Qualified business income explained.
Congress has created a de facto rate reduction for small business owners. It’s known as the “qualified business income” (QBI) deduction, and it’s gotten a lot of attention. The best way to think of it is to envision two separate sets of QBI rules: one for businesses in households making less than $315,000 in taxable income (income after accounting for all deductions, including itemized deductions) per year, and one for everyone else.
If you’re married and your taxable income is less than $315,000 per year ($157,500 if you’re not married), the QBI rule is very simple: take your business profit (that is, net profit from a trade or business that flows from your Schedule C, E, or F) and claim a deduction for 20% of that amount. Simple and easy. Your business profit’s tax rate is thereby reduced by 20%.
It gets slightly more complicated if you’re just north of this income level. The 20% QBI deduction phases out as your taxable income approaches $415,000 if married ($207,500 if single).
It doesn’t matter what type of business you are in. It doesn’t matter if you have employees or not. You just get it. The great majority of small business owners will be able to claim this simple deduction as described above.
The “alternate” QBI is for more mature small businesses whose profits and other income put their 1040 taxable income north of this range. For these businesses and only these businesses, there are “guardrails” to deal with. They help to avoid high-income wage earners converting their W-2s into business 1099s and claim the QBI deduction in an attempt at tax evasion.
The first “guardrail” is that your business cannot be in a specified service trade, such as health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or 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.
If you’ve passed the first guardrail, it’s onto the second – the wages test. The QBI deduction for mature, non-service businesses is the lesser of 20% of profit or half the W-2 wages paid by the business. The idea here is to require that businesses actually be more than just earnings mechanisms for owners. It’s another way of testing to make sure that a business is not just a hidden salary of a sophisticated taxpayer in search of a QBI deduction. If a non-service business carries a sizeable payroll, chances are you’re in the clear for a QBI deduction.
Suppose you don’t have a lot of wages? Well, there’s another way to pass the second guardrail. The other way is to have a QBI deduction equal to the lesser of 20% of profit, or the sum of one-quarter of W-2 wages paid plus 2.5% of the unadjusted basis of qualified property. This alternate equation will be most useful to companies that have a lot of assets (especially real estate assets), but not a heavy payroll burden.
If a mature business passes through these two guardrails – the service income test and the wages paid test – they qualify for a QBI deduction. Assuming their business income is taxed at the top rate, that means a tax rate cut on business income from 37% all the way down to 29.6% (the lowest rate since the 1986 Tax Reform Act).
Some of our clients will easily know where they stand with the QBI tax and others will need some guidance. At DeHoek & Company, we schedule mid-year tax planning meetings with our business clients so that at year-end, their tax return is not a surprise, but a strategic document.
Our biggest piece of advice is to talk with your tax advisor or CPA. It’s important to note that all businesses will receive tax relief under the tax reform law, even those who don’t get a QBI deduction. The worst case scenario for a top tax rate business is that their business income tax rate declines from 39.6 percent under the old law to 37 percent today.