The new US Federal tax law, known as the Tax Cuts and Jobs Act (TCJA) went into effect for the 2018 tax year. Many provisions are in place until 2025, unless the law is extended. The most significant change for small business is the Qualified Business Income (QBI) deduction also known as the 199A deduction or the 20% deduction for pass-through entities.
It is an up to 20% deduction with certain conditions. Yes really, up to potentially 20% of your business income tax free!
There are specific rules for specialized service trades or businesses known as SSTBs. A SSTB is a trade or business where the principal asset is the reputation or skill of one or more of its employees or owners, such as a professional service business. It includes services in the area health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management and trading. This post does not cover QBI rules for other types of businesses, which you can learn more about on the IRS website.
The sections below explain what income qualifies, what factors determine if you get this deduction and how much you get, examples to illustrate the deduction and where the deduction will appear on your individual tax return.
The QBI deduction applies to pass-through income only. Pass-through income comes from a sole proprietorship, Limited Liability Company (LLC) or entities taxed as a S-Corporation. A C-Corporation or Professional Corporation (PC) is not a pass-through entity and is not eligible for the QBI deduction, unless it has elected to be taxed as an S-Corp.
Qualified Business Income
Income must not only come from a trade or business, it must also be taxable income to qualify for the deduction. Taxable income is the income after business deductions, or the net income from the business, and after all deductions and credits.
The QBI deduction is not applied to personal income, guaranteed partnership income or from W2 wages. As will be discussed below, if your entity is taxed as an S-Corp you will have W2 wages. The W2 wages are not eligible for the QBI deduction.
Partnership income is pass-though income and is eligible, however, if a partnership agreement provides for guaranteed payments to the partners, the guaranteed payments are excluded from the QBI deduction. If you have guaranteed payments in your partnership agreement, speak to an attorney and consider revising your agreement to better take advantage of the QBI deduction.
Specialized Service Trade or Business (SSTB) limitation
The TCJA says that income from an SSTB does not qualify if it is above certain income limits. In other words, make too much and you lose part or all of the deduction. Income limits are the first factor to consider in determining if you will get this deduction.
Factor 1: Income limitations and eligibility
Total taxable income on your return determines if you are eligible to get all, a portion or none of the QBI deduction. The idea is that this deduction is not for high earning business owners.
The limits will be adjusted for inflation each year. Both 2018 and 2019 limits are listed below for each filing status. Find your filing status to determine what income limits permit you to be eligible. For example, if you are married and file jointly, you can ignore the single filer limits and vice versa.
Total taxable income limits for 2019 are divided into three categories as follows:
2019 filing single or head of household
Under $160,700 >> eligible for full 20% deduction
$160,700 to $210,700 >> partial deduction between 0-20%
Over $210,700 >> no deduction
2019 married but filing separately
Under $160,725 >> eligible for full 20% deduction
$160,725 to $210,725 >> partial deduction between 0-20%
Over $210,725 >> no deduction
2019 filing married jointly with a spouse
Under $321,400 >> eligible for full 20% deduction
$321,400 to $421,400 >> partial deduction between 0-20%
Over $421,400 >> no deduction
For 2020, the limitations for single and head of household filers begins at $163,300, and for married filing jointly the limitations begin at $326,600.
How it works: Your business income might only be $50,000 but if you have a highly paid spouse who earns $500,000 and you file jointly, if your taxable income after deductions and credits exceeds $421,400 in 2019, you will not qualify for the QBI deduction.
If you are single in 2019 and your taxable income is $50,000 you will be eligible for up to the full deduction. If your taxable income is $300,000 as a single filer you will not get this deduction.
The partial deduction is a pro rata reduction. Meaning that if you fall right in the middle of the "partial deduction" income range for your tax status, you will get 10%, or half, of the QBI deduction. Once you are in this middle range, the more you make, the less of a deduction you are eligible for until you hit the upper limit and there is no deduction.
