The qualified business income deduction (also known as Section 199A) was a significant part of the Tax Cuts and Jobs Act of 2017. It allows business owners of various entity types a deduction on their personal tax returns of up to 20% of their total qualified business income (QBI), qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. As simple as the mathematics may sound, the calculation is rather complex, requiring the application of specific technical rules. So let’s break this down into some straightforward, easy to understand concepts.
What is considered Qualified Business Income?
QBI is the net amount of income, gain, deduction and loss from any qualified trade or business including income from pass-through entities such as partnerships, S-corporations, trusts and estates. C-Corporations do not qualify for this deduction. Also included in the net calculation of QBI, (so these items will reduce QBI), are any deductible portion of self-employment taxes, self-employed health insurance premiums and contributions to qualified retirement plans. There are some specific rules as it relates to rental income but a good guideline to follow would be, if the rental activity rises to the level of a trade or business it is generally includable in QBI and subsequently eligible for the QBI deduction.
How is QBI Calculated?
The QBI deduction has two parts: the QBI component and the REIT/PTP component. The QBI component’s premise is a 20% deduction based off of the QBI we calculated above. However, there are a number of limitations that can be applied based on specific circumstances. Let’s see how those limitations interact:
1. The Taxpayer’s level of taxable Income needs to be determined. If it is greater than $160,700 for single, $321,400 married filing joint (for 2019) then step 2 and 3 come into play. If it is below that threshold the QBI component portion is quite simple. It is equal lesser of 20% of QBI or 20% of taxable income before QBI deduction.
2. To be determined is the type of trade or business for each income source qualifying as QBI. Is this business considered a Specified Service Trade or Business (SSTB)? An SSTB is a business involved in the performance of services in the fields of health, law, accounting, athletics, consulting and financial services just to name a few. If the answer to this is yes and you are over the above limits the QBI deduction starts to phase out (phase out computation for SSTB is beyond the scope of the discussion here). Once your taxable income reaches $210,700 for single, $421,400 then no QBI deduction is allowed for SSTB income.
3. The last limitation relies on two pieces of information, W-2 wages paid by the qualified business and the unadjusted basis immediately after acquisition (UBIA) of qualified property. In the case of a partner or shareholder this would be the Taxpayer’s portion of the two amounts (ex. if 50% shareholder then 50% of wages and UBIA). Therefore the QBI component deduction that is evaluated is the greater of:
a. 50% of the Taxpayer’s portion of W-2 wages OR
b. 25% of the Taxpayer’s portion of W-2 wages plus 2.5% of their portion of UBIA
The second component, the REIT/PTP component, is the easier of the two calculations by simply taking 20% of the total REIT dividends and PTP income. The only limitation that may apply comes into play based on the Taxpayer’s level of taxable income at the same threshold as we previously discussed. If this threshold is surpassed then the PTP’s type of business conducted may create a phase-out of the qualified income.
Now that we know what type of income qualifies and the different pieces of the calculation for the deduction, the final step is a limitation on the deduction as a whole. The entire QBI deduction will be the lesser of: the QBI Component plus the REIT/PTP component OR 20% of the Taxpayer’s (and spouse’s if joint filing) taxable income minus any capital gains.
The lesser of:
+ REIT Dividends x 20%
+ PTP Income (with no income phase-out) x 20%
20% x Taxable Income
- Net Capital Gains
= QBI Deduction
*See steps 1-4 above.
If you have any questions about how this applies to your specific situation, please reach out to your Faw Casson advisor.