Posted by : Jordon Rosen, CPA, MST, AEP®
The centerpiece of the Tax Cuts & Jobs Act (the “Act”) was the reduction in the top corporate income tax rate from 35% to 21%. This includes personal service corporations which were previously taxed at a flat rate of 35%. However, since many U.S. businesses operate as a flow-through entity (i.e., partnership or S corporation) or sole proprietorship, there was still the inequity of the profits of these entities being taxed at the individual owner’s top bracket of 37%. Congress therefore provided a 20% deduction against the profits from these flow-throughs, known as the “qualified business income (“QBI”) deduction.” If only it were that simple.
In short, QBI must be from sources effectively connected with U.S. sources and can only be claimed by non-corporate taxpayers, including estates and trusts. Most trade or business type income qualifies, including passive income from businesses and real estate rentals.
The Act breaks out a different computation of the QBI deduction for income from “specified service trade or businesses” (think personal services), which rely on the performance of personal services such as accounting, law, performing arts, consulting, athletics, financial services and any business where the principal asset of such business is the reputation or skill of one or more of its employees. Does this mean that the income attributed to a celebrity chef or famous designer will be considered income from personal services? The devil will be in the detail (in this case, the regulations). For specified service income businesses, the QBI deduction is 20% of business income for individuals with taxable income less than $157,500 ($315,000 for MFJ). The deduction amount is phased out over the next $50,000 of taxable income ($100,000 for MFJ), after which no deduction is allowed.
For other types of businesses, the computation is the same (20% of QBI) so long as taxable income does not exceed the $157,500/$315,000 threshold. Above those limits, the Act imposes a wage/asset test whereby the deduction cannot exceed the greater of (a) 50% of allocable business wages or (b) 25% of allocable business wages plus 2.5 percent of the cost basis of assets used during the year in the business (with certain exceptions). The reason for the second test, which includes wages and assets, is to take into consideration those businesses that are more capital intensive and pay relatively few wages. This computation is not for the faint of heart, so be sure to seek the assistance of your CPA!
One final hurdle-The QBI deduction cannot exceed 20% of taxable income, net of capital gains. Also, should the total of all qualified trade/businesses be a loss, there is no deduction in that year and the loss is carried forward to reduce QBI in the succeeding year.
The bottom line is – it will depend on the type of business and the type of entity you are operating as, that will determine whether or not and how much of a deduction you will be entitled to. For example, for taxpayers under the $157,500/$315,000 taxable income threshold, operating as an LLC or sole proprietor may be more advantageous than operating as a C corporation, even with the lower 21% corporate rate in place. You need to do the math. Unless Congress acts otherwise, the QBI deduction provision sunsets after 2025.
If you have questions or want further information on the above or other income, retirement or estate planning techniques, please contact Jordon Rosen at firstname.lastname@example.org.