A significant new tax deduction went in to effect January 1, 2018 under the new Tax Cuts and Jobs Act (TCJA) tax law. The changes are extensive and should provide a substantial tax benefit to individuals with “qualified business income” from a sole proprietorship, farm, rental, partnership, or S corporation. The new deduction is called the Qualified Business Income Deduction (QBID).
The QBI deduction is 20% of your “qualified business income (QBI)” from sole proprietorships, rentals, farms, partnerships and S corporation. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces your taxable income. The deduction is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain.
Rules are in place (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. Specified service businesses are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Specified service business with income above $207,500 ($415,000 for joint filers) are not allowed the deduction. Businesses falling in between the above amounts will have the deduction reduced by a phase out percentage.
Additionally, for taxpayers with taxable income more than the above thresholds, the deduction for QBI cannot exceed the greater of (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). When the deduction is limited to the wage component and the taxable income is within the phase out range above, the limitation on the deduction is reduced. When the taxable income exceeds the threshold the deduction is the lesser of 20% of QBI or the wage component.