While we provided a summary of the Tax Cuts and Jobs Act enacted in late December 2017 in our last newsletter, the new Section 199A deduction for “qualified business income” merits a more thorough examination. Beginning in 2018, the deduction allows a taxpaying entity (other than a C Corporation) to deduct up to 20% of its qualified business income.
First, qualified business income must be defined, which, somewhat circularly, is defined as income from a qualified trade or business. A qualified trade or business is then defined as a business other than a “specified service or trade.” Specified services or trades are those where the primary ‘asset’ of the business is the skills and reputation of its owners or employees, and includes lawyers, doctors, accountants, financial service providers, and artists. However, even where taxpayers are engaged in a specified trade or business, they may still claim the deduction if their taxable income is less than $315,000 for joint filers or $157,500 for all other taxpayers. After reaching this threshold, the ability to claim the deduction phases out and is eliminated at $415,000 for joint filers, and $207,500 for all other filers.
Generally, income that is reported on Schedule C for a sole proprietorship, a disregarded LLC, or some partnerships; real estate rentals, multi-member LLCs and S-Corps, or trusts is eligible for the deduction unless it is disqualified because it comes from a specified trade or business. Farmers may also claim the deduction for their net income but they are subject to special rules that are discussed below when they sell to cooperatives.
Once it is determined if income is qualified business income—either because it was not earned in a specified trade or business, or because the taxpayer has not exceeded the taxable income limits—the deduction is then calculated. For taxpayers with taxable income under the $315,000/$157,500 threshold, the deduction is the lesser of 20% of qualified income or 20% of modified taxable income. Therefore, for taxpayers under the thresholds, unless they report losses that reduce taxable income below their business income, the deduction is simply 20% of qualified business income.
For taxpayers above the thresholds, the amount of the deduction is the lesser of:
- 20% of qualified business income, or
- The greater of either:
- 50% of W-2 wages paid by the business or
- 25% of W-2 wages paid plus 2.5% of the unadjusted basis of all qualified property owned by the business.
For example, if a business has net income of $100,000, and pays its employees $45,000, the deduction will be $20,000 because 20% of the net income ($20,000) is less than 50% of its W-2 wages ($22,500). If the same business paid only $35,000 to its employees, the deduction would be limited to $17,500 since 50% of its W-2 wages are less than 20% of its net income.
For farmers selling exclusively to cooperatives, the deduction partially functions in the same way the now eliminated DPAD functioned. An amount to deduct is provided by the cooperative. Then added to that amount is 20% of net farm income minus the lesser of 9% of net farm income or 50% of wages paid. So, a farmer who sells $2,000,000 of grain to a cooperative, has net income of $100,000, pays $50,000 in wages, and receives a $15,000 deduction from the cooperative would have a deduction of $26,000; which is the $15,000 deduction from the cooperative plus $11,000 ($20,000 (20% of net farm income) minus $9,000 (9% of net farm income which is less than 50% of wages ($25,000))).
If a farmer does not sell to a cooperative, the deduction is calculated in the same manner as any other business. For farmers that sell to both, net income from cooperative and non-cooperative sales are calculated separately.
This deduction, which is in effect for the 2018 through 2025 tax years, is a significant benefit to business owners and a significant change to how they prepare their taxes. If you wish to explore how the deduction may affect you or your business, or require additional assistance with the preparation of your tax returns, the attorneys and CPAs at Plager, Krug, Bauer & Rudolph, Ltd. are prepared to assist you.