One of the more important provisions in P.L. 115-97, known as the Tax Cuts and Jobs Act, enacted Dec. 22, 2017, is new Sec. 199A, the deduction for qualified business income (QBI). Sec. 199A allows a deduction for up to 20% of QBI from partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships.
Sec. 199A creates a deduction based on an "artificial" calculation of business income instead of actual economic outlays required for most other business deductions. The provision is a significant tax benefit for many noncorporate businesses and was passed in part on the premise that a sizable tax rate cut for C corporations--from a maximum graduated rate of 35% down to a flat 21% rate--justified a corollary tax benefit to non-C corporation businesses. The Sec. 199A deduction is taken at the partner, S corporation shareholder, estate and trust, or sole proprietor level for tax years beginning after Dec. 31, 2017.
Most basically, the deduction is equal to the sum of 20% of the QBI of each of the taxpayer's qualified businesses. The full calculation, however, involves a multistep process that may phase out some or all of the deduction. These steps are discussed below. Calculations involving cooperative dividends, real estate investment trust (REIT) dividends, publicly traded partnership (PTP) income, and agricultural and horticultural cooperatives are beyond the scope of this article.
The initial step in calculating the Sec. 199A deduction begins with determining QBI. QBI is determined separately for each of the taxpayer's qualified businesses. For any tax year, QBI is the net amount of items of income, gain, deduction, and loss with respect to any qualified business of the taxpayer. Qualified items of income, gain deduction, and loss include such items that are effectively connected with the conduct of a U.S. trade or business and are included in determining the business's taxable income for the tax year.
Certain investment items are excepted from QBI, including short-term and long-term capital gains and losses, dividends, and interest income not properly allocable to a trade or business. QBI also does not include reasonable compensation payments to a taxpayer for services rendered to a qualified business, guaranteed payments to a partner for services rendered to a business, and, to the extent provided in regulations, a Sec. 707(a) payment to a partner for services rendered to the business (Sec. 199A(c)).
Another critical definition is for the "combined QBI amount" (Sec. 199A(b)). The combined QBI amount serves as a placeholder: It is the amount of the Sec. 199A deduction before taking into account a final overall limitation. Under this overall limitation, a taxpayer's QBI deduction is limited to 20% of the taxpayer's taxable income in excess of any net capital gain. The combined QBI amount is the sum of the deductible QBI amounts for each of the taxpayer's qualified businesses. The deductible QBI amount of a qualified business is generally 20% of its QBI, but the deductible QBI amount maybe limited (1) by a wage and capital limitation and/or (2) when the business is a specified service trade or business.
The calculation of a taxpayer's Sec. 199 A deduction depends on whether the taxpayer's taxable income is (1) below a lower taxable income threshold ($157,500, or $315,000 if filing a joint return), (2) above a higher taxable income threshold ($207,500, or $415,000 if filing a joint return), or (3) between the lower and higher taxable income thresholds. (When computing taxable income for this purpose, the Sec. 199A deduction is ignored.)
TAXPAYERS BELOW THE LOWER TAXABLE INCOMETHRESHOLD
If a taxpayer has income below the lower threshold, calculating the Sec. 199A deduction is straightforward. The taxpayer first (1) calculates the deductible QBI amount for each qualified business and (2) combines the deductible QBI amounts to determine the combined QBI amount. If the taxpayer has only one qualified business, the combined QBI amount is the deductible QBI amount for that business. The taxpayer then applies the overall taxable income limitation to the combined QBI. Thus, the taxpayer's Sec. 199A deduction is equal to the lesser of (1) the combined QBI amount or (2) the overall limitation (20% x taxpayer's taxable income in excess of any net capital gain).
H and W file a joint return on which they report taxable income of $310,000, of which $10,000 is net capital gain and $280,000 is ordinary net income from H's interest in an S corporation. H and W's combined QBI is $56,000 (20% x QBI of $280,000). Combined QBI is $56,000 before applying the overall limitation of $60,000 (20% x [$310,000 taxable income--$10,000 net capital gain]). H and W's Sec. 199A deduction is $56,000.
TAXPAYERS ABOVE THE HIGHER TAXABLE INCOMETHRESHOLD
If the taxpayer has taxable income above the higher threshold amount, two issues arise in...