CH15: The Deduction for Qualified Business Income for Noncorporate Taxpayers
W-2 Wages Limit
"W-2 wages" includes the total amount of wages subject to income tax withholding, compensation paid into qualified retirement accounts, and certain other forms of deferred compensation paid to the employees of the business.35 For labor-intensive businesses, 50 percent of the W-2 wages paid by the business will likely be the relevant limit on the QBI deduction.
In general, the deduction for qualified business income is the lesser of :
1. 20 percent of qualified business income (QBI),14 or 2. 20 percent of modified taxable income.
Example 16: Return to the facts of Example 14, but assume that Tom and Eileen's taxable income before the QBI deduction is $366,600 (this is also their modified taxable income), QBI is $320,000, and W-2 wages are $100,000. Their unadjusted property basis remains at $500,000. Tom and Eileen's initial calculation yields a qualified business income amount of $50,000, computed as follows:
1. 20% of qualified business income ($320,000 × 20%) $64,000 2. But no more than the greater of: • 50% of W-2 wages ($100,000 × 50%), or $50,000 • 25% of W-2 wages ($100,000 × 25%) plus $25,000 • 2.5% of the unadjusted basis of qualified property ($500,000 × 2.5%)12,500$37,500And no more than: 3. 20% of modified taxable income ($366,600 × 20%) $73,320 Since Tom and Eileen's taxable income before the QBI deduction exceeds $326,600 but is less than $426,600 and the W-2 Wages/Capital Investment portion of the computation is capping the deduction, the general 20% QBI amount is used, but reduced as follows: 1.Determine the difference between the general 20% QBI deduction amount and the W-2 Wages/Capital Investment amount: General 20% QBI deduction amount$64,000Less: The W-2 Wages/Capital Investment Limit(50,000)Excess$14,000 2.Determine the Reduction Ratio: 3.Determine the Reduction in the W-2 Wages/Capital Investment Limit: 4.Determine Final QBI Amount: General 20% QBI deduction amount$64,000Less: Reduction in the W-2 Wages/Capital Investment Limit (5,600)Final QBI amount$58,400 Since the QBI amount ($58,400) is less than 20% of their modified taxable income ($73,320; $366,600 × 20%), they will be allowed a $58,400 deduction for qualified business income.
The W-2 Wages/Capital Investment Limit, which does not apply to taxpayers below the taxable income thresholds mentioned previously and is phased in as a taxpayer's income exceeds those thresholds, limits the 20 percent QBI deduction to the greater of:
1. 50 percent of the "W-2 wages" paid by the QTB, or 2. 25 percent of the "W-2 wages" paid by the QTB plus 2.5 percent of the taxpayer's share of the unadjusted basis immediately after acquisition of all tangible depreciable property (including real estate) used in the QTB that has not been fully depreciated prior to the close of the taxable year.
If, however, the taxpayer's taxable income before the QBI deduction is between these two amounts and the W-2 Wages/Capital Investment portion of the QBI deduction is capping the deduction, then the general 20 percent QBI amount is used, but reduced as follows:
1.Determine difference between the general 20 percent QBI deduction amount and the W-2 Wages/Capital Investment amount.38 2.Determine the Reduction Ratio. 3.Determine the Reduction in the W-2 Wages/Capital Investment Limit: Reduction = Difference [from (1)] × Reduction ratio [from (2)] 4.Determine QBI amount: 20% QBI deduction − Reduction [from (3)]
Once these thresholds are reached, § 199A imposes two independent limitations.
1.The QBI deduction is capped based on the percentage of the W-2 wages paid by the business (i.e., wages paid to its employees) or based on a smaller percentage of W-2 wages paid by the business and a percentage of the cost of its depreciable property used to produce QBI.32 2.The QBI deduction generally is not available for income earned from "specified service" businesses.33 "Specified service" businesses include doctors, dentists, lawyers, accountants, consultants, investment advisers, entertainers, and athletes (among others), but not engineers and architects.
