Learn how you can use QBI (Qualified Business Income) to lower your taxes…
After the tax cuts and jobs act of 2017, a popular buzzword or acronym that has crept up in the American lexicon is QBI or Qualified Business Income as it has the potential to lower the taxes for those who qualify.
In this discussion TheWealthIncreaser.com will try to explain what QBI is and show you ways that you can use this new tax change that occurred as a result of the tax cuts and jobs act of 2017 to reach your future goals more efficiently.
What exactly is QBI and why should I be concerned about QBI?
QBI stands for Qualified Business Income!
QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business as the result of the 2017 tax cuts and jobs act that occurred in the United States.
In laymen terms if you have income from a sole proprietor, partnership or other pass through entity you could potentially deduct 20% of the income and lower the taxes that you pay on your tax return.
The pass-through deduction is a personal deduction that you may take on your Form 1040 whether or not you itemize and the deduction is taken on line 9 (second page) of your Form 1040.
It is not an “above the line” deduction on the first page of Form 1040 that reduces your adjusted gross income (AGI).
Furthermore, the deduction only reduces income taxes, not Social Security or Medicare taxes so keep that in mind.
Can QBI be used for rental property?
The new Section 199A regulations make it clear that merely owning rental real estate that generates rental income is not a trade or business of being a real estate investor, and as such, wouldn’t qualify for the QBI deduction.
However, if you actively manage your rental real estate—there is the potential for some or all to be classified as QBI.
Who qualifiies for the QBI deduction?
If you are self-employed or your business qualifies as a pass-through entity, the Tax Cuts and Jobs Act says you may deduct up to 20% of your QBI on your federal income tax return if you meet the qualifications.
The QBI deduction is known as the pass-through entity deduction that you may have heard about!
The following would have to be subtracted out of your business income when calculating the QBI deduction:
* capital gains and losses
* dividends or interest
* annuity payments
* foreign currency gains or losses
* reasonable compensation for owner/employees of S-Corps
* guaranteed payments to partnerships and LLCs
Are there Income Thresholds?
The QBI Thresholds for the 2018 tax year are:
- $157,500 for single filers, and
- $315,000 for people filing joint returns
The numbers will be adjusted for inflation after the 2018 tax filing season.
Also, keep in mind that for certain businesses that provide services such as law firms, accounting firms, and doctors’ offices, the limitations are steeper and the deduction is phased out altogether when taxable income reaches $207,500 ($415,000 for joint filers).
Example 1:
You formed a new company in 2018 and operated as a sole proprietor.
During 2018, your w-2 wages total $82,183, you itemize, make IRA contributions and pay tuition and fees (both of which would be non-deductible due to your combined income exceeding the threshholds) and your businesses generates a loss of ($11,763) from business 1 and a gain of $196,987 from business 2.
Your QBI deduction would be $34,956 calculated as follows:
$196,987 gain from business 2 minus ($11,763) loss from business 1 equals net gain of $185,224 less 1/2 of self employment tax paid of $10,442 equals QBI deduction of $34,956.
You file jointly with your spouse for 2018, and the combined “taxable income” for the year for both you and your spouse, after subtracting out your itemized deductions of $24,765 and the QBI deduction or qualified business income deduction, is $198,084.
You have two dependents that allow you to claim the “credit for other dependents” of $1,000, and your other taxes total $20,912 which consist of self-employment tax of 20,883 and an additional medicare tax of $29 since AGI exceeded the $250,000 threshold for married filing jointly.
Your total tax would be $56,031 and with federal withholding of only $3,198 you would owe taxes in the amount of $52,833 for the 2018 tax year.
Deduction for Income Above $315,000 ($157,500 for Singles)
If your taxable income exceeds $315,000 if married, or $157,500 if single, calculating your deduction is much more complicated and depends on your total income and the type of work you do.
Your first step would be to determine whether your business falls within one of the following service provider categories:
- health (doctors, dentists, and other health fields)
- law
- accounting
- actuarial science
- performing arts
- consulting
- athletics
- financial services
- brokerage services
- investing and investment management, or
- trading and dealing in securities or commodities.
There is a final catchall category that includes any business where the principal asset is the reputation or skill of one or more of its owners or employees such as that of TheWealthIncreaser.com’s.
This likely includes many individuals who provide services not listed above.
Architecture and engineering services are expressly not included in the list of personal services.
Pass-through owners who provide personal services are not favored under the pass-through deduction.
They lose the deduction entirely at certain income levels.
