Maximizing the Qualified Business Income Deduction
One of the most complex provisions enacted by the Tax Reform and Jobs Act (the Act) is the Qualified Business Income Deduction (QBID), which is made available thanks to the new Internal Revenue Code Section 199A. In the world of income tax, complexity often presents opportunities, and the QBID is no exception. The QBID is the most beneficial provision in the Act for closely owned businesses, but there were many questions regarding the eligibility requirements and the various limitations. Recently issued Treasury Regulations have provided clarification in regards to eligibility for the QBID, and the Regulations provide a number of detailed examples outlining calculations of multiple limitations. The information included below will focus on maximizing the QBID by avoiding the Income Phase-In Limitation.
What is the Qualified Business Income Deduction?
For tax years starting on or after January 1, 2018, individuals whose taxable income includes income from a qualified trade or business are eligible to deduct up to 20% of the qualifying income from eligible businesses. Individuals may be reporting qualified income from a sole proprietorship, partnership, S-Corporation, trust, or real estate investments to the extent the income is deemed to be trade or business income. As a result, most small businesses will be paying tax on 80% of their net taxable income beginning in 2018. However, this deduction is subject to multiple limitations and phase outs.
How is the Qualified Business Income Deduction Calculated (Limited)?
While there is no limit to how large the deduction can be, there are certain scenarios for higher earning taxpayers in which a taxpayer’s deduction may be limited to less than 20% or eliminated completely.
1. Taxable Income Limitation – The QBID is limited to the lesser of 20% of Qualified Business Income OR 20% of Taxable Income before QBID adjusted for net capital gains.
2. W-2 Wages and Depreciable Property Limitations – For high income taxpayers with taxable income over $157,500 ($315,000 for joint filers), another limitation calculation applies prior to the Taxable Income Limitation. The QBID is limited to the lesser of 20% of Qualified Business Income OR 50% of Wages paid by the qualified trade or business. Alternatively, the QBID is limited to the lesser of 20% of Qualified Business Income OR 25 percent of the W-2 wages paid by the trade or business plus 2.5% times the qualified property’s original cost
3. Specified Service Trade or Business Disqualification – A high earning taxpayer will lose the deduction if income generated by the qualified trade or business is earned in a specified service trade or business, such as accounting, law, doctor, etc. The same income level is used to phase in this limitation beginning at taxable income of $157,500 ($315,000 for joint filers).
These limitations must be applied separately for each trade or business from which the individual taxpayer reports qualified business income. The following example outlines how this limitation applies for an individual with multiple trades or businesses.
Example 1 – F is an unmarried individual with $2,722,000 of taxable income and he owns and operates three separate trades or businesses. Business X generates $1 million of QBI and pays $500,000 of W-2 wages with respect to the business. Business Y also generates $1 million of QBI but pays no wages. Business Z generates $2,000 of QBI and pays $500,000 of W-2 wages with respect to the business.
Because F’s taxable income is above the threshold amount, the QBI component of F’s section 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. These limitations must be applied on a business-by-business basis. None of the businesses hold qualified property, therefore only the 50% of W-2 wage limitation must be calculated.
Because QBI from each business is positive, F applies the limitation by determining the lesser of 20% of QBI and 50% of W-2 wages for each business.
1. For Business X, the lesser of 20% of QBI ($1,000,000 x 20 percent = $200,000) and 50% of Business X’s W-2 wages ($500,000 x 50% = $250,000) is $200,000
2. Business Y pays no W-2 wages. The lesser of 20% of Business Y’s QBI ($1,000,000 x 20% = $200,000) and 50% of its W-2 wages (zero) is zero.
3. For Business Z, the lesser of 20% of QBI ($2,000 x 20% = $400) and 50% of W-2 wages ($500,000 x 50% = $250,000) is $400.
4. The total QBID is the combination of the allowable deduction for all three trades or businesses, which is $200,400.
Maximizing the Qualified Business Income Deduction by Aggregating Trades or Businesses
The most beneficial provision in the recently issued Treasury Regulations is the aggregation rule for taxpayers owning multiple trades or businesses. With a simple election attached to their individual tax return, high income taxpayers can choose to aggregate allowable trades or businesses with common ownership to compute the W-2 wage limitation as if they were a single trade or business. The benefits of this election can be seen by taking the above example and aggregating them as one trade or business.
Example 2 – Aggregation – Assume the same facts as Example 1 except the businesses will be aggregated.
Because QBI from each business is positive, F applies the limitation by determining the lesser of 20% of QBI and 50% of combined W-2 wages for all aggregated businesses.
1. Total QBI Limit = $400,400 (20% x $2,002,000 Total QBI)
2. Total Wage Limitation = $500,000 (50% x $1,000,000 Wages)
3. QBID = $400,400
By aggregating, F would receive an additional deduction of $200,000 ($400,400 – $200,400).
What Trades or Businesses Can Be Aggregated?
The benefits of aggregation are obvious, but it is not as simple as taking businesses with common ownership. The aggregated businesses must each rise to the level of a trade or business on a standalone basis before aggregation is allowable. Additionally, aggregated trades or businesses must meet the following criteria:
1. The same person or group of persons, directly or indirectly (through ownership of spouse, children, grandchildren, or parents) owns 50 percent or more of each trade or business to be aggregated;
2. The ownership exists for a majority of the taxable year;
3. All of the items attributable to each trade or business to be aggregated are reported on returns with the same taxable year, not taking into account short taxable years;
4. None of the trades or businesses to be aggregated is a specified service trade or business; and
5. The trades or businesses to be aggregated satisfy at least two of the following factors:
- The trades or businesses provide products and services that are the same or customarily offered together.
- The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources.
- The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies)
As outlined above, not all businesses under common ownership meet the tests to be aggregated. It is critical that each situation be reviewed because small fact pattern changes can change the outcome and resulted in a limited deduction. Taxpayers need to review their business structure and evaluate the potential Qualified Business Income Deduction available. Proper planning before year end can result in an increased deduction through proper aggregation.