Unlike proprietorships, partnerships, and S corporations, C corporations are subject to an entity-level Federal income tax. This results in what is known as double taxation.
A C corporation reports its income and expenses on Form 1120 and then computes tax on its taxable income using a flat 21 percent rate.3 When a corporation distributes its income, the corporation's shareholders report dividend income on their own tax returns; further, no corporate deduction is allowed for the dividends paid (discussed next). As a result, income that has already been taxed at the corporate level is also taxed at the shareholder level.
Double taxation stems, in part, from the fact that dividend distributions are not deductible by a C corporation. To avoid this, closely held corporation shareholders try to convert dividend distributions into tax-deductible expenses.
A common way to do this is to increase compensation to shareholder-employees. However, the IRS scrutinizes compensation and other economic transactions (e.g., loans, leases, and sales) between shareholders and closely held corporations to ensure that payments are reasonable in amount.
Architects and engineers are specifically excluded from this definition.
A de minimis rule excludes from the "specified services" rule a business that derives a small amount of its gross receipts from specified service activities (i.e., services income is less than 10 percent of gross receipts earned by the business).
Deduction for qualified business income
A deduction allowed for noncorporate taxpayers based on the qualified business income of a qualified trade or business. In general, the deduction is limited to the lesser of 20 percent of qualified business income, or 20 percent of taxable income before the qualified business income deduction less any net capital gain. There are three limitations on the deduction— an overall limitation (based on modified taxable income), another that applies to high-income taxpayers, and a third that applies to certain types of services businesses. § 199A.
Limited liability partnership (LLP)
A legal entity allowed by many of the states, where a general partnership registers with the state as an LLP. All partners are at risk with respect to any contractual liabilities of the entity as well as any liabilities arising from their own malpractice or torts or those of their subordinates. However, all partners are protected from any liabilities resulting from the malpractice or torts of other partners.
Limited liability company (LLC)
A legal entity in which all owners are protected from the entity's debts but which may lack other characteristics of a corporation (i.e., centralized management, unlimited life, free transferability of interests). LLCs generally are treated as partnerships (or disregarded entities if they have only one owner) for tax purposes.
W-2 Wages/Capital Investment Limit
A limitation on the deduction for qualified business income that caps the deduction at the greater of (1) 50 percent of the wages paid by a qualified trade or business or (2) 25 percent of the wages paid by the qualified trade or business plus 2.5 percent of the taxpayer's share of the unadjusted basis of property used in the business that has not been fully depreciated prior to the close of the taxable year. § 199A(b)(2)(B).
Limited partnership (LP)
A partnership in which some of the partners are limited partners. At least one of the partners in a limited partnership must be a general partner.
C corporation
A separate taxable entity subject to the rules of Subchapter C of the Code. This business form may create a double taxation effect relative to its shareholders. The entity is subject to the regular corporate tax and a number of penalty taxes at the Federal level.
Sole Proprietorships
A sole proprietorship is not a separate taxable entity. Rather, its operations are reported as part of the sole proprietor's individual income tax return. The owner of a sole proprietorship reports all business income and expenses of the proprietorship on Schedule C of Form 1040, with the net profit or loss from the proprietorship included in the taxable income of the individual proprietor. The proprietor reports all of the net profit from the business, regardless of any amounts actually withdrawn during the year.
Example 10: Assume that Abby is a single taxpayer who does not itemize deductions and operates a sole proprietorship. During 2020, her business generates $140,000 of business income, $40,000 of deductible business expenses (including her self-employment tax deduction), and $2,400 of interest income from her business deposits. She has no other sources of income. Abby's AGI is $102,400.
Abby has $100,000 of qualified business income ($140,000 − $40,000). The interest income does not qualify for the QBI deduction. Her modified taxable income is $90,000 ($102,400 AGI − $12,400 standard deduction). Abby's QBI deduction is $18,000, the lesser of: 1.20% of qualified business income ($20,000; $100,000 × 20%), or 2.20% of modified taxable income ($18,000; $90,000 × 20%). Abby's taxable income is $72,000 ($90,000 of taxable income before the QBI deduction less her $18,000 QBI deduction).
