With the recent implementation of the new tax reform, the Tax Cuts and Jobs Act has left many taxpayers in the dark concerning many new major tax provisions. One of these provisions includes the new Qualified Business Income Deduction (QBI), which provides a 20% deduction for passthrough businesses with “qualified business income”. Sounds easy enough – but there’s more to it than that with questions of what types of businesses qualify for the deduction, income limitations, phaseouts, and more. Fortunately, the IRS recently issued a 184 page guidance report concerning the highly questioned QBI deduction. This article will focus on a more simplified approach to the QBI deduction.
Overview
Going into effect as of January 1st, 2018, the QBI deduction allows a 20% deduction on “qualified business income” earned from a passthrough business, which includes the following business sources:
- Sole proprietorship (money that you earned while self-employed)
- S Corporation
- Partnership
- Rental Activity
If you earn income from any of these business sources, then you potentially qualify for the deduction – but what exactly is the “qualified business income?” requirement?
Fancy IRS terminology states that “qualified business income” means “the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business.” To put it more simply, it’s the net income provided from your passthrough business. This does not include any W-2 income earned from passthrough businesses.
The meat of the story is this: If you have positive net income earned from a passthrough business, then you may qualify for the 20% QBI deduction.
How It Works and Limitations
We now know that you may qualify for the QBI deduction if you had net income sourced from a passthrough business, but how exactly is the deduction calculated?
First, there are income limitations that could phaseout your QBI deduction. This is where calculations and rules can get convoluted and messy, so hang tight. For the sake of simplicity, you are entitled to the full 20% deduction if your income falls below these thresholds:
- Single with income below $157,500 (including all earned income from W-2’s, capital gains, etc.)
- Married filing jointly with income below $315,000 (including all household income)
Note: See our Part 2 article if your income falls past these thresholds. Assuming your income falls below these thresholds, however, the calculation is straight forward. It is the lesser of:
- 20% of the taxpayer’s QBI, plus 20% of the taxpayer’s REIT dividends and qualified publicly traded partnership income
- 20% of the taxpayer’s taxable income minus net capital gains
In other words, the deduction is either 20% of your total QBI income that you received, or, 20% of your total taxable income minus net capital gains, whichever is lesser. The latter could apply if you have higher itemized deductions or a major loss, but we will continue to focus on the former.
For example, imagine that one day you decide to open a bakery shop as a side business. In the eyes of the IRS, you are a sole proprietor who must file a Schedule C on your taxes. At the end of the year, you had net income from the bakery shop of $25,000, as well as W-2 income from your other job of $50,000. Remember that qualified business income is the net income provided from a trade or business, which in this case is $25,000 from your bakery shop and excludes your W-2 income. Because you are filing as single and your total income is below the $157,500 threshold, you are entitled to the full 20% QBI deduction on your passthrough income of $25,000. This is equal to a $5,000 deduction ($25,000 bakery net income x 20% QBI deduction). Not bad!
Conclusion
The QBI deduction is a great way for many business owners to save on taxes for 2018. While more complex limitations do apply to high income earners, the deduction is mostly straightforward for all other taxpayers with lower to medium income earnings. A solid understanding of how the QBI deduction works will allow you to plan ahead to maximize your tax savings, such as reallocation of W-2 wages or guaranteed payments. For further tax planning needs concerning the QBI deduction, contact Paragon today!
