Since the recent signing into law of the Tax Cuts and Jobs Act on December 22, 2017, the CK team has received many inquiries about its effect on future tax burdens. According to a recent survey from HubSpot, 88.5% of small businesses don’t understand the full impact of the tax bill. It’s apparent that business owners are seeking more clarity. As your trusted business advisors, we hear you loud and clear. To help you get through this transition, we will be posting our latest insights into the effects of the new law. You can subscribe here to receive our weekly email updates.
Last week, we discussed the Qualified Business Income (QBI) deduction for “specified service” businesses. For those businesses, the phaseout of the QBI deduction is aggressive – phasing out completely at taxable incomes above $415,000 for married filing jointly taxpayers and $207,500 for all other taxpayers. But what happens if your business is not a “specified service”?
Although the computation is more challenging in this case, the good news is that the phaseouts are not as aggressive as for specified service businesses. As we spelled out in a prior blog, QBI is the lesser of:
- 20% of the taxpayer’s QBI or
- The greater of:
- 50% of the W-2 wages paid by the business, or
- 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of all qualified property.
What is the “unadjusted basis of all qualified property”? Qualified property is defined as tangible property subject to depreciation (inventory does not qualify) that is used in the production of qualified business income. The unadjusted basis means tax basis before tax depreciation. However, there is a special rule that excludes property where the depreciable period ended before the last day of the tax year. Further discussion of this point is beyond the scope of this article. Please contact us directly for more information.
Here’s an example:
A manufacturing company that is 100% owned by one married individual has: QBI of $500,000; paid company wages of $1,000,000; $100,000 of unadjusted basis in qualified property; and the individual has taxable income of $550,000. QBI is the lesser of:
- 20% of the taxpayer’s QBI ($500,000 * 20%) = $100,000 or
- The greater of:
- 50% of W-2 wages paid ($1,000,000 * .5) = $500,000, or
- 25% of W-2 wages paid ($1,000,000 * .25) = $250,000 plus 2.5% of unadjusted basis ($100,000 * .025) = $2,500 yields $252,500
In this case, the QBI is $100,000 as the manufacturing company’s wage limitation was much more than 20% of the QBI. The individual receives the full 20% QBI deduction despite having taxable income over the thresholds.
The key takeaways for all businesses considering the QBI are:
- For married individuals with taxable income less than $315,000 (or $157,500 for all other filing statuses), the 20% QBI deduction is not subject to the wage/asset threshold regardless of the type of business.
- For married individuals in “specified service” businesses, if taxable income exceeds $315,000 (or $157,500 for all other filing statuses), the 20% QBI deduction is phased out based on the amount of taxable income above the thresholds; the deduction is fully phased out at taxable income of $415,000 (married) or $207,500 (all others).
- For married individuals NOT in “specified service” businesses, if taxable income exceeds $315,000 (or $157,500 for all other filing statuses), the 20% QBI deduction is phased out based on the wage/asset thresholds discussed above. Even if taxable income thresholds are exceeded, the full QBI deduction may be allowable in a labor-intensive business.
- Allowing companies NOT in “specified service” businesses to use their unadjusted basis of assets as part of the QBI threshold computation will allow real estate ventures to qualify for the QBI, despite these generally not being labor-intensive businesses.
- Once the QBI deduction is computed, the individual taxpayer must still make sure that the QBI cannot exceed 20% of the excess of taxable income over the sum of any net capital gain. In other words, if there is no taxable income, there is no QBI.
As you can see, the provisions of the QBI are complex. We eagerly await regulations that will help define some of the terms of the deduction. Cray Kaiser will keep you informed as we learn more. If you would like to discuss the QBI deduction in more detail, please call us at 630-953-4900.