20% qualified business income deduction overview
One of the biggest complexities in the Tax Cuts and Jobs Act is the new 20 percent qualified business income deduction some business owners and independent contractors can take when they file their personal tax returns in 2019.
“As we’re coming to understand more about the qualified business income deduction via guidance released by the IRS, we’re able to give taxpayers more information about it,” said Jackie Perlman, principal tax research analyst at The Tax Institute at H&R Block.
Generally, the 20 percent deduction means an eligible business owner with $50,000 in qualified business income could deduct up to $10,000. This generous tax benefit is meant to level the playing field between businesses filing as C corporations, which have a 21-percent tax rate, and small businesses paying individual tax rates ranging from 10 to 37 percent. But, for the last nine months the question has been who exactly qualifies for the deduction and how it – and its limitations – are calculated.
WHO (more specifically)
According to Perlman, taxpayers are eligible for the qualified business income deduction if they:
- Have income from S corporations, LLCs, partnerships, trusts and estates
- Are sole proprietorships filing Schedule C
- Are non-corporate farms filing Schedule F.
“All kinds of businesses – and people – can qualify. It could be someone running a small firm with dozens of employees or it could be someone driving for Uber or running an online sales business on Etsy,” Perlman said. “But there are some situations that are still unclear to some, such as the treatment of some kinds of rental income. The qualified business income deduction also is referred to as the pass-through deduction, which is a bit of a misnomer because it isn’t limited to pass-through entities.”
The deduction is limited for taxpayers with taxable income of more than $157,500 for single filers and more than $315,000 for married couples filing jointly.
If the taxpayer’s business is a specified service trades or business – which includes services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and investing and investment management – the deduction for higher income taxpayers is more severely limited than for other businesses.
WHAT (it will do)
The brand-new qualified business income deduction allows some small business owners to deduct 20 percent of their qualified business income on their personal tax return.
Specifically, qualified business income is the net of the taxpayer’s income, gains, deductions, and losses from a U.S. trade or business. Dividends from real estate investment trusts and income from publicly traded partnerships also might be considered qualified business income; however, capital gains and losses, and interest income are not considered qualified business income. In other words, the 20 percent deduction is figured on profit, after all business expenses are deducted.
“If the owner pays salaries and makes retirement plan contributions for employees, those are deductible business expenses, which reduce their tax liability. The profit is then used to calculate the 20 percent deduction, which reduces their tax liability even further,” Perlman said.
WHAT (it won’t do)
In addition to knowing the limitations for certain types of businesses and for taxpayers with higher incomes, taxpayers should know the qualified business income deduction does not affect the taxpayer’s adjusted gross income or self-employment tax due calculation. AGI determines when many other tax benefits phase out. And, the deduction can’t be more than 20 percent of the taxpayer’s net taxable income (taxable income less any capital gain).
The qualified business income deduction is live for tax years starting after Dec. 31, 2017.
As explained above, the taxable income limit is $157,500 ($315,000 for married filing jointly). Following are some examples about how this works.
Taxpayer No. 1 is part owner of an S corp and his qualified business income is $40,000. On the joint return he files with his spouse their total taxable income is $200,000. Because the income is below the $315,000 limit, the qualified business income deduction is $8,000 ($40,000 in qualified business income x 20%).
Taxpayer No. 2 also earned $40,000 in qualified business income, but she files single. After deductions are made, her taxable income is $20,000. The qualified business income deduction is restricted because her taxable income ($20,000) is lower than her qualified business income ($40,000). Her qualified business income deduction is $4,000 ($20,000 taxable income x 20%).
Taxpayer No. 3 has $25,000 qualified business income from being a partner in a partnership. When this income is combined on the joint return the taxable income is $325,000, which is over the $315,000 limit. This means the deduction will be reduced, but by how much depends on whether the partnership is a specified services trade or business.
This is where it gets more complicated (WHYs) and under what conditions (WHEREs) come into play. For more information about the intricacies of the qualified business income deduction, contact a local H&R Block tax professional. To find the nearest H&R Block tax office, visit www.hrblock.com or call 800-HRBLOCK.
Learn how H&R Block’s free tax reform checkup can help taxpayers prepare for tax reform impact now before it’s time to file and too late to change anything.
Learn whether tax reform will mean a larger or smaller tax refund this year with H&R Block’s tax refund and tax reform calculator.