How does the new IRS Qualified Business Income deduction work?
by: Anthony Parent
The 2017 Tax Cuts and Jobs Act (otherwise knowns as the 2017 tax reform) includes a fantastic tax benefit for many entrepreneurs, self-employed individuals, and investors by allowing them to deduct 20% of their business income. The problem is that the rules are incredibly complicated. In this article, we will explain the basics of how it works and under which circumstances you may want to consult with a tax advisor so that you can best take advantage of this new tax break.
A very basic example of how QBI works
For this hypothetical, let's assume a taxpayer makes $300,000 in profit as a self-employed civil engineer, and he files jointly. This engineer is able to deduct 20% of his profit, in this case $60,000 from his tax return. So even before any other deductions or the standard deduction, he is taxed on not $300,000, but $300,000 less 60,000 for a taxable income of $240,000.
Based on the revised tax brackets, the marginal tax rate at play in this example is 32%, meaning the QBI for this engineer is worth $60,000 x .32 = $19,000. QBI has saved this taxpayer $19,000 in taxes.
A taxpayer with larger QBI stands to gain even more. For example, $10,000,000 in profit would qualify for a $2,000,000 deduction. At a top tax rate of 37%, this translates into a $740,000 tax savings.
Do I need to convert to or be an S-corporation to take advantage of QBI?
No. This is confusing because the original break proposed by Congress was a lowered pass-through (S-corp) taxation rate of 25%. However, this did not make it into the final bill. Instead, partnerships, sole proprietors, trusts, and S-corps owners can all take advantage of the 20% QBI.
What is a Specified Service Trade or Business?
A Specified Service Trade or Business (SSTB) is not able to take advantage of QBI in the same way a taxpayer whose business income is NOT an SSTB can. An SSTB is any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletic, financial services, brokerage services, or any trade or business where the reputation or skill of one or more of its employees is the reason for the revenue. Also included are any trades or businesses involving investing and investment management, trading or dealing in securities, or partnerships. Engineers and architects were specifically exempted.
I am in a “Specified Service Trade.” Can I use the QBI at all?
Yes, as long as your adjusted gross income falls below a certain threshold. The magic number is $315,000 for married filing jointly, $207,500 for head of household, or $157,500 for single filers. If your AGI is at or below these figures, you can claim the QBI regardless if you are listed in a specific trade or service.
If your AGI is above these figures, it may make sense to consider some tax planning or strategies so that you can legally take advantage of QBI.
What is the top effective tax rate if I have unlimited QBI income?
The top effective tax rate for investors and business owner with QBI approaches 29.8%. This is a big improvement over the previously highest top tax rate of 39.6% and the new top tax rate of 37%.
Does rental real estate qualify as a business for QBI?
It can. The key is to make sure that you as landlord have more responsibly than just getting a check every month.
REIT (Real Estate Investment Trust) income may also have a 20% deduction under its own rules for QBI under Qualified REIT income, along with Qualified Cooperative Dividends and Qualified Publicly-Traded Partnership Income.
When do things get complicated with QBI?
If you aren’t already confused, the QBI deduction quickly gets even more complicated. Here are situations where the use of the deduction may be significantly impaired, or require additional planning or strategies:
Where income increases and you have an SSTB even though you have non-SSTB income.
Where you have multiple trades and businesses and some have losses.
Where one spouse has SSTB income and the other spouse does not, but total income is high.
Where income increases yet W-2 wages paid are low and/or the business is not capital intensive.
What should you do to maximize the use of QBI?
For our clients, especially those with worldwide income and other ventures, we are always looking for and implementing ways to maximize tax benefits through various structuring. It is important to understand that this new tax reform is ripe with loopholes that we and other practitioners continue to uncover. Some of these loopholes we believe are intentional.
To learn about what we can provide to you, we invite you to contact us for a complimentary strategy session.
We believe the more control our clients have, the better place the world is. It is our mission to help US taxpayers around the world make their IRS problems and tax bills a bit more manageable.