Factor 2: Business income vs. taxable income
Now that we know the income limits that determine eligibility, there is one other factor to consider: how your business income compares to your total taxable income.
The idea with this step is that even if you are eligible for the full 20% deduction, you will only get to take it on income that is being taxed. If your income is not being taxed, there is no deduction for the non-taxed portion.
We are all eligible for at least the standard deduction on our IRS taxes but many of us get other deductions or credits like the child tax credit, and we may even itemize for more deductions. These lower our taxable income making more of our income tax free.
Another way to look at it is that the income limits listed above determine what percentage you are eligible to take (20%, less than 20%), while this second step determines which number on our tax return we will apply that percentage to.
How it works: You earn $50,000 net income from your service business but after the standard deduction your taxable income is only $37,800, the QBI deduction will be 20% of the LOWER number or $37,800 x 20% = $7,560.
Or you earn $50,000 net income from your service business and $20,000 from a W2 job. Now your total income is $70,000 and after you take the standard deduction your taxable income is $57,800. Because your business income is lower, you take 20% of the LOWER number or $50,000 x 20% = $10,000.
You always need to know two numbers for this step: your pass-through income and your total taxable income on your return. The QBI percentage is always applied to the lower of these two numbers.
Entities taxed as an S-Corporation
If your specialized service business is taxed as an S-Corp then you know you must take a reasonable salary for your work effort. This results in your income falling into one of two buckets: W2 salary which is not pass-through income and amounts earned over the W2 salary which are pass-through income. As mentioned above, W2 wages are not eligible for the QBI deduction.
How it works: Your specialized service business is taxed as an S-Corp. Your net income from the business is $50,000. You have determined a reasonable salary for your work is $35,000 and that is paid throughout the year via payroll. $50,000 net income - $35,000 W2 wages = $15,000 pass-through income. Your maximum QBI deduction will be $15,000 x 20% = $3,000.
S-Corps have other tax benefits to hopefully offset the loss of QBI. But if you are considering making a new S-Corp election ensure that your tax preparer has helped you calculate the costs and the loss of QBI deduction so they may be factored into your decision. If you want to learn more about the forms of business and how they are taxed, see the free Simple Profit Form of Business Webinar.
Where to find the deduction on your tax form
The QBI deduction appears on line 9 of the individual tax return, Form 1040.
There was significant confusion over this deduction at the end of 2018 and during the tax filing season, unfortunately with some tax preparers telling owners of SSTBs that they did not qualify for the QBI deduction even if they were under the income limits. If you owned a pass through entity in 2018 and you were under the income limits listed above, you can look at line 9 of your 2018 return to determine if you received the QBI deduction. If you did not and suspect you were eligible, ask your tax preparer to double check your prior year return.
Specialized service businesses have special rules related to the QBI deduction, however, as long as you are below the top income thresholds you qualify for some or all of this deduction. The QBI deduction relates to pass-through business income only and you do not get the deduction on W2 wages, guaranteed partnership income or other personal income. The deduction is up to 20% of your business income or total taxable income, whichever is LOWER. Once you fall into the middle range of income limits, the more you earn the less of the QBI deduction you are eligible to take. The deduction appears on line 9 of the Form 1040 individual return.
This 20% deduction is a significant boost for small business owners of pass-through entities. There are several steps to determine if you are eligible, what percentage you are eligible to take and which tax number the percentage is applied to. Be sure your tax preparer knows that you are an SSTB and if you fall below the upper income limits, that you get this important deduction on your return this year.
Questions: email [email protected]
Jennie Schottmiller, LMFT, CPA is a licensed marriage and family therapist who practiced as a CPA prior to becoming a therapist. She has an active solo therapy practice and offers courses to help small business owners with accounting, tax and financial analysis matters.
Disclaimer: This blog is for education only. Please consult with a qualified professional when you have any questions about your personal accounting, tax or legal situation. Information contained in this post is for informational purposes only and not intended to replace professional advice.