Signed into law on December 22, 2017, the sweeping tax reform enacted by President Donald Trump includes a number of provisions of particular interest to businesses. In particular, Section 199A Deduction for Qualified Business Income of Pass-Through Entities can result in huge savings for qualifying entities, but there are some critical limitations to keep in mind. This is one of the more complicated areas of the tax reform law – but if you’re able to navigate the calculations appropriately it can result in substantial income tax savings for pass-through entity owners.
The Deduction for Qualified Business Income of Pass-Through Entities was designed to give pass-through entities (Sole proprietorships, S-Corporations, LLCs, partnerships, and trusts and estates) a similar deduction to that of C-corporations, which enjoy a lower tax rate. The deduction is calculated based on “Qualified Business Income” and may be as much as 20% of this income.
Three Steps to Calculating the 199A Deduction
First: Calculate QBI
The Qualified Business Income, or QBI, is defined in the act as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” These items, added together, make up a pass-through entity’s QBI. In other words, a pass-through entity’s ordinary income minus its ordinary deductions make up the entity’s QBI. (Income – Ordinary Deductions = QBI)
Note: some forms of income, however, do not count towards the QBI: these include reasonable compensation paid to S-corporation shareholders & guaranteed payments paid to partners, foreign income, and capital gain income. Capital gain income is already taxed at favorable rates, so it is not entitled to the Section 199a deduction.
Next, Determine the Combined QBI
Having calculated its QBI, the entity must then determine its “combined qualified business income,” which is calculated as the lesser of two options:
- 20 percent of the QBI, or the wage and capital limitations, which can be defined as the greater of either 50 percent of allocable W-2 wages for the trade or business,
- or the sum of 25 percent of allocable W-2 wages plus 2.5 percent of the unadjusted basis of qualified property.
- However, the latter of these two options, the wage and capital limitations, does not apply to taxpayers whose taxable income does not exceed $157,500 for single taxpayers or $315,000 for those married filing jointly. Having exceeded this base income, the 20 percent deduction is phased-in over the next $50,000 for single taxpayers or $100,000 for those married filing jointly. If the wage limitation does not apply, the combined qualified business income is equal to 20 percent of the QBI.
The final step in calculating the deduction is to subject the combined qualified business income to the lesser of either combined qualified business income or 20 percent of taxable income. Having subjected the QBI to both limitations, the entity will have calculated its final 199A deduction.
While not every entity will get to utilize the full deduction, knowing how to calculate the 199A deduction will help you get the maximum deduction you are entitled to the 2018 tax year.
You may or may not fully understand what has been explained above, but rest assured that the tax experts at Sousa & Weber, LLP do! Please contact us for clarification about how this complex area of the 2017 tax reform legislation impacts your business.