The Tax Reform Act of 1986 lowered the Federal corporate income tax rate from a maximum of 46 percent to 34 percent. This led many other industrialized countries also to lower their corporate tax rate.
After many years, most of these countries had lowered their rate below 34 percent, while the United States raised the top corporate rate to 35 percent. With U.S. companies facing increasing global competition, most members of Congress and U.S. Presidents favored lowering the corporate tax rate.
S corporations, which generally do not pay Federal income tax, are similar to partnerships in that ordinary business income (loss) flows through to the shareholders to be reported on the shareholder's separate returns.
Also like partnerships, certain items flow through from the S corporation to the shareholders and retain their separate character when reported on the shareholders' returns.
Coordination with Other Rules: The deduction for qualified business income operates along with other rules (e.g., how to determine business income). In other cases, Congress specified the treatment. For example, § 199A(f)(3) provides that the QBI deduction is allowed only for income taxes. As a result, the QBI deduction does not reduce the tax bases for self-employment taxes or the net investment income tax (NIIT).
Also, in computing an individual's alternative minimum taxable income (AMTI), qualified business income is not changed by any of the AMT's preferences or adjustments (like depreciation) that usually apply in determining AMTI.
Considerations for Partnerships and S Corporations
Although the earlier examples involved sole proprietors, the same result would occur if the business income was instead generated by a partnership or an S corporation. These entities will need to report information to their owners (on the Schedule K-1) to enable the owners to compute their QBI deduction. The QBI deduction will vary among owners even if they share equally in the net earnings of the partnership or S corporation because the taxable income of owners will vary.
Employee Turned Independent Contractor
An employee of an employer who becomes an independent contractor while providing substantially the same services (either directly or indirectly through another entity) to the same employer is presumed, for a three-year period, still to be an employee.47 The purpose of this rule is to prevent taxpayers from converting wages (non-QBI) into self-employment (or pass-through) income (QBI).
Character of Business Income Unlike other forms of business, the tax attributes of income and expense items of a C corporation do not pass through the corporate entity to the shareholders.
As a result, if the business is expected to generate tax-favored income (e.g., tax-exempt income or long-term capital gains), it may be better to choose a different business form.
Many owners of pass-through businesses, especially landlords, have no employees.
As a result, the 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of qualified property is most likely to affect them.
Check-the-box Regulations
By using the check-the-box rules prudently, an entity can select the most attractive tax results offered by the Code, without being bound by legal forms. By default, an unincorporated entity with more than one owner is taxed as a partnership; an unincorporated entity with one owner is a disregarded entity, taxed as a sole proprietorship or corporate division. No action is necessary by the taxpayer if the legal form or default status is desired. Form 8832 is used to "check a box" and change the tax status. Not available if the entity is incorporated under state law.
With the reduction in the corporate income tax rate to 21 percent in 2018, Congress needed to provide a means of reducing the taxes on businesses that operate in different business forms (e.g., sole proprietors, partnerships, and S corporations).
Congress accomplished this with the creation of the deduction for qualified business income (§ 199A), which applies to noncorporate taxpayers.
The partnership ordinary business income (loss) and the separately reported items are allocated to the partners according to the partnership's profit and loss sharing agreement. Each partner receives a Schedule K-1 that reports this information.
Each partner then reports these items on his or her own tax return. In addition, individual partners can claim the deduction for qualified business income (to the extent available) on their individual tax return (Form 1040).
Partnerships
Entity Tax Return: Form 1065 Taxation of Entity Income: No separate entity-level income tax. Partnership's income and expenses are allocated and reported (on Schedule K-1) to partners who report these items on their returns (e.g. Form 1040 for individual partners). Character of entity income and expenses retained at partner level. Individual partners eligible for deduction for qualified business income. Taxation of withdrawals/distributions from entity: Distributions to partners are generally not subject to separate tax. Employment Taxes: Some partnership allocations subject to self-employment tax.
