Understanding the Business
When Congress passed the Tax Cuts and Jobs Act (TCJA) in 2017, it was one of the most sweeping changes to the federal tax code since the mid-eighties. One of the legislation’s major benefits was a 20 percent deduction on qualified business income (QBI) for pass-through entities (also referred to as the 199A deduction). Taking advantage of this deduction has the potential to greatly reduce a business taxpayer’s marginal federal tax exposure.
Do you qualify?
Pass-through entities are those in which business profits are taxed at an owner’s individual rate. Eligibility for the deduction depends on both the type of business and its taxable income. Many owners of sole proprietorships, partnerships, S corporations, LLC and some trusts and estates are eligible for the QBI deduction. Not all entities are treated the same regarding QBI. If a business is classified as a specified service trade or business (SSTB), the deduction may be limited, or may disappear once taxable income reaches a certain threshold. Income earned through a C corporation or by providing services as an employee is not eligible for the deduction.
An SSTB is considered to be any trade or business providing services in the fields of health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; investing and investment management; trading/dealing in securities, partnership interests, or commodities; or any trade or business where the principal asset is the reputation or skill of one or more of its owners or employees.
Non SSTBs: It is important to note that even within the definition of a SSTB, there are exceptions. Many single-owner and self-employed businesses are NOT considered to be SSTBs. Those generally not falling into the SSTB designation are: rideshare services, sales, engineering, architecture, real estate and property management, contracting, landscaping, childcare and eldercare, grooming (even of pets), notary services, and restaurants and food trucks. The categorization of consulting businesses can be a bit complicated, because the segment is so broad. If you provide counsel or advice to clients to help them achieve goals and solve their problems, then your business would be a SSTB. But, if you do not provide professional advice, you would NOT be considered a SSTB – such as those in educational training, or even fitness training.
How does it work?
Every year the IRS sets thresholds and phase-in ranges for QBI, which are adjusted for inflation. For instance, for 2022 returns, total taxable income will have to be under $170,050 for single filers or $340,100 for joint filers in order to qualify for the full deduction. Phase-in ranges apply above these thresholds, which could limit, or eliminate the deduction.QBI is defined as net domestic business taxable income. It disregards investment income, guaranteed compensation for a partner’s services to a partnership, payments for services rendered to the business, REIT or cooperative dividends, and income from publicly traded partnerships (PTPs). It is the net amount of qualified items of income, gain, deduction and loss from any qualified business, and generally this includes, but is not limited to, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans (e.g. SEP, SIMPLE and qualified plan deductions). The deduction is limited to the lesser of the QBI component plus any REIT/publically traded partnership (PTP) component or 20% of the taxpayer's taxable income minus the net capital gain. When an owner has multiple qualified businesses, the deduction is calculated for each, with the aggregate limited to 20 percent of overall taxable income. For SSTBs, both the thresholds and phase-in ranges apply. The SSTB exception does not apply for taxpayers with taxable income at or below the threshold amount (they may take the 20% deduction) and is phased in for taxpayers with taxable income within the designated phase-in range above that threshold. For taxpayers with taxable income above the phase-in range, no deduction is permitted with respect to any SSTB. Even for taxpayers with taxable income from non-SSTB entities which falls above the highest level of phase-in range there are some limitations to the deduction. For 2022, those top levels are $220,050 for single filers and $440,100 for joint filers with total taxable income from qualified businesses (non-SSTB), REITs and PTPs. For taxable income above these levels, the QBI deduction is based on a formula. The GREATER of 50% of W-2 wages is compared to 25% of those W-2 wages plus 2.5% of the acquisition cost of depreciable business property. The GREATER of this calculated number is compared to QBI. The SMALLER of these two numbers is the QBI deduction based on the formula.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Hart Vida & Partners recommends that you consult professional tax, legal and accounting advisors before engaging in any tax, legal and accounting action or transaction.
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