When Is Service Business Income Eligible for the New QBI Deduction?
The IRS has issued much-anticipated regulations addressing the new deduction of up to 20% of qualified business income (QBI) from pass-through entities. The QBI deduction was a major piece of the Tax Cuts and Jobs Act that was signed into law in December 2017.
The deduction is available to eligible owners of pass-through entities for tax years beginning in 2018 through 2025. It's scheduled to sunset after 2025 unless Congress extends it.
While the QBI deduction regs are in proposed form, taxpayers can rely on them until final regulations are issued.
In this article, we focus on an important question that owners of pass-through service businesses are commonly asking: "Do I qualify for the QBI deduction?" The answer is: "It depends."
Important note: Architecture and engineering businesses aren't considered specified service trades or businesses (SSTBs).
Close-Up on Service Businesses
In general, an SSTB is any trade or business involving the performance of services in the following fields:
Before the proposed regulations were released, there was concern that the last SSTB definition in the preceding list could snare unsuspecting businesses, such as local restaurants with well-regarded chefs. Thankfully, the proposed regulations limit the last item on this list to businesses that receive fees, compensation or other income for:
Deduction Disallowance Rule for SSTBs
Status as an SSTB is critical. Why? QBI deductions based on income begin to be phased out when an SSTB owner's taxable income (calculated before any QBI deduction) exceeds $157,500, or $315,000 for a married joint-filer. Phaseout is complete when the owner's taxable income exceeds $207,500, or $415,000 for a married joint-filer.
Specifically, when the SSTB owner's taxable income (calculated before any QBI deduction) is between $157,500 and $207,500 ($315,000 and $415,000 for a married joint-filer), only the applicable percentage of the owner's QBI, W-2 wages and unadjusted basis immediately after acquisition (UBIA) of qualified property for each SSTB counts when determining the owner's allowable QBI deduction based on SSTB income. (See "Limitations Based on W-2 Wages and the UBIA of Qualified Property" above.)
In this range of income, the applicable percentage equals 100% minus the phaseout percentage. The phaseout percentage equals taxable income in excess of the threshold ÷ the $50,000 or $100,000 phaseout range.
So, if the owner's taxable income exceeds $207,500 (or $415,000 for a married joint-filer), the phaseout percentage is 100%. In that case, none of the owner's QBI, W-2 wages or UBIA of qualified property for any SSTB can be counted. Therefore, no QBI deduction can be claimed for income from any SSTB.
Important note: If the SSTB owner's taxable income (calculated before the QBI deduction) is below the phaseout threshold listed above, the allowable deduction from the SSTB is simply 20% of QBI from the SSTB.
Example 1: SSTB Disallowance Rule Applies
To illustrate when the disallowance rule might kick in, suppose you file as a single taxpayer and report taxable income (before any QBI deduction) of $187,500 for 2018. You have $125,000 of QBI from an SSTB that you operate as a single-member LLC that's treated as a sole proprietorship for tax purposes.
For simplicity, assume the W-2 wage and UBIA of qualified property limitations aren't a factor in calculating your allowable QBI deduction. So, your tentative QBI deduction from the SSTB is $25,000 (20% x $125,000).
Under the SSTB disallowance rule, your applicable percentage equals 100% minus the phaseout percentage. Your phaseout percentage equals 60% ($30,000 of taxable income above the $157,500 applicable threshold ÷ the $50,000 phaseout range). So, the applicable percentage in this example equals 40% (100% – 60%).
Therefore, you can count only 40% of the QBI from the SSTB. So, your QBI would equal $50,000 ($125,000 x the applicable percentage of 40%). And your allowable QBI deduction is only $10,000 (20% x $50,000 of QBI).
Example 2: Income below the QBI Threshold
Now, let's assume the same facts as in Example 1, except your taxable income (before any QBI deduction) is only $150,000. Since your taxable income is below the $157,500 threshold for the SSTB disallowance rule, you're unaffected by the rule. So, your QBI deduction from the SSTB is $25,000 (20% x $125,000 of QBI).
Example 3: Interaction of SSTB Disallowance Rule and the W-2 Wage Limitation
The calculations are even more complicated when your deduction is affected by both the SSTB disallowance rule and the other limitations based on W-2 wages and the UBIA of qualified property. For example, assume the same facts as in Example 1. But now, the W-2 wage limitation applies. (For simplicity, we'll assume that the UBIA of qualified property isn't relevant.)
For 2018, your business has $40,000 of W-2 wages. You can take into account only the applicable percentage (40%) of W-2 wages. So, you can count only $16,000 of wages (40% x $40,000).
Under the W-2 wage limitation, your allowable QBI deduction from the SSTB is $8,000 (50% x $16,000). That's lower than the $10,000 allowable deduction calculated under the SSTB disallowance rule in Example 1. So, your allowable deduction is only $8,000.
Example 4: Income above the QBI Threshold
Finally, assume the same facts as in Example 1. But now, your taxable income (before any QBI deduction) is $300,000. Your taxable income exceeds $207,500. So, the phaseout percentage equals 100%, and the applicable percentage of QBI and W-2 wages equals 0%. So, you're ineligible for a QBI deduction from any SSTB.
Antiabuse Rule for SSTBs
The proposed regulations also include an antiabuse rule intended to prevent service business owners from separating out parts of what would otherwise be an integrated SSTB to make income from the separated part eligible for the QBI deduction.
For example, an optometrist can't separate the practice's retail sales of vision-care items and then claim a QBI deduction for the income generated from the nonservice segment. For purposes of claiming the QBI deduction, all of the optometrist's income would potentially be subject to the disallowance rule for SSTBs, depending on the optometrist's taxable income level.
The Final Limitation
When claiming this deduction, there's an overall limitation to bear in mind: An individual's allowable QBI deduction can't exceed the lesser of:
We Can Help
The proposed QBI deduction regs are lengthy and complex. This article covers only one specific aspect of them, and not every detail has been covered. Your tax advisor can sort through your situation to help you maximize the QBI deduction.