The TCJA, also known as the Tax Cuts and Jobs Act, came into being on December 22, 2017. It reduced the tax rate for C corporations from 35 percent to 21 percent while increasing the tax liability pressure on the owners of pass-through entities (S corporations, Sole proprietors, and partnerships). They now had to pay a higher tax than C corporations. To dissolve this problem, the government enacted Section 199A, also called Qualified Business Income Deduction (QBID).
This article is a complete guide for those who have a hard time understanding section 199A.
What is the qualified business income deduction?
Various calculations need to be made before finally deciding the tax return amount of a taxpayer. Qualified Business Income Deduction (QBID) is the last deduction made before finalizing the taxable income of a taxpayer. QBID is only applicable to a few trades and businesses with limited exceptions. This income deduction has nothing to do with employees of a company and concerns only businesses.
The pass-through entities are divided into two categories of businesses who are eligible for the deduction as per the relevant regulations:
- Specified service trades or businesses and
- Qualified trades or businesses. Only qualified trades or businesses.
We consider the income that is eligible for the deduction as Qualified Business Income (QBI). This income can generate from a sole proprietorship (reported on Schedule C of Form 1040), a partnership (reported on Form 1065), or an S Corporation (reported on Form 1120S).
The taxpayers are reported about their share of S corporation or partnership’s qualified business income and property on Schedule K-1.
Who qualifies for the QBI deduction?
Sec. 199A or QBID permits taxpayers other than C corporations to deduct 20% of their qualified trade or business. The taxpayers can take up to 20% deduction on Qualified Business Income earned through a sole proprietorship, S corporation, trust, or estate. It should be noted that no C corporations or wage worker avails the benefits of sec 199A.
Certain eligibility criteria determine whether one is eligible for availing the benefits of the Qualified Business Income Deduction. Single taxpayers whose 2018 taxable income falls below $157,500 and those filing for joint returns and have taxable incomes less than $315,000 are eligible for taking advantage of the deduction.
Components of Deduction
The deduction on Qualified Business Income has primarily two components:
- QBI Component:
20% of the Qualified Business Income generated through a qualified trade or business makes the deduction’s QBI component. But, there are certain limitations posed on the QBI component. These limitations are based on the type of business, the amount of W-2 paid, and also the unadjusted basis after acquisition (UBIA) of qualified property owned by the business.
These limitations are only applicable to taxpayers with income above a certain threshold. As of 2020, the income threshold is up to $210,700 and $421,400 for joint filing returns.
The deductions can be further reduced for patrons of the agricultural or horticulture sector.
- REIT/PTP component:
This deduction component is composed of 20% of the qualified REIT dividends and qualified PTP income.
Qualified REIT (Real Estate Investment Trusts) dividend refers to a dividend generated from a REIT received during a taxable year provided it is not a capital gain dividend and is not qualified dividend income.
Qualified PTP (Publicly Traded Partnership) income is a type of partnership where only limited shares are available to be traded. Qualifying PTP is only possible when 90% of the partnership income comes under IRS defined “qualifying” sources.
Both of these components need to be considered when calculating Qualified Business Income.
What is a Qualified Business Income (QBI) or taxable income?
Qualified Business Income or taxable income is the net amount of qualified income earned through gain, loss, and deduction from any qualified business or trade. But some other types of income, such as wage income or income earned as an employee, do not come under QBI. Income earned through service-based businesses does not count under taxable income for QBID.
Also, incomes paid to taxpayers for reasonable compensation, such as wages and guaranteed payments, do not come under QBI and are hence not eligible for deduction.
Which is a qualified trade or business?
A qualified business or trade is one that comes under the list of section 162 trade or business except for the following situations:
- The business comes under C corporations.
- The taxable income exceeds the threshold amount.
- The trade of business comes under specified services trades or business (SSTBs). An SSTB is a business or trade involving services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, investing and investment management, financial services, and trading. Other than these, the businesses involving in dealing with certain assets or any business where the principal asset includes the skills of one or more of its employees.
- The taxpayer works as an employee in a company.
How to calculate qualified business income deduction?
A taxpayer can only get a maximum of 20% of deduction on QBI. The deduction can also be less than 20% if the taxpayer is single and earns more than $160,700 or is married and has filed jointly and makes more than $321,400. There is no way a taxpayer can get more than 20% of QBID.
Following are the steps to calculate your qualified business income deduction:
Consider only your taxable income and not adjusted gross income (AGI). How is AGI different from taxable income? Subtract your deductions and personal exemptions from the adjusted gross income to get the taxable income.
If you own various qualified business, calculate the taxable income for each business for the tax year to find out the next QBI. In other words, combine the multiple sources of your income provided they all are qualified business or trades.
Apply the W-2 wages and qualified property limitation. W-2 wages are the total number of W-2 wages and the qualified property it has. It is the total W-2 wages the company pays to employees that are subject to tax withholding, elective deferrals, and deferred compensation.
After combining all qualified income sources and W-2 wages, you get the total deduction amount. 20% of this amount is the deduction you get, provided your income is less than the threshold income. If your net amount of total QBI during this tax year is under loss, the loss is carried forward to the succeeding tax year.