A New Deduction for Business Owners - Decoding the Tax Law

By Miles Pfeifer (guest post)

I hope you had a happy Thanksgiving and are looking forward to the year-end holiday season. If you’re a business owner, Congress has already prepared an exciting ‘gift’ for you, as part of the Tax Cuts and Jobs Act of 2017: a shiny new business tax deduction. For those who qualify, properly taking advantage of these new tax rules may result in substantial tax savings.

As part of the new tax laws, effective for income earned in 2018, the IRS has added a new Internal Revenue Code Section 199A, and come up with some ‘exciting’ new terms, most importantly “Qualified Business Income” (QBI) and “Specified Service Trade or Business” (SSTB). As is often the case with Congress and the IRS, the new laws come with instructions. Lots of instructions. The IRS has published its first set of guidance for these new rules, totaling only 184 pages. Don’t worry, more explanations are anticipated.

For those brave enough to read on, I am going to try to convey the essence of the new rules, trying (somewhat in vain) to avoid too many details.

What is the new IRS Code Section 199A deduction?

Internal Revenue Code Section 199A (199A) is a deduction for Qualified Business Income. The new rules are targeted toward the owners of business, including individual businesses, rentals, partnerships (including publicly traded partnerships) and S corporations. QBI is a deduction of up to 20% of the net income from the business.

Who gets the deduction?

Step 1 – Do I have Qualified Business Income (QBI)?

Qualified Business Income is the net profit from a ‘flow-through’ business. A ‘flow-through’ business is one where the income is reported and taxed on the individual tax return. The most common examples are sole proprietorships (Schedule C), rental real estate income (Schedule E), S corporation income (K-1 from S corporation) and partnership income (K-1 from partnership or LLC).

Step 2 – I have QBI, are there any limits to the 20% deduction from that income?

The new rule does not result in a 20% deduction for all taxpayers. The IRS has limited the deduction for certain types of businesses, and included some phase-out rules for high income taxpayers.

Step 3 – Am I phased out of the income due to my income?

Congress wanted taxpayers with lower income to get a 199A deduction. If your income is above certain thresholds, there are additional rules for calculating the deduction. There are two sets of rules, depending on if your business is a Specified Service Trade or Business (SSTB).

Step 3A – Is your income from a Specified Service Trade or Business (SSTB)?

Income from the performance of services in certain fields are defined as SSTB. Examples include:

  • Attorneys
  • Accountants
  • Consulting
  • Financial Services
  • Health Services

If your income is from a SSTB, then your 199A deduction is phased out based on your total personal taxable income from your individual tax return for the year.

Income Thresholds for SSTB Tax Phase-out

Amount Ranges Single Married Filing Jointly
Total 20% Deduction Up To: $157,500 $315,000
Phase-out Between: $157,500-$207,500 $315,000-$415,000
No Deduction Above: $207,500 $415,000


Step 3B – If your income is not from a SSTB, or the income is below or within the SSTB phase-out thresholds, then you are entitled to the deduction (or portion) depending on additional calculations.

Note: QBI does NOT include:

  • W-2 wages to owners, or employees of other corporations
  • Guaranteed payments in partnerships
  • C corporation earnings 

How to calculate the deduction:

The deduction is limited to the lesser of:

  1. 20% of Qualified Business Income, or
  2. The greater of:
    1. 50% of W-2 wages paid to employees
    2. Or 25% of wages plus 2.5% of unadjusted basis in qualified property

Yup, that’s confusing!

Putting the deduction on your tax return:

After calculating QBI for all the business entities you are involved in, the deduction is then the lesser of allowed QBI or the taxable income in excess of net capital gains.

If the overall calculated QBI is negative (a loss) for the year, you must carry the amount forward to offset QBI in the following years.

If you made it to the bottom of this post, congratulations! You can impress your tax advisor by asking well informed questions about this brand new tax deduction.

While the new tax rules provide a valuable deduction for certain business owners, the rules are complex. As always, you should consult your tax professional to help analyze your individual circumstances and provide guidance with regard to your tax situation.

 

Miles Pfeifer, CPA, is a member-manager of Coleman Huntoon & Brown PLLC in Chapel Hill, NC. He specializes in tax and business planning for small businesses and their owners.

 

Disclaimers:

Hilltop Wealth Advisors does not provide tax advice.  The tax information contained herein is general and is not exhaustive by nature.  Federal and state laws are complex and constantly changing. You should always consult your own legal or tax professional for information concerning your individual situation. 

These are the views of the author, not Coleman Huntoon & Brown PLLC or Hilltop Wealth Advisors, and should not be construed as investment or tax advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.