Understanding the Qualified Business Income Deduction

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.

When we recently discussed S corporations vs. C corporations, we touched upon the Qualified Business Income (QBI) deduction and how the deduction reduces taxes for S corporations. Besides corporate structure questions, the QBI deduction is what we receive the most questions about.

In short, the QBI deduction allows all taxpayers, other than C corporations, to deduct 20% of their qualified business income from their taxable income. Sounds simple, right? Unfortunately, this simple looking deduction is fraught with uncertainty as to which businesses are allowed the full 20% deduction.

Let’s start with some basics*. The QBI deduction…

  • is available for tax years beginning after December 31, 2017. As such, this will not affect the calendar year corporate tax returns you may be working on now.
  • replaces the domestic production deduction (DPAD). Generally, this was a 9% deduction for domestic producers.
  • is available even if your business is not a domestic producer (i.e. service business).
  • applies to qualified publicly traded partnership income.
  • flows from the business entity down to the individual owners/beneficiaries.
  • is a “below the line” deduction. It does not reduce your adjusted gross income (or your Illinois tax, accordingly).

The deduction is the lesser of:

1) The “combined qualified business income (QBI)” of the taxpayer, or
2) 20% of the excess of taxable income over the sum of any net capital gain

What is “combined QBI”? Well, it depends, as we will discuss in a moment. Ironically, “combined QBI” is the technical term for the deduction allowed.

“Combined QBI” is the lesser of:

1) 20% of the taxpayer’s QBI or
2) The greater of:
a. 50% of the W-2 wages paid by the business, or
b. 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of all qualified property.

You may be asking yourself, why didn’t anyone tell me about the wage limitation? Well, because the wage limitation doesn’t apply to all taxpayers. The wage limitation will not apply if your taxable income, as shown on your 1040, is less than $315,000 if you file married or filing jointly. Or, $157,500 if you use any other filing method.

Here’s an example:

You are the sole owner of an S corporation that provides consulting to other businesses. Your individual taxable income on the 2018 Form 1040 that you file with your spouse shows $300,000. $250,000 of that amount is generated by your S corporation, none of which is from capital gains.

QBI is the lesser of:
1) Your QBI (20% * $250,000) = $50,000, or
2) 20% of taxable income over net capital gain (20% * ($300,000 – $0)) = $60,000

You will show a QBI deduction of $50,000 on your 2018 Form 1040. Your net reported income would be $250,000 (= $300,000 joint income – the QBI deduction of $50,000).

What happens if your income is above the $315,000/$157,500 thresholds? Click here to read more. Please don’t hesitate to contact us at 630-953-4900 with any questions.

*Please note: For purposes of trying to keep this blog as simple as we can, we are ignoring certain QBI deduction provisions that do not apply to most of our clients.