In Part One of our article series we discussed what the QBI deduction is, which business entities it applies to, and how it is calculated. If you need a quick refresher of the QBI deduction, go ahead and read that article here. In part two of our QBI deduction series we’ll be looking more closely at how the income phaseout range will impact your allowable deduction, as well as how the Specified Service Trades and Businesses (SSTBs) requirement works.
Taxable Income in Excess of the Threshold
From our Part One article, we learned that you are entitled to the full deduction if your total income falls below $157,500 for Single and $315,000 for Married Filing Joint returns. But what if your income falls above these thresholds? Well, this is where it gets a little trickier – but let’s try to keep it simple. For now, remember that the full phaseout range of the QBI is as follows:
- Single: $157,501 – $207,500
- Married Filing Joint (MFJ): $315,001 – $415,000
The deduction is calculated in one of two ways depending on your income. First, if your income falls above the top thresholds ($207,500 of Single, $415,000 for MFJ), the QBI deduction is restricted based on wage limitations, and is the greater of either:
- 50% of W-2 wages
- 25% of W-2 Wages plus 2.5% of unadjusted basis of qualified property, earned from passthrough business
For the above calculations, make sure you use the W-2 wages earned only from the passthrough business.
For example, assume you file jointly with your spouse and earn $320,000 from your S-Corporation, a bakery. You paid yourself W-2 wages of $28,000 and – to keep calculations tidy – your share of the unadjusted basis of qualified property is $0. Your spouse also earns W-2 wages from his employer of $152,000 for the year which results in a taxable household income of $500,000, which exceeds the $415,000 top threshold. Because you exceed the top threshold, you are limited to 50% of the W-2 wages earned from the passthrough S-Corporation. In this case, the total deduction is $14,000 ($28,000 S-Corp wages x 50%)
If your total income falls in between the QBI phaseout range, there are a couple more steps needed to find your deduction. Here’s how it works: First, calculate the difference between the full 20% QBI deduction and the QBI deduction based on the wage limitations. This is your tentative deduction.
Confused? Let’s continue with our above example. Let’s change your spouse’s W-2 income to $37,000 so that your taxable income is now $385,000. First, we find the difference between the deduction you’d take if your taxable income was below the threshold ($315,000) and if your taxable income was above the phaseout range ($415,000). In other words, we’re comparing the deduction when the wage limitations apply and when they don’t. The deduction excluding wage limitations is simply 20% of your QBI income, which is $64,000 ($320,000 S-Corp income x 20%). We already know that your QBI deduction with wage limitations is $14,000, so the difference between both amounts is $50,000 ($64,000 minus $14,000). This $50,000 is your tentative deduction and reflects the deduction you lose out on over the phaseout range – but how much of this amount can you really deduct?
Next, we find how much of the tentative deduction you can take based on how far your taxable income is in the phaseout range. Calculate the amount your taxable income exceeds the threshold, in this case $70,000 ($385,000 minus $315,000). From here, we calculate the percentage that $70,000 is of the phaseout range. The phaseout range is $100,000 ($315,001 to $415,000) for joint filers, so by dividing $70,000 by $100,000 we get 70%. Therefore, you have surpassed 70% of the phaseout range and should lose 70% of your tentative deduction, or $35,000. Finally, subtract the $35,000 from 20% of your QBI or $64,000. The final amount of $29,000 is the deduction you are allowed to take.
Think You Might Be One Of Those ‘Specified’ Businesses? Further QBI Limitations Apply…
(If not, feel free to stop here)
This is what the IRS states an SSTB is:
- Any trade or business involving the performance of services in the fields of:
- Actuarial science
- Performing arts
- Financial services
- Brokerage services
- Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners
- Any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities
The fields described above are mostly straightforward, but some confusion may arise from the last point in #1, that is, when a business relies on the reputation or skill of one or more of its employees or owners. The IRS caught wind of this during their writeup of the regulations, and in attempt to reduce confusion as much as possible, the regulation defines “reputation or skill” through three items:
- Receiving income for endorsing products or services
- Licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity
- Receiving appearance fees or income
So, we’ve gone through what an SSTB is…but why do they matter? Well, unfortunately you won’t be able to capture ANY amount of the QBI deduction from an SSTB if you’re taxable income is in excess of the phaseout range ($207,500 for single or $415,000 MFJ). However, owning an SSTB won’t affect you if you are below the phaseout range. Being within the phaseout range on the other hand adds one more step to the process; let’s use our first example but assume you own a consulting business now:
Calculate the amount your taxable income exceeds the threshold and the resulting percentage as we did in the second example. Take the 70% and subtract it from 100%. The 30% is the “applicable percentage of QBI, W-2 wages, and unadjusted basis of qualified property.” Basically, multiply your applicable percentage of 30% by your QBI, W-2 wages, and unadjusted bases and use those numbers to find your tentative and final deduction.
QBI is now $96,000 (30% of $320,000), wages are $8,400 (30% of $28,000), and your share of unadjusted bases is still $0. Following the same formula as the first example, your tentative deduction comes out to be $15,000. Multiplying the $15,000 by 70% and subtracting that number from 20% of your (new) QBI gets you a deduction of $8,700.
It’s no surprise that harnessing the QBI deduction as much as possible can really help you out come tax season, and there are many pieces to the pie that must all be considered. For high income earners especially, the QBI deduction will become a large part of tax planning. Need help finding ways to become eligible to capture at least part of the QBI deduction? Schedule an appointment with Paragon Accountants and we’ll get you where you need to be!