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Tax Cuts and Jobs Act: What is the New Qualified Business Income?

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The Tax Cuts and Jobs Act (“Act”) of 2017 provides for a new deduction for partners, shareholders, and other owners of pass-through entities, known as the Qualified Business Income Deduction (“QBI”). The QBI allows taxpayers to deduct up to 20 percent of domestic business income attributable to partnership, S Corporation, or sole proprietorship income (“PTE”).

The deduction limitation is the greater of:

  1. 50% of the W-2 wages paid by the business, or
  2. The sum of 25% of the W-2 wages paid plus 2.5% of the unadjusted basis of certain property the business uses to produce QBI.

Each percentage is applied to the partner or shareholder’s applicable percentage of the pass-through entity’s activity.

What is QBI?

QBI is the net amount of income, gain, deduction, and loss that is effectively connected with the conduct of a trade or business within the United States. Items not considered QBI include capital gain or loss, interest and dividends, guaranteed payments for services rendered, or publicly traded partnership income.

The QBI deduction applies to certain industries. Typically, it does not apply to specified service trades or businesses such as accounting, brokerage, consulting, or investment management. However, a modified QBI deduction can be claimed if taxable income is below certain thresholds -- $157,500 (single) and $315,000 (married).

To make the limitations applicable to real estate investment partnerships, which typically are not mainly wage-based, limitation B was created. This limitation applies to the unadjusted basis of qualified property. In order to be qualified property, the property must be depreciable tangible property held by the business at the end of the tax year and used to produce QBI.

Why QBI?

The QBI deduction was created to provide a similar benefit to the reduction in the corporate tax rate. Since pass-through income is taxed at the individual level, in many cases it would be taxed at a rate higher than the new corporate rate of 21%, with a maximum individual rate of 37%. The 20% reduction in income will be deemed to equate the taxation of owners of flow-through entities with corporate rates. (The net income tax rate applicable to flow-through entities will be 29.6%, which is 80% of the top individual rate of 37%).

The QBI deduction does not effect a taxpayer’s adjusted gross income, but rather, an adjustment to income after adjusted gross income is computed. Since QBI is an adjustment to taxable income, the deduction may be potentially limited, as the deduction cannot be greater than taxable income. The QBI deduction is similar to the Domestic Production Activities Deduction, as both deductions allow taxpayers to deduct a portion of their taxable income as it relates to business income. The Domestic Production Activities Deduction was repealed under the Act and basically replaced by the new lower rate regimes.

Potential Savings Example

Consider the following example: A taxpayer has $157,500 of income (not QBI) and files single. The federal tax liability would be $29,210. Using the same facts, however, assuming the income is from a flow-through entity and is QBI, the federal tax liability would be $22,226 -- a tax savings of almost $7,000.

With this new deduction, members and shareholders of PTEs may see a reduction in their tax liability.

Should you participate in a flow-through entity or have questions on how this new law will affect you or your company, please contact your Marcum tax advisor.

 
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