There are no such limitations on pass-through owners who do not provide personal services and that discussion follows.
Deduction for Non-Service Providers (Income Over $315,000/$157,500)
If your business is not included in the list of service providers, and your taxable income is over the $315,000/$157,500 thresholds, how you figure your deduction depends on your taxable income.
Non-service Provider Taxable Income Above $415,000 ($207,500 for Singles)
If you’re a non-service provider and your taxable income is over $415,000 if married filing jointly, or $207,500 if single, your maximum possible pass-through deduction is 20% of your QBI, just like at the lower income levels.
However, when your income is this high a W2 wage/business property limitation takes effect.
Your deduction is limited to the greater of:
- 50% of your share of W-2 employee wages paid by the business, or
- 25% of W-2 wages PLUS 2.5% of the acquisition cost of your depreciable business property.
Therefore, if you have no employees or depreciable property, you get no deduction.
This is intended to encourage pass-through owners to hire employees and/or buy property for their business in order to stimulate the economy.
The business property must be depreciable long-term property used in the production of income—for example, the real property or equipment used in the business (not inventory).
The cost is its unadjusted basis—the original acquisition cost, minus the cost of the land, if any.
The 2.5% deduction can be taken during the entire deprecation period for the property; however, it can be no shorter than 10 years.
Example 2:
Example: David and Monica are married and file jointly. Their taxable income this year is $1,000,000, including $800,000 in QBI they earned from their nightclub business they own through an LLC or limited liability company.
They employed eight employees during the year to whom they paid $300,000 in W2 wages. They own their nightclub building outright and are not leasing.
They bought the nightclub building two years ago for $1.2 million and the land is worth $200,000, so its unadjusted acquisition basis is $1 million.
Their maximum possible pass-through deduction is 20% of their $800,000 QBI, which equals $160,000.
However, since their taxable income was over $415,000, their pass-through deduction is limited to the greater of:
(1) 50% of the W2 wages they paid their employees $150,000, or,
(2) 25% of W2 wages (75,000) plus 2.5% of their nightclub building’s $1 million basis (25,000) equals $100,000.
Since (1) is greater, their pass-through deduction for tax year 2018 is limited to $150,000–not $160,000 that was initially calculated above prior to the limitations being applied.
Many owners of pass-through businesses, especially landlords, have no employees, thus the 25% plus 2.5% deduction is of most benefit to them.
Conclusion:
We will conclude this discussion by defining what a pass through entity is and then reiterate how you can make the QBI deduction work better for you and your family.
Definitions:
Pass-through entity:
A pass-through entity is a business entity that passes through its income to the owners of the business. The owners then report the business income on their personal returns.
Generally, pass-through entities include partnerships and S corporations, but the qualified business income deduction also applies to other unincorporated entities such as sole proprietorships and single-member LLCs.
Partnership
S-Corporation
Sole Proprietorship
Single-Member LLC
Common Questions:
How can I make the Qualified Business Income Deduction work for me?
By becoming a business owner or continuing as a business owner with the right form of ownership (discussed above) you can deduct up to 20% of your qualified business income or, if lower, 20% of your taxable income net of any capital gain.
This deduction would be claimed on your individual tax return.
Generally, qualified business income refers to the business’s profits (income minus expenses).
Qualified business income does not include salary or wages paid to you–either as W-2 wages from an S corporation or guaranteed payments from a partnership.
This basic formula applies if the taxable income that business owners report on their individual returns does not exceed certain thresholds that were mentioned earlier–and will be presented again to further your understanding.
The thresholds for taxable income are:
$157,500 for single filers and $315,000 for people filing joint returns.
The numbers will be adjusted for inflation after 2018.
If taxable income does exceed these thresholds, the deduction factors in limitations relating to the wages the business pays to its employees and depreciable assets the business owns–also discussed above.
A key point to keep in mind – the latest pass-through business tax reform reduces “federal income tax” but does not reduce self-employment taxes for income from partnerships and sole proprietorships, or income for purposes of the alternative minimum tax.
How can I benefit throughout the year?
If you have the right form of business ownership and your income passes through on your federal 1040 return you can adjust your estimated taxes to account for this reduction in taxable income.
But, be sure to use caution because if you “underestimate” how much income you’ll earn in a year, the penalty for underpayment of estimated taxes can hurt you during filing time as you will be penalized.
In the examples presented above in this discussion “estimated taxes” were not taken into consideration and in both examples “a penalty” would more than likely apply for underpayment of estimated taxes!
