A whole year has passed since the Tax Cuts and Jobs Act (TCJA) was enacted, and there is a lot of talk about all the changes that are coming this tax season. Some of them are fairly simple and some are rather complex. One of the most complicated changes, though extremely important, is the section 199A - Qualified Business Income (QBI) Deduction. It is similar to the previous section 199 – Domestic Production Activity Deduction (DPAD) in that a taxpayer can deduct a percentage of their qualified income from their bottom line. However, DPAD was narrower in scope and only applied to manufacturers of tangible property. Without going through the details of the proposed regulations, which are nearly 200 pages long, let’s take a 30,000-foot view on what this code section is all about.
The deduction is available for tax years beginning after December 31, 2017, and before January 1, 2026. It is also called the “pass-through deduction” as it is generally equal to 20% of your pass-through income from a partnership, S corporation, or sole proprietorship. The deduction is calculated for each pass-through investment separately and is taken at the individual level. Trusts and estates are eligible for the deduction as well.
What is QBI?
Qualified Business Income is all the income, gains, deductions, and losses that are effectively connected with a qualified U.S. trade or business. Certain types of investment-related items are excluded from QBI such as capital gains and losses, dividends, and interest. If your taxable income is under $157,500 for single taxpayers, or $315,000 for married couple filing joint return (MFJ), there are no limitations and you are entitled to the full 20%. If your taxable income is higher than those amounts, the QBI deduction will be limited by the percentage of W-2 wages and the unadjusted basis in acquired qualified property. Once the deduction is calculated for the business, it is also limited at the individual level by the 20% of the taxable income over net capital gains.
If your business is a Specified Service Trade or Business (SSTB), there are further limits. An SSTB is defined as one performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, or another field in which the principal asset is the reputation or skill of its employees. If the taxable income of an SSTB exceeds the amounts mentioned above, the deduction is going to be limited and completely phased out at $207,500 (single taxpayer) and $415,000 (MFJ).
Pass-through entities can be aggregated on an individual level to maximize the QBI deduction, but in some instances aggregation might not be beneficial. In addition to meeting the aggregation requirements, netting losses and income from the various businesses can get tricky.
There are a lot of different nuances in the proposed regulations. Needless to say, the regulations are still in the “proposed” phase and there might be changes and clarifications. This year, more than ever, taxpayers will need help from tax professionals.
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