The Tax Cut and Jobs Act introduced a major new tax deduction which many small businesses will benefit from. This includes business taxed as a partnership, S corporation or sole proprietorship. The deduction is equal to 20% of “qualified business income” from a pass-through entity or sole proprietorship. Qualified business income is defined as the net amount of income, gain, deduction, and loss with respect to a trade or business conducted within the U.S. However, certain investment income is not included, e.g., capital gains or losses, dividends, and interest income.
The deduction reduces taxable income and is available whether you itemize deductions or take the standard deduction. One limitation is that the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. Also, if your Qualified Business Income is less than zero, it is treated as a loss from a qualified business in the following year.
Phase Out
For business that provide “specified services,” the deduction will begin to phase out for taxpayers with taxable income above $157,500 ($315,000 for joint filers). “Specified services” are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. This is a significant limitation and will limit the tax benefit for certain service based businesses.
In addition, a secondary phase-out could apply to taxpayers with taxable income more than the above thresholds based either on (1) wages paid or (2) wages paid plus a capital element. In brief, here is how it works: If your taxable income is at least $50,000 ($100,000 for married filling joint) above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of your allocable share of the W-2 wages paid by the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of depreciable property used in the business (including real estate).
There are numerous additional complexities surrounding this significant new deduction. This article provides you a good foundation to the topic. If this deduction applies to you, consider contacting a tax professional to help you work through all the mechanics of the deduction and how it applies to your business.