If the new tax reform for pass-through entities sounds complex—you can increase your understanding by comprehending this article and site, gaining a real handle on your personal finances and hiring competent professionals if you now have a pass through entity or you anticipate having one in your future.
What is QBI?
The new qualified business income deduction provision in the Tax Cuts and Jobs Act (TCJA) gives a 20% deduction for qualified business income.
QBI is also called the section 199A deduction.
The goal of the legislation is to improve the benefits for flow-through entities and sole proprietors, who did not receive the major tax cuts that were given to C corporations (regular corporations) where their tax rate was reduced to 21%.
Whether the rule meets the goal remains to be seen. Any strategies you consider should be approached with caution as the new law has some grey areas.
However, you can review the basic rules and strategies and see how they may apply to you, and what questions you may want to explore further as you expand and grow your business.
What exactly is a qualified business?
A qualified business is any business except those “specified service businesses” and the income earned by an employee, from guaranteed payments or personal interest, dividends or capital gains.
The specified service businesses can be in health, law, accounting, consulting, brokerage services, financial services, and others, but exclude architects and engineers.
What forms of ownership qualify?
QBI is available to sole proprietors and owners of pass-through entities such as S-Corps, LLCs, and partnerships.
Are there any limitations?
QBI is subject to limitations based on the taxpayer’s income and the type of business they operate.
Service businesses face additional limitations, however non-service businesses face limitations based on:
(1) 50% of the W2 wages they paid their employees or,
(2) 25% of W2 wages plus 2.5% of their capital expenditures
W- 2 and depreciation limits apply to non-service businesses but they are always allowed a deduction of some amount if they qualify (contrast that with a service business where elimination of the deduction will occur at some income level).
Exactly how does a Qualified Business Deduction work?
The QBI deduction reduces your taxable income, but not your adjusted gross income and can be taken regardless of whether you itemize deductions on your tax return.
To get the full benefit of the deduction, and not be subject to further wage and capital limitations, taxable income must be no greater than:
$315,000 for married filing jointly (phases-out through $415,000);
and $157,500 for single or married filing separately (phases out through $207,500).
- If the pass-through entity owner is over the dollar threshold and a specified service business, it does not get the deduction; but if it’s a qualified trade or business it does, although it is subject to wage and capital limitation.
What is the amount of the deduction?
The deduction is the lesser of: 20% of the taxpayer’s qualified income, and a wage and capital limitation.
The wage and capital limitation is the greater of: 50% of the W-2 wages; or 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property–whichever is greater.
In addition, there is 20% deduction of REIT dividends and distributions from publicly traded partnerships.
What is the W-2 wage limit all about?
The W-2 wage limit minimizes the deduction if the business does not employ a substantial number of people relative to its size, or invest in a substantial amount of property under the “wage-and-property limit.”
Specified service businesses that rely primarily on the efforts of their owners or those with limited employee or capital investments will be affected the most and they may not be able to fully utilize the new qualified business income deduction.
In addition, there is an overall limitation on the deduction!
The limitation is the lesser of: the combined qualified business income, and 20% of any excess taxable income minus the sum of any net capital gain plus any qualified cooperative dividends.
The total amount cannot exceed the taxpayer’s taxable income (minus the taxpayer’s net capital gain) for the tax year.
How can I better qualify for the deduction?
If some portion of your qualifying business income comes from a “specified service business” you could:
- Redefine your business if done so legally
- You could consider spinning off portions of your business (separating the specified service business portion from the other qualified trade or business portion)
- You could consider operating as a real estate investment trust (REIT), which do especially well. There is only one level of tax, and shareholders are entitled to a 20% qualified business income deduction for ordinary distributions with no W-2 basis limitation. On the flip side, REIT compliance and maintenance rules are complicated.
- You could consider operating as a publicly traded partnership (PTP), which are not subject to the W-2 wage limit and qualified property cap.
- If you are participating in an S corporation, it may be beneficial to take advantage of reasonable compensation so that you could meet the 50% of wages limitation by paying out more in compensation.
- You could possibly rearrange your employer-employee relationship to one in which there is a partnership under an agreement in which the individual’s income from the partnership would be higher and their salary would be lower, thus making them (or you) eligible for the deduction.
- You could use a gifting strategy (give up a percentage of business ownership) to bring in more people that qualify under the “$157,500 per person threshold.”
- If you are in a partnership, consider switching from guaranteed payments, which don’t qualify, to preferred returns, which do.