Regular (C) Corporations
Entity Tax Return: Form 1120 Taxation of Entity Income: Corporate income tax applies. Flat rate of 21% on corporate taxable income. Taxation of withdrawals/distributions from entity: Character of entity income and expenses not retained at shareholder level. Instead, distributions to shareholders are generally taxed as dividend income. Preferential tax rates (0%/15%/20%) apply to qualified dividends. Employment Taxes: Compensation paid to shareholders/employees subject to payroll taxes.
S Corporations
Entity Tax Return: Form 1120S Taxation of Entity Income: Generally, no separate entity-level income tax. S Corporation's income and expenses are allocated and reported (on Schedule K-1) to shareholders who report these items on their returns (e.g. Form 1040 for individual shareholders). Character of entity income and expenses retained at shareholder level. Shareholders eligible for deduction for qualified business income. Taxation of withdrawals/distributions from entity: Distributions to shareholders are generally not subject to separate tax. Employment Taxes: Compensation paid to shareholder/employees subject to payroll taxes. Shareholder's allocated portion of entity income not subject to self-employment tax.
Sole Proprietorships
Entity Tax Return: None Taxation of Entity Income: No separate entity-level income tax. Proprietorship's income and expenses are reported on owner's Form 1040 (Schedule C). Character of entity income and expenses retained at owner level. Proprietor eligible for deduction for qualified business income. Taxation of withdrawals/distributions from entity: Withdrawals by owner are not subject to separate tax. Employment Taxes: Schedule C Income subject to self-employment tax.
W-2 Wages/Capital Investment Limit
For capital-intensive businesses (e.g., real estate), an alternate limit exists. It begins with 25 percent of W-2 wages paid by the QTB and adds to this amount 2.5 percent of the unadjusted basis (immediately after acquisition) of "qualified property."
At its most basic level, § 199A permits an individual to deduct 20 percent of the qualified business income generated through a sole proprietorship, a partnership, or an S corporation.12 As will quickly become apparent, § 199A uses the word qualified to modify many phrases.
For example, to determine the "qualified business income deduction," one has to understand the definition of a "qualified trade or business" and "qualified business income."
Determination of Unadjusted Basis Immediately After Acquisition (UBIA): UBIA generally will be the property's cost (under § 1012) when the property is placed in service. An addition or improvement to qualified property already placed in service is treated as separate qualified property on the date the addition or improvement is placed in service.
For purposes of the QBI deduction, property is not qualified property if it is acquired within 60 days of the end of the tax year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the QBI deduction.
Specified service trade or business
For purposes of the deduction for qualified business income, a specified service trade or business includes those involving the performance of services in certain fields, including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; services consisting of investing and investment management, trading or dealing in securities, partnership interests, or commodities; and any trade or business where the business's principal asset is the reputation of one or more of its employees or owners. § 199A(d)(2).
Qualified business income (QBI)
For purposes of the qualified business income deduction, it is the ordinary income less ordinary deductions a taxpayer earns from a qualified trade or business conducted in the United States by the taxpayer. Includes the distributive share of these amounts from each partnership or S corporation interest held by the taxpayer. Does not include certain types of investment income (e.g., capital gains or losses and dividends), "reasonable compensation" paid to a taxpayer with respect to any qualified trade or business, or guaranteed payments made to a partner for services rendered. § 199A(c).
Definition of a Qualified Trade or Business
For taxpayers who fall below critical taxable income thresholds established under § 199A (in 2020, $326,600 for married taxpayers filing jointly $163,300 for single and head-of-household taxpayers), the scope of a qualified trade or business (QTB) is broad. In general, it includes any trade or business other than providing services as an employee.
An even more complex setting is having multiple businesses—some "specified services" and others not.
Here, a QBI deduction is determined for each business and then combined. This "combined qualified business income amount" is then compared to the overall modified taxable income limitation.
A second complication exists if a taxpayer has a "specified services" business with taxable income before the QBI deduction in the phaseout range.
