Tax Reform: The New 20% Qualified Business Income Deduction

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the fourth in a series of articles reviewing some of the more important changes.  This post deals with the new 20% deduction for qualified business income.

Qualified Business Income

QBI is domestic ordinary income less deductions.  QBI does not include wages earned as an employee or guaranteed payments received as a partner of the business.  S corporation shareholder-employees must be paid a reasonable wage for their work.  However, there is no such requirement to pay a reasonable guaranteed payment to a partner of a partnership.  QBI does not include investment income such as interest, dividends, or capital gain, but “business” interest income is included.  QBI includes ordinary gains and losses on the sale of business assets, but not §1231 capital gain.  A QBI loss in one tax year carries over to the next year in calculating the 20% QBI deduction.  QBI does not include business income of a “specified service business.”

Specified Service Business Income

With an exception for “small” taxpayers, specified service business income is not eligible for the 20% QBI deduction.  Specified service businesses are defined as those in the fields of:  health, law, accounting, actuarial science, performing arts, consulting, athletics, financial & brokerage, investment management, trading, dealing in securities, or any business where the principal asset of the business is the reputation or skill of one or more of its owners or employees.  Importantly, engineering and architecture are excluded from this definition.

There is much uncertainty in applying this definition.  Many business entities have several different business activities that can be distinguished one from another.  Does the predominant activity govern the whole or are they separately accounted for?  While special tax rules have applied to service businesses for many years, in many situations it is not always clear how the definition applies.

A special “small” taxpayer exception permits the 20% QBI deduction for specified service businesses.  A taxpayer is considered “small” if taxable income does not exceed $315,000 for those filing a married joint tax return and $157,500 for others.  The deduction for small taxpayers phases out over the next $100,000 of taxable income for MFJ and $50,000 for others.  A very high marginal tax rate applies during the phaseout range, perhaps 175% times the normal tax rate, so managing taxable income near the threshold levels is extremely important.  On the other hand, deductions lowering taxable income in the threshold range are very valuable.

Amount of the Deduction

The deduction is often termed the 20% “pass-through entity” deduction.  That is a bit of a misnomer in that an entity is not required.  The deduction applies to sole proprietorships as well.  In addition, it is not the entity that claims the deduction, it is the individual, trust or estate that owns the business that claims the deduction.  The deduction is not available for C corporations.

The 20% QBI deduction is effective for tax years beginning after 2017 but not after 2025.  It is unknown when the deduction takes effect for fiscal year pass-through entities.  One line of thought is that since the deduction is taken by the entity’s owners, the income from the entity’s fiscal year ending in 2018 should be eligible.  Another line of reasoning is derived from looking at how the IRS applied the effective date of the domestic production activities deduction.  The DPAD is claimed under Section 199.  The 20% QBI deduction is claimed under Section 199A.  There are many similarities between the two provisions.  The DPAD was enacted to apply to tax years beginning after 2004.  In Notice 2005-14, the IRS interpreted the effective date to apply to fiscal year pass-through entities in tax years beginning after 2004 and not tax years ending after 2004.  Assuming a similar interpretation, the 20% QBI deduction may not apply to fiscal year pass-through entity income until the fiscal year beginning after 2017.  Note that the new law repeals the DPAD for tax years beginning after 2017 to coincide with the start of the 20% QBI deduction.

The deduction lowers the top 37% Federal tax rate to a 29.6% effective tax rate.  The deduction is not a deduction for adjusted gross income, nor is it an itemized deduction.  The deduction is a calculation for taxable income.  The deduction is permitted for alternative minimum tax without adjustment.  The deduction is only for income tax, not for the net investment income tax or for the self-employment tax.  The deduction is not permitted in calculating a net operating loss.

Limitations on the Amount of the Deduction

The 20% QBI deduction cannot exceed 20% of the excess of taxable income over net capital gain.  Net capital gain is the excess of net long-term capital gains over net short-term capital losses.  In addition, for taxpayers with taxable income equal to or above $415,000 for a married taxpayer filing a joint tax return; or $207,500 for others; the deductible amount for each trade or business is limited to the greater of:

·      50% of W-2 income allocable to the QBI of the business, or

·      The sum of 25% of W-2 wages plus 2.5% of the unadjusted basis of tangible, depreciable property for which the depreciable period has not ended

The depreciable period begins on the date the property is first placed in service and ends on the later of 10 years after that date or the last full year in the applicable recovery period.  There is some uncertainty whether property that has been “expensed” under Section 179 can be included in the 2.5% limitation.  Property that has received 100% bonus depreciation is included because the deduction is considered depreciation.

W-2 payments to S corporation owners are included in the W-2 limit, but equivalent payments made by a partnership or sole proprietorship to an owner do not count for the W-2 limitation because such payments are not in fact reported on Form W-2.

Small Taxpayer Exception

The W-2/unadjusted basis limitation doesn’t apply if taxable income is equal to or less than $315,000 for a married taxpayer filing a joint tax return or $157,500 for other filing statuses.  But the limitation phases in during the next $100,000 / $50,000 of taxable income.  During the phase-in range, if the W-2/unadjusted basis limit is lower than 20% of QBI, then the phase-in percentage times the difference is subtracted from 20% of QBI.