- You could possibly increase the W-2 limit by switching from 1099 independent contractors to W-2 employees–think this process through carefully as there may be other negative effects as well.
- You could manage your total income and taxable income so it is below the phase-out thresholds in order to qualify for the deduction.
- You could manage your pension contributions to reduce taxable income as no part of the pension contributions would be included in income, so the QBI deduction could apply.
- You could make tax-deductible qualified retirement plan contributions to reduce your or your employee’s taxable income in order to qualify for the deduction.
- You can use your imagination to come up with other scenarios that might allow you to legally qualify for the QBI deduction–be sure to run it by your tax professional to ensure that it falls under the QBI guidelines.
In summary, The Tax Cuts and Jobs Act (HR 1, “TCJA”) established a brand new tax deduction for owners of pass-through businesses that can provide a tangible advantage for those who put themselves in position to qualify.
Pass-through owners who qualify can deduct up to 20% of their net business income from their income taxes, reducing their effective income tax rate by 20%.
This deduction begins for 2018 and is scheduled to last through 2025—that is, it will end on January 1, 2026 unless extended by Congress–as it was not made permanent in the manner that the 21% tax rate for corporations were.
If you are a small business owner–or desire to be one–you need to understand this somewhat complex, but highly beneficial deduction.
Always remember that:
You Must Have a Pass-Through Business
- a sole proprietorship
(a one-owner business in which the owner personally owns all the business assets)
- a partnership
- an S corporation
- a limited liability company (LLC), or
- a limited liability partnership (LLP).
As an owner you would pay tax on the money on your individual tax return (as opposed to corporate tax return) at your individual tax rates.
The majority of small businesses are pass-through entities.
Regular “C” corporations do not qualify for this deduction; however, starting in 2018 they do qualify for a low 21% corporate tax rate–that was made permanent and could be more beneficial–depending on your type of business, revenue generation and your intended goals for the business.
Therefore, if you are structuring a new business or have an existing business you must determine the best form of ownership from both a tax and liability position among other considerations that you may have to determine the best type based on your future goals and the direction that you desire to take your future.
Other Key Points:
QBI is determined separately for each separate business you own.
If one or more of your businesses lose money, you deduct the loss from the QBI from your profitable businesses.
If you have a qualified business loss—that is, your net QBI is zero or less–you get no pass-through deduction for the year.
Any loss is carried forward to the next year and is deducted against your QBI for that year.
This serves as a penalty for having a money-losing business.
Example: During 2018, you earned $20,000 in QBI from a lawn care business and had a $40,000 loss from your office store business.
You have a $20,000 qualified business loss, so you get no pass-through deduction for 2018. The $20,000 loss must be carried forward and deducted from your QBI for 2019.
You Must Have Taxable Income!
To determine your pass-through deduction, you must first figure your total taxable income for the year (not counting the pass-through deduction). This is your total taxable income from all sources (business, investment, and job income) minus deductions, including the standard deduction ($12,000 for singles, $18,000 for head of household and $24,000 for married filing jointly in 2018).
You must have positive taxable income to take the pass-through deduction!
Moreover, the deduction can never exceed 20% of your taxable income.
Example: You are a single taxpayer who run a consulting business which earned $80,000 in profit this year. You had no other income and you take the standard deduction ($12,000).
Your taxable income is $68,000 ($80,000 income – $12,000 standard deduction = $68,000).
Your pass-through deduction cannot exceed $13,600 (20% x $68,000 = $13,600). Even though you had $80,000 in QBI, your deduction is limited to $13,600, not 20% of $80,000 = $16,000 because you had no other income such as w-2 income.
If you have other income that allows you to take advantage of the full 20% deduction you can do so as long as your taxable income is below $315,000 ($157,500 for Singles).
If you exceed the above limits that is a good problem to have–just realize your QBI deduction may be limited or eliminated if you are a “service business owner” and you exceed the threshold limits.
Deduction for “Service Business Owners” (Income Over $315,000/$157,500)
If your business involves providing personal services, and your taxable income is over the $315,000/$157,500 thresholds, your pass-through deduction is gradually phased out up to $415,000/$207,500 of QBI.
And remember that if you fall at the top of the income range you get no deduction at all.
That is, if your total income is $415,000 if you’re married, or $207,500 if you’re single, you get no deduction. This was intended to prevent highly compensated employees who provide personal services—lawyers, for example–from having their employers reclassify them as independent contractors so they could benefit from the pass-through deduction.
There is no such phase-out of the entire deduction for non-service providers.
All the best toward your effective use of QBI and your future success…
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