Here, in addition to the amount of QBI, W-2 wages, and unadjusted basis of property being subject to a limitation, the W-2 Wages/Capital Investment Limitation might also apply (provided the 20 percent QBI deduction is greater than the W-2 Wages/Capital Investment Limit). The following example illustrates the complexity.
State Taxes At the entity level, state corporate income taxes and/or franchise taxes apply to corporations. Some states impose a franchise tax on all business forms (including partnerships and S corporations).
If a business will be operating in multiple states, state taxes become more important (Chapter 24 discusses the taxation of multistate corporations). At the owner level, the income of sole proprietorships, S corporations, and partnerships (along with dividend distributions) is subject to state individual income taxation.
Treatment of Losses
If a taxpayer has a qualified business loss in one year, no QBI deduction is allowed, and the loss is carried over to the next year to reduce QBI (but not below zero).45 Further, if a taxpayer has more than one QTB and the net results of all businesses create a loss, the net loss is carried forward to the following year.
Under the Check-the-box Regulations, an unincorporated entity with more than one owner is, by default, classified as a partnership. An unincorporated entity with only one owner is, by default, classified as a disregarded entity (or DRE). A DRE is treated as a sole proprietorship if it is owned by an individual or as a branch or a division of a corporate owner.
If the entity wants to use its default status, it simply files the appropriate tax return. If it wants to use a different status or change its status, it does so by "checking a box" on Form 8832. Thus, an LLC (single or multi-member) can choose to be taxed as a C corporation and, if it otherwise qualifies, even elect S corporation status.10 Although an LLC does not typically pay Federal income taxes, LLCs are required to report and pay employment and excise taxes.
Example 18:
In 2020, a single taxpayer has modified taxable income of $193,300, of which $150,000 is attributable to an accounting sole proprietorship that pays wages of $100,000 to employees. The taxpayer has an applicable percentage of 40%, computed as follows: Applicable percentage = 100% - $193,300 - $163,300/$50,000 = 40% In determining includible qualified business income, the taxpayer takes into account 40% of $150,000, or $60,000. In determining the includible W-2 wages, the taxpayer takes into account 40% of $100,000, or $40,000.
In general, only individuals can be S corporation shareholders (no such limitation exists for partnerships). The S corporation ordinary business income (loss) and the separately reported items are allocated to the shareholders according to their stock ownership interests.
In addition, S corporation shareholders can claim the deduction for qualified business income (to the extent available) on their individual tax return (Form 1040).
Income and expenses of the proprietorship retain their character when reported by the proprietor. For example, ordinary income of the proprietorship is treated as ordinary income when reported by the proprietor, and capital gain is treated as capital gain.
In addition, a deduction for qualified business income is available for sole proprietors. In general, this deduction is 20 percent of proprietorship net income (or, if less, taxable income before the qualified business income deduction less any net capital gain) and is claimed on the proprietor's Form 1040 in determining taxable income.
One obstacle to lowering the Federal corporate income tax rate is that most businesses in the United States operate as sole proprietorships, partnerships, or S corporations, rather than as C corporations. These non-C corporation entities are pass-through entities, where the business income is taxed to owners (rather than being subject to double taxation).
In addition, the owners of these businesses are likely to recognize other forms of income. For example, a sole proprietor is likely to also have investment income and wages. As a result, determining how to tax the business income of pass-through entities in a manner comparable to that of a C corporation is challenging, as explained next.
In all cases, the § 199A deduction may not exceed 20 percent of the taxpayer's modified taxable income. Modified taxable income is taxable income before the deduction for qualified business income19 reduced by any net capital gain.
In computing modified taxable income, the term net capital gain includes both a net capital gain [the excess of a long-term capital gain over a short-term capital loss; § 1222(11)] plus any qualified dividend income.
Qualified business income 22 is defined as the ordinary income less ordinary deductions a taxpayer earns from a "qualified trade or business" conducted in the United States by the taxpayer (e.g., from a sole proprietorship).23 It also includes the distributive share of these amounts from each partnership or S corporation interest held by the taxpayer.
