What is this new 20% business deduction?
The new 20% business
deduction (also called the pass-through deduction, qualified business income
deduction, or section 199A deduction) was created by the 2017 Tax Cuts and Jobs
Act (TCJA) and is in effect for tax years 2018 through 2025.
This new deduction means
that most self-employed taxpayers and small business owners can exclude up to
20% of their qualified business income from federal income tax (but not self-employment
tax), whether they itemize or not.
At higher income levels,
the deduction may be reduced or eliminated, depending on the nature of the
business.
What is
“qualified business income” (QBI)?
For the purposes of the new
deduction, QBI is defined as net business income, excluding:
·
Income generated outside the United States
·
Investment income
·
W-2 compensation paid to an S corporation owner
·
Guaranteed payments to a partner
·
Income from REITs, publicly traded partnerships, and qualified
cooperatives*
*These 3 entities can
qualify for the 20% deduction under a different set of rules, the explanation
of which is beyond the scope of this article.
What types of
businesses does this new deduction apply to?
This new deduction applies
to Schedule C filers (sole proprietorships and other self-employed businesses),
LLCs, partnerships, S corporations, and trusts. Corporations are not eligible
because they received their own tax breaks under the TCJA.
That said, not every
eligible business automatically qualifies for the deduction. In particular,
some types of service businesses (SSTBs) are disqualified once their owners’
taxable incomes exceed a certain threshold.
What’s an SSTB?
The SSTB (specified service
trade or business) classification doesn’t come into play as long as total
taxable income is under $157,500 ($315,000 if filing jointly). At higher income
levels, the deduction for SSTBs is reduced and in some cases, eliminated.
For the purposes of the new
20% deduction, an SSTB is defined as any trade or business that performs
services in the fields of:
·
Accounting
·
Actuarial science
·
Athletics
·
Consulting
·
Health
·
Law
·
Performing arts
·
Financial services
·
Brokerage services (including investment management and
investing, trading, or dealing in securities, commodities, or partnership
interests)
Engineering and
architecture were specifically excluded from the SSTB definition as it relates
to this new deduction.
How is the
deduction calculated?
That will depend on the
business owner’s total taxable income, which includes nonbusiness
income (wages, interest, capital gains, etc.) as well as business income.
Under $157,500 ($315,000 if
filing jointly): The calculation is straightforward — 20% is applied to QBI
or taxable income minus capital gains and dividends (whichever is less) to come
up with the deduction.
For instance, a taxpayer
with $30,000 of QBI, $100,000 in total taxable income, and $5,000 in capital
gains would simply apply 20% to their QBI because it’s the lesser of the two
amounts ($30,000 vs. $95,000). In this case, they’d get 20% of $30,000 for a
$6,000 deduction.
$157,500 to $207,500
($315,000 to $415,000 if filing jointly): Here’s where
things start getting complicated. We’ll explain it below, but rest assured that
TurboTax will handle this calculation with ease. Let’s start with a fictitious example
so you can follow along.
Jack and Jill are joint
filers, and here’s the info they’ll need to calculate their deduction:
·
Total taxable income = $400,000
·
QBI = $300,000
·
20% of QBI = $60,000
·
W-2 wages paid = $50,000
·
Unadjusted basis of qualified property = $800,000
·
Their business is not classified as an SSTB
They first need to figure
their reduction ratio. The formula is:
·
(Taxable income – $315,000) ÷ $100,000 for joint filers
·
(Taxable income – $157,500) ÷ $50,000 for all others
Jack and Jill’s reduction
ratio = ($400,000 – $315,000) ÷ $100,000 = 0.85.
Next, they need to figure
their excess amount. It starts with the greater of these 2 amounts:
·
50% of W-2 wages paid, or
·
25% of W-2 wages paid plus 2.5% of the unadjusted basis of
qualified property.
For Jack and Jill, these 2
amounts work out to $25,000 and $32,500 respectively. To figure their excess
amount, they subtract the greater amount ($32,500) from 20% of their QBI
($60,000) to come up with $27,500.
Now, they plug their
numbers into this formula to calculate their deduction:
20%
of QBI – (excess amount x reduction ratio)
The deduction for Jack and
Jill’s non-SSTB business = $60,000 – ($27,500 x 0.85) = $36,625.
Now, if their
business was an
SSTB, they would simply apply a special factor (1 minus their reduction ratio,
or 0.15) to the above result to calculate their deduction (in this case, 0.15 x
$36,625 for a deduction of $5,493.75).
Over $207,500 (over
$415,000 if filing jointly)
SSTBs don’t qualify for the
deduction. For non-SSTBs, the deduction is the lesser of:
·
50% of the business's W-2 wages paid (or 25% of the W-2 wages
paid plus 2.5% of the business's unadjusted basis in all qualified property),
whichever is the greater amount, or
·
20% of QBI.
For illustration purposes,
if we reuse the numbers from Jack and Jill’s business, the deduction would be
the lesser of:
·
$25,000 or $32,500 (whichever is greater) or
·
$60,000
which works out to a
$32,500 deduction.
If all of this sounds
complicated… well, it is, at least at the higher income levels. TurboTax will
take care of the calculations and let you know if you qualified and how much of
a deduction you’re entitled to.
Related
Information:
·
How
will tax reform affect my 2018 federal tax return?
·
Do I qualify for the qualified business income deduction?
·
Do I need to incorporate to get the qualified business income
deduction?
