Want to Maximize Your “Qualified Business Income” Deduction for a Pass-Through Entity?
Noncorporate taxpayers take note. For tax years 2018 through 2025, the IRS allows you to claim an income tax deduction for “qualified business income” (QBI) from a partnership, S corporation, or sole proprietorship – as long as you meet certain requirements.
Section 199A Deductions
Sec. 199A of the Internal Revenue Code allows noncorporate taxpayers to deduct 20 percent of their QBI from the above pass-through entities, along with 20 percent of the aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. The deduction is limited to the excess of your taxable income over your net capital gain for the tax year.
According to Thomson Reuters Tax & Accounting, claiming the QBI deduction is particularly advantageous when the pass-through entity has substantial W-2 wages and capital and equipment investments, especially high-headcount manufacturing businesses.
Let’s look at who qualifies for the QBI deduction and the tax strategies involved.
Specified service trades or businesses (SSTBs) in health, law, consulting, athletics, financial services, and brokerage services fields do not fully qualify unless the taxpayer’s taxable income is equal to or below the threshold amount of $157,500 ($315,000 for married individuals filing jointly). Those businesses completely fail to qualify if a taxpayer’s taxable income is above $207,500 ($415,000 for married individuals filing jointly). For 2019, the threshold ranges increase to $160,700 to $210,700 for singles and heads of households, $160,725 to $210,725 for married taxpayers filing separately, and $321,400 to $421,400 for joint filers.
If you are involved in an SSTB, you should estimate your 2018 and 2019 taxable income and consider shifting income as you approach the threshold range. Likewise, if your taxable income exceeds the threshold for the new deduction, consider incorporating the business or your business model away from an SSTB. In some situations, married couples may benefit from filing separately to avoid the SSTB limit, but note that there are many disadvantages to filing separately, making it essential to compare a couple’s total tax liability under both filing scenarios.
For taxpayers subject to the W-2 wages limitation, a QBI deduction cannot exceed the greater of:
- 50 percent of the W-2 wages of the qualified trade or business, or
- The sum of 25 percent of the W-2 wages paid with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition of all “qualified property” (certain tangible, depreciable property held by and available for use in the qualified trade or business at the close of the tax year).
This limit doesn’t apply for taxpayers with taxable income below the threshold amount, and application of the limit is phased in for individuals with taxable income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals).
An S corporation owner who qualifies for the QBI deduction (and where the W-2 wage limitation doesn’t impact his deduction) can increase his QBI deduction by minimizing the wages he is paid by the S corporation, but when the W-2 wages limitation does affect his deduction, he could increase the QBI deduction by increasing the wages he received from the business.
Within this same thinking, partnerships and sole proprietorships might benefit from converting to S corporations. And businesses subject to the W-2 wage limitation may also benefit from hiring employees instead of independent contractors.
Owners or investors of rental real estate whose taxable income exceeds the threshold amount should consider a REIT. Under Section 199A, a deduction for qualified REIT dividends (with qualified publicly traded partnership income) is not restricted by the income-based QBI deduction rules. As such, for high-income taxpayers, in most instances, REITs offer a deduction higher than directly-owned real estate.
Because the QBI deduction is only available in conjunction with a trade or business, direct ownership of rental property may or may not constitute a trade or business depending on the taxpayer’s level of activity. For REITs, even passive investment makes the taxpayer fully eligible for the QBI deduction, regardless of the investor’s individual level of activity in the enterprise.
Generally, owners of rental real estate with taxable income above the threshold amount will benefit from increasing the amount of their “qualified property” subject to the “2.5 percent of adjusted basis” rule described above. To meet that test, however, the property must be owned by the end of the tax year, so investors who wish to dispose of property might benefit from delaying the sale until the start of the next tax year, and those who want to purchase property should do so before the end of the tax year – as long as the property remains “qualified” by not violating anti-abuse rules, meaning that the taxpayer demonstrates that an acquisition or disposition of property was intended for a principal purpose other than increasing the passthrough deduction.
Tax laws are ever changing. If you have questions about your filing status, eligibility for the QBI deduction and other deductions, or choice of an appropriate business entity for tax purposes, please contact us to discuss your situation.