Washington’s freshly signed Tax Cuts and Jobs Act of 2017 means a gamut of research and planning is fully underway for countless businesses and CPA firms across the nation. While the new tax law brings fresh opportunity, its infancy includes layers of complexity that will need to be addressed in a technical corrections bill and IRS interpretive regulations. Rather than attempting to address the unanswered nuances of the new legislation, let’s focus on one of the cornerstone provisions that is expected to be a major stimulus to our economy.
QBI – What is it?
As all major news networks publicized, the Tax Cuts and Jobs Act slashed corporation tax rates from 35% to 21%. However, in considering the taxation of corporate ownership, businesses must consider the tax that will also be paid when the corporation ultimately distributes profits to its shareholders. Upon calculation, one will find that the total tax (including the corporate and shareholder level taxes) is much closer to 39.80%, which is just 2.8% above the new top individual income tax rate.
In response, Congress created the Qualified Business Income (QBI) deduction (under new Internal Revenue Code Section 199A) for sole proprietors and owners of partnerships and Subchapter S corporations. When maximized to its full potential, this deduction allows these pass-through entities the opportunity to retain some of their competitive edge over the taxation of corporations. The QBI deduction allows a taxpayer to deduct up to 20% of the entity’s Qualified Business Income against the taxpayer’s taxable income (creating more profitable after-tax business outcomes, and a potential effective tax rate of 29.60%).
QBI is defined as “qualified items of income, gain, deduction, and loss are items of income, gain, deduction, and loss to the extent these items are effectively connected with the conduct of a trade or business within the U.S. under Code Sec. 864(c) and included or allowed in determining taxable income for the year.” Plainly speaking, QBI should include all ordinary taxable income derived from the domestic trade or business within each given tax year. However, the taxpayer’s QBI calculation must exclude investment income (interest, dividends and capital gains) as well as the taxpayer’s S corporation wages and/or the partner’s compensation (guaranteed payments).
Once the 20% QBI calculation is derived, it must be determined whether any of this will be disallowed due to an employee W-2 compensation and business assets threshold.
Who does it apply to?
While new Section 199A constructs the vehicle that the QBI deduction is able to flow through, old Code Section 1202(e)(3)(A) specifically defines which trades or businesses are not eligible. Other than a last- minute exclusion of engineering and architecture, ineligible trade or businesses under Code Section 1202(e)(3)(A) include:
“Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, 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 1 or more of its employees.”
Though Congress clearly identified certain businesses that do not qualify (largely service based businesses), Code Section 1202(e)(3)(A)’s general definition left much uncertainty regarding other service based businesses. Businesses will need to approach these classification guidelines patiently while waiting for the IRS to address these questions in upcoming technical correction legislation or IRS interpretive regulations.
Even with the aforementioned service business restrictions, Congress is generously allowing the 20% QBI deduction for all taxpayers with taxable income less than $315,000 (with a phase-out at $415,000).
Finally, in incorporating this new QBI deduction into your individual income tax return, you will note that there are other applicable thresholds, including the provision that the derived QBI deduction cannot exceed 20% of your taxable income without the consideration of capital gains income.
The Tax Cuts and Jobs Act has given businesses the unique (and potentially lucrative) opportunity of revaluating their current tax structure to determine what can best aid in the reduction of their tax liabilities. To this end, tax planning has become rather challenging. There are many provisions in the new tax law that give additional deductions associated with higher income levels (such as QBI and the Business Interest Deduction). Therefore, taxpayers must be wary of the opportunity to accelerate deductions in other areas, such as the very aggressive asset write-off provisions. An overly aggressive tax strategy can dilute the benefits of the other provisions. So, now more than ever, it is very important for all businesses to consult with their tax advisors in understanding how these new laws apply to them and to determine how best to take advantage of the provided opportunities.
Hayden T. Grahm, CPA, is Senior Manager – Tax Services at JTaylor. Hayden brings with him over 9 years of public accounting experience in many industries but retains a strong focus in entertainment, healthcare, oil/gas and real estate. He can be reached by email at firstname.lastname@example.org or by phone at 817.502.7723.