The Section 199A deduction introduced by the Tax Cuts and Jobs Act is something of a rarity in tax law. Unlike other tax deductions, you don’t have to buy anything to qualify. Many self-employed taxpayers get this 20% deduction just by making money in a qualified trade or business.
To be eligible for the qualified business income (QBI) deduction, a taxpayer must own an interest in a business that is organized as a sole proprietorship, partnership, limited liability company (LLC), S corporation, trust, or estate. Income earned through a C corporation or by providing services as an employee is not eligible for the deduction regardless of the taxpayer’s taxable income. However, it’s important to note that the new law contains limitations that may lessen or even eliminate the deduction as well.
The complexity of the deduction calculation varies depending on the taxable income of the owner. As a business owner’s taxable income increases, limitations are phased in, making the calculation more complex. For a better understanding of the deduction calculation, download our QBI deduction flowchart to help you follow along as you continue to read on.
The Basic Calculation
Some taxpayers who qualify for the deduction will have a relatively simple calculation. If taxable income for the year is $160,700 or less ($321,400 or less for married couples filing a joint return), the deduction will be the lesser of:
- 20% of QBI, or
- 20% of taxable income minus capital gains.
Individuals with taxable incomes between $160,700 and $210,700 ($321,400 and $421,400 for joint filers) will face the more complicated calculation as the limitations phase in over that income range. However, these limitations can be managed to some degree based on factors that are within an owner’s control, such as W-2 wages paid to employees and owners, retirement deferrals, and accelerated depreciation elections.
Taxpayers with taxable income above $210,700 ($421,400 if married filing jointly) will face additional complexities because (depending on the type of business that generates the income) they will have to calculate whether they:
- receive the full deduction
- receive a limited version of the deduction, or
- lose the deduction altogether
Specialized Service Trade or Business
For taxpayers beyond the income limits listed above, no QBI deduction will be allowed for income generated by a specialized service trade or business (SSTB). An SSTB is a business that involves the performance of services in professions such as health, law, accounting, consulting, and others. This rule is intended to prevent the use of the QBI deduction by individuals whose principal business asset is the reputation or skill of one or more of the employees or owners.
Taxpayers above the income limits with QBI from non-SSTB entities still qualify for a deduction, but it may be limited. To determine the limit, follow these steps:
- Determine the greater of:
- 50% of the W-2 wages paid by the business, or
- 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of qualified property.
- Compare the result calculated from step 1 to the basic computation of QBI or modified taxable income × 20%. The lower of the two results will be the QBI deduction for the year.
Tax Planning Implications
The QBI deduction offers significant tax savings for many businesses, but the complexity of the limitation calculation will require careful planning for higher-income taxpayers. To best utilize this deduction, you will need to work with your CRI tax advisor to develop an effective strategy that plans for income and expenses across multiple years.