2019. There can be no W-2 wages or qualified property associated with this loss. Therefore, the QBIA from the loss carryforward is -$5,000 (-$25,000 x 20%).

Howard and Marian have a CQBIA of $68,825 ($60,000 + $5,000 + $4,225 + $3,000 + $1,600 – $5,000). Ordinary taxable income reduced by patronage dividends is $339,000 ($350,000 – $6,000 – $5,000), and 20% of this amount is $67,800. Since the CQBIA exceeds the taxable income limitation, the tentative non-patronage portion of the QBI deduction is limited to $67,800. It is noteworthy that there is no real reduction in the 2020 QBI deduction attributable to the loss carryforward from 2019, because the taxable income limitation applies.

Twenty percent of Marian’s patronage dividends is $1,000 ($5,000 x 20%). This is less than taxable ordinary income of $344,000 ($350,000 – $6,000). Therefore, the tentative patronage portion of the QBI deduction is $1,000.

The tentative QBI deduction is $68,800 ($67,800 + $1,000). Since this is less than taxable ordinary income of $344,000, the QBI deduction is $68,800. The QBI deduction pushes Howard and Marian down from the 32% ordinary income bracket to the 24% bracket and saves them $19,312 in federal income tax, resulting in an effective value of the deduction of 28% ($19,312 ÷ $68,800).

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