For many businesses, one of the most attractive features of the 2017 Tax Cuts and Jobs Act (TCJA) was the new Section 199A deduction for qualified business income (QBI). In practice, however, the QBI deduction has proven to be one of the TCJA’s more confusing provisions.
With one complete tax cycle behind us and some additional IRS guidance now available, this is a good time to review the law’s basic provisions and re-evaluate strategies for maximizing the QBI deduction for 2019.
QBI Deduction Basics
Although the QBI deduction is sometimes referred to as the “pass-through deduction,” that term is technically incomplete, because the deduction also can be claimed by self-employed individuals and some trusts and estates.
The deduction allows non-corporate taxpayers—such as owners of sole proprietorships, partnerships, and S corporations—to deduct up to 20 percent of the qualified business income they report on their individual tax returns. Another component of Section 199A allows up to a 20 percent deduction on dividends from qualified real estate investment trusts (REITs) and income from qualified publicly traded partnerships (PTPs).
Only income from domestic business operations qualifies for the deduction. Capital gains, certain dividends, and interest income are excluded, as is any income reported on a Form W-2. The amount of QBI that is eligible for the deduction is reduced by any contributions a company makes to its owners’ health insurance, retirement plans, and self-employment tax.
Rental income from real estate can qualify for the QBI deduction, but only under specific circumstances. Recent guidance indicates that rental income received under a triple net lease does not qualify for the deduction unless the property is rented to a commonly controlled qualified trade or business.
Keep in mind that the business itself does not take the QBI deduction—it’s taken at the individual level. Thus, even if pass-through owners or partners receive identical shares of a company’s profits, their deductions vary, depending on individual circumstances.
For example, if a taxpayer has several sources of income, qualifying profits in one pass-through entity could be offset by losses in another. Moreover, the QBI deduction can amount to no more than 20 percent of the taxpayer’s total taxable income minus net capital, so the deduction offsets only ordinary income, not income taxed at preferential rates.
Other limitations apply when taxpayers reach certain taxable income thresholds. For 2019 returns, those thresholds are $321,400 for couples filing jointly and $160,700 for all other taxpayers. For taxpayers with taxable incomes above these thresholds, the QBI deduction is limited by the taxpayer’s allocation of W-2 wages the business pays and the cost basis of qualified property.
There are additional limitations for taxpayers engaged in specified service trades or businesses such as health, law, accounting, actuarial science, performing arts, consulting, athletics, and financial and investing services and management, or where the company’s principal asset is the reputation or skill of its employees or owners. For such taxpayers, the QBI deduction starts phasing out when their incomes reach the initial thresholds, and phases out completely once their taxable income reaches $421,400 for joint filers ($210,700 for all other taxpayers).
Strategies and Steps
There are no shortcuts for maximizing the QBI deduction—it’s usually a matter of “crunching the numbers” under various scenarios. Recent guidance and the new Form 8995 help clarify some questions, but some of the most important steps involve basic sound business practices, such as maintaining separate books for various lines of business, and paying officers a reasonable salary in addition to their profit distributions.
For taxpayers whose taxable income is at or above the QBI thresholds, a more thorough review could reveal additional strategies for taking full advantage of this potentially valuable deduction. Please contact us at ASL if you have any questions about the QBI or any other business deductions.