This is not an easy deduction to understand, but we will do the best we can to simplify it for you. The 20% Qualified Business Income Deduction apart of the Tax Cuts and Jobs Act. It is also known as a Section 199A deduction.
Under the new law, after January 1, 2018 the owner of a:
- sole proprietorship reported directly on Schedule C
- rental activity reported directly on Schedule E
- S corporation, or
…is entitled to take a deduction equal to 20% of the “qualified business income” earned from the business.
Qualified business income is best described as the ordinary, non-investment income of the business. So we don’t include things like interest, dividend income or capital gains from the sale of property.
The deduction, however, is limited. It is limited to the LESSER OF:
- 20% of qualified business income, or
- 50% of the total W-2 wages paid by the business.
There is also an alternative limitation based on the owner’s allocable share of 2.5% of the unadjusted basis of certain business assets, but we’re not going to discuss that today.
It is important to note the “50% of W-2 wage limitation” because sometimes it will apply to you and sometimes it may not apply. It will apply to you when and if the total TAXABLE INCOME of the business owner (you) is more than $315,000 for the year (if married, $157,500 if single). It is said that there is a short range of income in excess of these thresholds where the W-2 limitation is phased in, but by the time taxable income reaches $415,000 (if married, $207,500 if single), the “50% of W-2 wage limitation” applies in full.
So let’s look at an example of this so that we can shed some light on the subject and hopefully make clearer.
A Forbes article really had a great example- so we are listing their example here (The New ‘Qualified Business Income Deduction’ Varies Based On Your Business Type – Or Does It?)
“Example: A, a married taxpayer, operates a business as a sole proprietor. The business has one employee, who is paid $50,000 during 2018. The business has no significant assets. During 2018, the business generates $200,000 of income to A, and A’s total taxable income, after deductions, is $215,000. A is entitled to a deduction of $40,000 ($200,000 * 20%). The “W-2 wage limitation” — which would normally be $25,000 ($50,000 * 50%) does not apply because A’s taxable income is less than $315,000.”
It is also important to note that there are other exceptions that may disqualify your business to this deduction. So let’s take a look at the Specified service trade or business (what the IRS calls SSTB). This includes a trade or business that involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, sonsulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.
The trick to these SSTB’s is that you have to surpass the income limitations before the exemption kicks in. The amounts are $315,000 for the year if married and $157,500 for all other taxpayers. If you’d like to know more about this phase-in range please visit the IRS and look at Q6.