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Qualified business income determines deduction

ALBUQUERQUE, N.M. — I want to revisit what some of you may think is my favorite topic – the new 20 percent deduction for income from a qualified business. Today we’ll focus on very general planning for the deduction.

First, let’s review the basic facts. A taxpayer that is not a regular (“C”) corporation is entitled to a deduction for “qualified business income.” There is a limit on the deduction based on taxable income, but in the interest of simplicity we’ll just focus on the 20 percent deduction.

If a taxpayer has $200,000 of qualified business income, they get a deduction of $40,000 (20 percent of the $200,000). They can run the business themselves, through a partnership, or through an S corporation.

In addition to the taxable income limitation, there is a “threshold income” limitation. A threshold limit means the taxable income is above a threshold. This may seem like the taxable income limit I mentioned above, but it is different, so I will call it the threshold income limit.

The threshold is $315,000 married filing joint and $157,500 otherwise. The threshold has a range, which is up to $415,000 MFJ and $207,500 otherwise.

If a taxpayer’s income is below the threshold, I will call that person a “no-threshold taxpayer.” If the income is past the threshold (e.g., $415,000 MFJ), I’ll call that person a “full-threshold taxpayer.” If income is above the start of the threshold but not fully through it (e.g., $365,000 MFJ), I’ll call that person a “partial-threshold taxpayer.”

For no-threshold taxpayers, the QBID is 20 percent of QBI. If the income comes from a business, it does not matter what type of a business it is.

For full-threshold taxpayers, the QBID is zero if the business is a service business. For a non-service business, the deduction may be reduced to the greater of: (1) 50 percent of W-2 wages paid by that business or (2) the sum of 25 percent of the W-2 wages and 2.5 percent of the acquisition cost of depreciable property used in the business.

For partial threshold taxpayers, the QBID is lowered from 20 percent of QBI to the wage or wage/capital limit mentioned above, in proportion to how far along the taxpayer is within the phase-out range ($100,000 for MFJ).

Now, basic tax planning. If no threshold, just deduct 20 percent of QBI. You don’t care what the business does or how much it pays in wages or how much property it has.

If partial threshold, you want some W-2 wages or depreciable capital. This is so because the 20 percent of QBI deduction is reduced, but not completely, down to the wage or wage/capital limit. You don’t need wages or capital because you’ll still get some deduction, but you want these items.

If full threshold, you get nothing if you have a service business. Otherwise, you need wages or depreciable capital to prevent a zero deduction.

Partnerships can have W-2 wages, but not paid to partners. So for full- or partial-threshold taxpayers, an S corporation may be better if it allows you to pay W-2 wages to shareholders to increase the QBID. Again, no-threshold taxpayers don’t care whether there are wages.

For full-threshold taxpayers, and to some extent for partial-threshold taxpayers, service business classification is bad. A service business includes designated activities, and generally includes professionals like doctors, accountants, lawyers, and so on.

It also includes any business for which the skill and reputation of an employee is the principal asset. This will cause confusion and needs clarification.

But let’s say we have two business operations at a common location. One provides veterinary services, the other is a boarding facility for dogs and cats.

If the owner is a no-threshold taxpayer, he or she can aggregate the income from the operations. If a partial- or full-threshold taxpayer, they need to segregate the income (service and non-service) to maximize the QBID.

Segregation is not easy. There are common expenses that will need to be allocated in some reasonable fashion. This is a “cost accounting” problem and the “how to” is not known to many people.

If you have a business use this basic framework to initiate planning discussions with your tax adviser.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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