The Tax Cuts and Jobs Act law was purported as being an act to simplify the tax code. Some of the provisions of the bill did make things a bit simpler, especially with respect to itemized deductions. However, when it comes to changes to how “pass-through” income is taxed, the new law has added a new layer of complexity.
This complexity is related to a new deduction for “Qualified Business Income” (QBI) which was included as part of the tax law. This deduction reduces taxable income by up to 20% on certain pass-through income (QBI) from a partnership, S corporation, LLC, sole proprietorships and rental properties. Note: This was done to provide smaller businesses with a tax break the way the tax on large corporations was reduced from 35% to 21%.
A 20% deduction for all pass-through income? Who cares if it is complex? That sounds like a fantastic change to the tax law. That is true, but the complexity factors in because there is a tangle of exceptions, phase-outs, phase-ins, limitations and nebulous terms that might or might not apply to a taxpayer who thinks that he might have QBI. For instance:
- Investment Income: Certain types of investment-related items are excluded from QBI, for example, capital gains and losses, dividends, and interest income (unless the interest is properly allocable to the business.)
- Service Related Businesses: Taxpayers in service related businesses may be ineligible for the QBI deduction. If the taxpayer's taxable income exceeds a threshold amount of $157,500 ($315,000 in the case of a joint return) their QBI deduction is phased-out. Note: “Service related” is defined as services such as healthcare professionals, law, accounting, actuarial science, performing artists, consulting, athletics, financial services, brokerage services, partnership interests or commodities, and 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. Engineering and architectural service provider income is specifically exempted from this restriction.
- QBI deduction limitation: Taxpayers whose taxable income exceeds the threshold amount of $157,500 ($315,000 in the case of a joint return) are also subject to limitations based on the W-2 wages and the adjusted basis in the business qualified property. Note: the QBI deduction is limited to the lesser of: (a) 20% of the taxpayer's QBI or (b) the greater of (I) 50% of the W-2 wages relating to the business or (II) the sum of (i) 25% of the W-2 wages relating to the business and (ii) 2.5% percent of the unadjusted basis of the tangible depreciable business property.
- Non-US Business: QBI includes only income connected with a U.S. business.
Just looking at these few exceptions leads to a multitude of follow up questions about how these rules will be applied and the mechanics of the calculations that will take place on the tax return. That will happen over time as the IRS (who is responsible for the administration, education and enforcement of the law) takes what Congress has written and translates it into forms, instructions and regulation.
But, for those who can take advantage of the QBI deduction, it can certainly reduce the amount of taxes that they will have to pay.
Sidebar: Corporations are subject to “double taxation”. So even though the corporate tax rate has been reduced to 21%, dividends that are distributed to shareholders and owners are subject to up to another 23.8% of tax on the shareholder’s tax return.