The Tax Cuts and Jobs Act, which was approved by Congress on December 22, 2017, brought about the reduction of tax rates for businesses and individuals. A large part of this reduction comes from a new deduction known as the Qualified Business Income Deduction which is designed to provide substantial tax benefit to individuals who have income from a partnership, S corporation, LLC or Sole proprietorship (a flow-through entity).

This deduction was created to bring individual tax rates in line with the new tax rate for U.S. corporations, which went from a graduated tax rate on net profits to a flat tax rate of 21% under the Act. Because individuals may have a higher tax rate than 21%, income that passes through to an individual from a flow-through entity could have been taxed higher than a corporation; and the whole concept for flow-through taxation would no longer work.

The solution for this problem is the new Qualified Business Income Deduction. Simply stated, this rule allows the net income from a flow-through to be reduced by up to 20%, thereby decreasing the taxable income and effective tax rate. But, as with many Acts, nothing is ever that simple. Two concepts that greatly affect the calculation of this deduction are: 1) Qualified Business Income and 2) Specified Trade or Business. The following represents a very basic discussion of these complex topics.

Qualified Business Income (QBI) is defined as the net income of the pass-through business after all business deductions have been claimed. However, net income specifically excludes:

  • Income from business conducted outside of the U.S.
  • Investment related income (i.e.: interest; unless directly allocable to the business, dividends, capital gains or losses, etc.)
  • Salaries to S corporation owners
  • Guaranteed payments to partners of a partnership or members of an LLC
  • Reasonable compensation of owners

As noted, the deduction is limited to 20% of the taxable income and is available regardless of whether you itemize deductions or take the standard deduction. If QBI results in a net loss, it is treated as a loss from a qualified business in the following year.

The deduction has certain wage limitations built in to deter high-income taxpayers from attempting to convert wages or other compensation into income eligible for the deduction.  In addition, the deduction can also be limited if it is a “Specified Trade or Business”.

A Specified Trade or Business  is defined as any business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. The only exceptions to this definition are engineering and architectural services. Generally, if the success of your business depends on you and not on something you sell, then you probably are considered to be a service trade.

Having a specified trade or business does not totally eliminate the deduction, but it does trigger a gradual elimination of the deduction for higher incomes at a lower threshold than a non-specified business as illustrated here:

accounting chart

While the 20% deduction is certainly a shining star of the new Act, the complexity requires a thorough discussion and analysis of individual circumstances as part of the business owners’ tax planning activities. 

For more information please contact
John Santucci