Optimal choice of entity for the QBI deduction.

AuthorVermeer, Beth Y.

On Dec.20, 2017, Congress passed the law known as the Tax Cuts and Jobs Act (TCJA) (1) to stimulate the economy and help create jobs. Although the corporate tax rate reduction from 35% to 21% has been emphasized as the TCJA's change with the greatest economic impact, the legislation also enacted new Sec. 199A, which allows a sole proprietorship or an owner in a passthrough entity to claim a deduction of 20% of qualified business income (QBI) for each qualified business owned by the taxpayer. Rather than an across-the-board tax rate cut like that provided for C corporations, the QBI deduction relies instead upon complex rules that favor certain sizes and types of businesses over others.

The QBI deduction introduces an additional layer of complexity to the choice of business entity where, depending on a taxpayer's circumstances, different forms of business entities will have significandy different QBI deduction amounts. This article illustrates the impact that differences between two types of passthrough entities can have on the amount of the QBI deduction and identifies situations in which a limited liability company (LLC), limited liability partnership, general partnership, or sole proprietorship (2) would provide a larger Sec. 199A deduction than an S corporation. Several factors may give rise to these differences, including S corporation shareholder/employee compensation, the taxpayer's income, the amount of W-2 wages paid by the business, the amount of capital investments made by the business, and whether the business qualifies as a specified service trade or business (SSTB). Many examples illustrate how these factors affect the calculation of the QBI deduction and how the choice of either S corporation or LLC form can maximize the deduction amount.

Overview of the QBI deduction

The QBI deduction is taken on the individual income tax return after the calculation of adjusted gross income, similar to itemized deductions or the standard deduction. An owner in a passthrough entity takes the deduction at the owner/partner/shareholder level rather than at the entity level. For an estate or trust, the deduction is taken either by the beneficiaries or by the entity itself if income is retained. The QBI deduction has no effect on the amount of income subject to self-employment tax. (3)

The first step in computing the deduction is determining the amount of QBI, which is the net amount of income (or loss) from any U.S. trade or business (including in Puerto Rico), other than one conducted by a C corporation or as an employee. QBI does not include investment items such as capital gains or losses, dividends, or interest income that is not properly allocable to a trade or business. (4) QBI is also reduced by reasonable W-2 compensation to employees (including S corporation shareholder/employees) and by guaranteed payments to partners. In addition, QBI must be reduced by the deductible portion of the self-employment tax, the self-employed health insurance deduction, the self-employed retirement contribution deduction, unreimbursed partnership expenses, charitable contributions related to the business, and interest expense incurred to buy entity assets or an interest in the entity. (5)

The second step in applying the QBI rules is determining whether the taxpayer's taxable income before the QBI deduction is: (1) at or below a limitations threshold amount ($321,400 for married filing jointly or $160,700 for single and head of household); (2) within the limitations phase-in range (between $321,400 and $421,400 for married filing jointly or between $160,700 and $210,700 for single and head of household); or (3) over the limitations phase-in range. (6)

Once the threshold amount is exceeded, the taxpayer must also determine whether a trade or business meets the definition of an SSTB. An SSTB is any trade or business providing services in the fields of health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; investing and investment management; trading/dealing in securities, partnership interests, or commodities; or any trade or business where the principal asset is the reputation or skill of one or more of its owners or employees. (7) If a trade or business meets the definition of an SSTB, the QBI deduction is fully permissible when taxable income is at or below the threshold amount, reduced when taxable income falls within the phase-in range, and eliminated when taxable income exceeds the phase-in range.

The third and final step in applying the QBI rules is determining the

QBI deduction, which depends on a taxpayer's taxable income calculated prior to the inclusion of net capital gains (8) and the type of business (i.e., SSTB or non-SSTB). Taxpayers with taxable income at or below the threshold amount (i.e., $321,400 for married filing jointly or $160,700 for single and head of household) have no limitations to the deduction (other than an overall taxable income limitation). For these taxpayers, the QBI deduction is the lesser of: (1) 20% of QBI; or (2) 20% of modified taxable income. (9) When taxable income is at or below the threshold amount, the QBI deduction is fully allowed without regard to whether the trade or business is an SSTB and without application of the wages/qualified property limitation (discussed below).

Once taxable income exceeds the threshold amount, the QBI deduction is the lesser of: (1) 20% of QBI with respect to any qualified trade or business; or (2) the greater of: (a) 50% of the taxpayer's share of W-2 wages with respect to the qualified trade or business; or (b) the sum of 25% of the taxpayer's share of W-2 wages with respect to the qualified trade or business, plus 2.5% of the taxpayer's share of the unadjusted basis immediately after acquisition (UBIA) of all qualified property. (10) For purposes of this calculation, qualified property is any tangible depreciable property that: (1) is held by, and available for use in, the qualified trade or business at the end of the tax year; (2) is used to produce QBI at some point during the tax year; and (3) has a depreciable period that does not end before the close of the tax year. All assets used in calculating UBIA have a minimum depreciable period of 10 years from the date placed in service. (11)

When a taxpayer with an SSTB has taxable income within the phase-in range (i.e., $321,400 to $421,400 for married filing jointly or $160,700 to $210,700 for single and head of household), the calculation of the QBI deduction becomes increasingly more complex, as the deduction is subject to both a phase-in of the SSTB limitation and a phase-in of the wages/qualified property limitation.

The choice of entity, along with the taxpayer's income, can affect the allowable QBI deduction. The flowchart

"Steps in Determining QBI Deduction for a Married Couple Filing Jointly" highlights the various steps involved in QBI deduction computations for both SSTBs and non-SSTBs. The following examples illustrate how these computations can result in a significantly different QBI deduction for an LLC than for an S corporation. The first seven examples illustrate the outcomes for SSTBs, and the latter six examples illustrate the outcomes for non-SSTBs. For each example, it is assumed that the taxpayers have only one trade or business and a nominal amount of UBIA.

QBI calculations

Example 1. SSTB using an S corporation--under the threshold amount:

A married couple filing jointly have $300,000 of taxable income and a business that is an SSTB with $225,000 of QBI before considering $125,000 of W-2 wages paid to the shareholder/employee. Since these taxpayers are under the threshold amount, the only limitation that applies is the overall modified taxable income limitation.

Determination of the QBI deduction: The lesser of $20,000 (20% of QBI [$225,000 - $125,000 = $100,000]); or $60,000 (20% of modified taxable income [$300,000]).

QBI deduction: $20,000.

Example 2: SSTB using an LLC --under the threshold amount: A married couple filing jointly have...

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