Specified service businesses will be subject to both a phase-in of the W-2/unadjusted basis limitation and to the 20% QBI deduction phase-out during this income range.

It is important to note that while the overall deduction is limited to 20% of ordinary taxable income, any type of taxable income (including capital gains) counts in the W-2/unadjusted basis limit phase-in range or in the specified service business phase-out range.

Implications

Below is a bulleted list of possible planning steps that should be considered to enhance the amount of the 20% QBI deduction.  The use of the word “small” means that the small taxpayer exception is met.  The use of the work “large” means that the W-2/unadjusted basis limit applies or that the deduction has phased out for a specified service business.  The following list is based upon the commonly accepted interpretation of the statute.  Some advisors are suggesting an alternate interpretation of how owner compensation is treated for purposes of computing the deduction.  In this alternate interpretation, owner compensation does not reduce QBI and owner W-2 wages are not included in the W-2 wage limitation calculation.  If this alternate interpretation ends up being correct, the implications listed below could change.

·      “Small” S corporations may wish to become an LLC partnership or LLC sole proprietorship to avoid shareholder W-2 reasonable compensation that doesn’t qualify as QBI.  But consider whether S corporation payroll tax savings and the tax cost of liquidating the corporation outweigh the benefits of the 20% QBI deduction.

·      “Small” partnerships should avoid guaranteed payments to partners as such payments don’t qualify as QBI.

·      “Large” S corporations should be sure that enough W-2 is paid to avoid the W-2 limitation.

·      “Large” sole proprietors with insufficient employee W-2 may wish to become S corporations so that a portion of the owner’s compensation can be reported as W-2 wages and to save payroll tax on S corporation profit distributions.

·      A business with low wages may wish to “own” its equipment rather than “leasing” it to qualify for the 2.5% of unadjusted basis test.  Or the business may wish to hire employees instead of using independent contractors.

·      Paying a portion of business income as W-2 wages to the owner only reduces the 20% QBI deduction to the extent the owner’s wages and other non-QBI exceed itemized or other tax return deductions because of the overall 20% of taxable income limitation.

·      “Small” wage earners may want to become independent consultants to qualify their income for the 20% deduction.

·      Individuals making gifts in trust may wish to set up separate trusts for each beneficiary, instead of using a single pot trust for multiple beneficiaries, to get multiple small taxpayer limitations.

·      Retirement plan contributions may be less advantageous because the deduction may reduce the 20% QBI deduction, yet when distributed will be subject to the full income tax rate.  On the other hand, such contributions could be very valuable for a specified service business in the taxable income phase-out range.

·      A “large” service business with capital or expansion needs may consider converting to a C corporation for the low tax rate.

·      A C corporation in combination with a pass-through entity could make sense for a service business in managing the taxable income phase-out threshold.

·      “Large” taxpayers whose 20% QBI deduction is limited by the 20% ordinary taxable income limit can increase the deduction by generating other non-capital gain income, such as by a Roth IRA conversion.  The marginal tax cost of the additional income will be reduced by the increased deduction.

New 2018-2025 Supplemental Wage Withholding Rates

Supplemental wages include bonuses, commissions, stock option income, and other income earned outside of regular payroll amounts.  Federal income tax withholding on supplemental wages is computed under one of three methods:

1.      Mandatory flat-rate method.  When supplemental wages exceed $1 million during a calendar year, federal income tax withholding must be at the highest ordinary income tax rate.  In 2017, this rate was 39.6%.  For 2018-2025, the flat-rate drops to 37%.

2.      Optional flat-rate method.  For supplemental wages (paid separately from regular wages) of $1 million or less during a calendar year, federal income tax withholding must be at the third lowest ordinary income tax rate.  In 2017, this rate was 25%.  For 2018-2025, the flat-rate drops to 22%.

3.      Aggregation method.  For supplemental wages of $1 million or less during a calendar year, the supplemental wages can simply be added to regular wages to determine the amount of federal income withholding for that payroll period.

In addition, back-up income tax withholding is required on payments to a person that had either a missing or an incorrect taxpayer identification number on a required information return filing (e.g., Form 1099).  The back-up withholding rate must be at the fourth lowest ordinary income tax rate.  In 2017, this rate was 28%.  For 2018-2025, the flat-rate drops to 24%.

Some taxpayers with supplemental wages fall into the trap of thinking that the optional flat-rate withholding pays all of the federal income tax due on those wages.  For example, employees with nonqualified stock option income or bonus income may have had 22% in federal income tax withholdings, but much or all of those supplemental wages may be subject to higher ordinary income tax rates (e.g. 24%, 32%, 35%, or 37%).  Therefore, it is important that such individuals estimate what the total income tax will be on those supplemental wages and set aside any shortfall in order to have the cash needed to fully pay the total income tax when the tax return is due.