The 2017 Tax Cuts and Jobs Act brought many changes. The new Section 199A qualified business income (QBI) deduction is one of the most welcomed. The QBI deduction allows pass-through businesses such as S corporations, partnerships, single member limited liability companies (LLCs), and sole proprietorships to deduct 20% of their qualified business income subject to income limitations.1
Once a taxpayer filing single reaches $163,300 of taxable income, their QBI deduction could potentially be reduced. Married filing jointly taxpayers are subject to the phaseout when their taxable income reaches $326,600.2 The top of the phaseout range is $50,000 and $100,000 above the aforementioned thresholds for single and married filing joint taxpayers, respectively.3 What’s worse is that the deduction is disallowed for QBI from “specified service trade or business (SSTB)” when a taxpayer’s taxable income is above the phaseout range.4 Health, law, financial services, performers, and accounting businesses are considered SSTBs.5
On a more positive note, non-SSTBs could potentially still receive the QBI deduction if a taxpayer’s taxable income is above the range. The deduction is, however, potentially subject to a reduction depending on the business’s W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of qualified property. The QBI deduction is the greater of (a) 50% of the W-2 wages or (b) 25% of W-2 wages plus 2.5% of UBIA of qualified property.4 An important note is that this figure could end up more than 20% of QBI. In that case, the QBI deduction is the lesser amount.
Let’s take a look at an example to see these provisions in action.
Assume a single employee sole proprietor that is considered an SSTB has $1,000,000 of QBI, no wages, and no qualified property. Unless the taxpayer has a lot of deductions to reduce taxable income, they would not be able to take the QBI deduction because they are an SSTB and have taxable income above the phaseout range. Assume the same facts except that the business is not an SSTB. In this case, the taxpayer would still not be allowed to take the deduction because they have no wages or qualified property. This is where the magical 28.57% W-2 formula comes in.
Now, assume the same facts except that this non-SSTB business is an S corporation and has $285,700 of wages. Now, the QBI drops to $714,300, which is the difference of $1 million of QBI in the first example and the new W-2 wage base. The new W-2 wage base was derived from taking the $1 million QBI and multiplying it by the magical 28.57% W-2 formula. As previously mentioned, the QBI deduction is the lesser of 20% of QBI or the greater of a) 50% of W-2 wages or b) 25% of W-2 wages plus 2.5% of UBIA of qualified property. In this example, 20% of QBI would be $142,860, and 50% of W-2 wages (this calculation is used because there is no qualified property) would be $142,500. These numbers “magically” match, except for a minuscule rounding error, and this is the purpose of the magical formula. It is a rule of thumb that eliminates guess-and-check mathematical calculations.
However, like many rules of thumb, this formula is not always appropriate. Here are three situations where using the magical formula is not a foregone conclusion.
Businesses with employees
The formula is useful when you are starting with a $0 W-2 wage base, but most businesses with employees pay some W-2 wages. The QBI deduction limitations use all W-2 wages, including the shareholder employee’s wages. Since businesses with employees will likely have some wages, the shareholder may be able to take a smaller wage while still maximizing the QBI deduction.
Partnerships and sole proprietors
The formula is typically used when trying to calculate how much to pay an owner. A partner or sole proprietor, however, does not receive W-2 wages and therefore would render the formula useless. Partners typically get their distributive share and/or guaranteed payments, which are not counted toward the W-2 wage base. On a side note, guaranteed payments actually reduce QBI.
Specified service trade or business
If a taxpayer with QBI from an SSTB has taxable income above the phaseout range, they cannot qualify for the deduction. Period. Therefore, it is unnecessary to apply the formula because the W-2 wage base is irrelevant. So, the formula is best used for non-SSTBs.
The new 199A deduction is fairly complex, and this magical formula is only one aspect of the deduction. While this formula is a useful tool, it may be unnecessary at times. The main takeaway here should be that some proactive tax planning should be done to maximize the QBI deduction.
- 26 US Internal Revenue Code § 199A(a).
- 26 US Internal Revenue Code § 199A(e)(2)(A).
- 26 US Internal Revenue Code § 199A(b)(3)(B)(i)(I).
- 26 US Internal Revenue Code § 199A(d)(3)(B).
- 26 US Internal Revenue Code § 199A(d)(2).
JAMES ENRIQUEZ, MST, CFP, EA, is a partner of Adaptive Tax Planning LLC (adaptivetaxplanning.com). He holds a master of science in personal financial planning and a master of science in taxation. He also holds the enrolled agent and certified financial planner designations. He can be reached at [email protected].