In determining QBI, all deductions attributable to a trade or business are taken into account.24 Relevant deductions include the self-employment tax deduction [§ 164(f)], the self-employed health insurance deduction [§ 162(l)], and any deduction for contributions to qualified retirement plans [§ 404].
Determination of "W-2 Wages"
In general, the term W-2 wages includes the total amount of wages [as defined in § 3401(a)] plus the total amount of elective compensation deferrals (under § 457) plus the amount of designated Roth contributions (§ 402A).
Tax Rates As noted earlier, a flat rate of 21 percent applies to corporate taxable income. The marginal rates for individuals range from 10 percent to 37 percent.
In many cases, taxes will be greater in the corporate form (as in Example 3). However, the corporate form of doing business presents tax savings opportunities when the applicable corporate marginal rate is lower than the applicable individual marginal rate.
Qualified property includes depreciable tangible property—real or personal—that is used by the QTB during the year and whose "depreciable period" has not ended before the end of the taxable year.
Land and intangible assets are not qualified property. The depreciable period for qualified property under § 199A is a minimum of 10 years.
Congress chose to adopt a deduction against qualified business income (QBI), allowing up to a 20 percent deduction on the qualified business income of noncorporate taxpayers. As a result, this deduction is potentially available to individuals, trusts, and estates.
Owners of partnerships and S corporations use relevant information provided to them from the entity (on their Schedule K-1 and related attachments) to calculate the deduction on their tax return (e.g., an individual's Form 1040).
Pass-Through of Losses C corporation losses are treated differently than losses of other business forms. A loss incurred by a proprietorship may be deductible by the owner, because all income and expense items are reported by the proprietor.
Partnership and S corporation losses are passed through the entity and may be deductible by the partners or S corporation shareholders. C corporation losses, however, are retained at the corporate level. If losses are anticipated, it may be better to choose a business form other than a C corporation.
Partnerships
Partnerships are not subject to a Federal income tax. However, a partnership is required to file Form 1065, which reports the results of the partnership's activities. Business income and expense items are aggregated in computing the ordinary business income (loss) of the partnership on Form 1065. Any remaining income and expense items are reported separately to the partners.
For individual shareholders, some of the double taxation effect is alleviated because dividends are generally taxed at lower tax rates.
Qualified dividend income is taxed at a rate of 15 percent (20 percent for high-income taxpayers; 0 percent for lower-income taxpayers).5 These rates also apply to long-term capital gains.
Subchapter S
Sections 1361-1379 of the Internal Revenue Code. An elective provision permitting certain small business corporations (§ 1361) and their shareholders (§ 1362) to elect to be treated for income tax purposes in accordance with the operating rules of §§ 1363-1379. S corporations usually avoid the corporate income tax, and corporate losses can be claimed by the shareholders.
Example 12: W-2 Wages Limit: Simone, a married taxpayer, operates a business as a sole proprietor. The business has one employee, who is paid $80,000 during 2020. Assume that the business has no significant assets. During 2020, Simone's qualified business income is $230,000, and her modified taxable income is $250,000 (this is also her taxable income before the QBI deduction).
Since Simone's taxable income before the QBI deduction is below the income threshold for married taxpayers filing a joint return ($326,600), the W-2/Capital Investment Limitation does not apply. As a result, Simone's QBI deduction is $46,000, the lesser of: 1.20% of qualified business income ($46,000; $230,000 × 20%), or 2.20% of modified taxable income ($50,000; $250,000 × 20%).
Example 14: Tom and Eileen are married and file a joint return for 2020. Their taxable income before the QBI deduction is $500,000 (this is also their modified taxable income). They have $400,000 in QBI from a restaurant they own (a two-member LLC that reports as a partnership). They employed four individuals (cook, bartender, and wait staff) during the year and paid them $150,000 in W-2 wages. They own the building in which the restaurant is located. They bought the building (and its furniture and fixtures) four years ago for $600,000, and the land was worth $100,000, so the unadjusted acquisition basis of the building (and its furniture and fixtures) is $500,000.
Since their taxable income before the QBI deduction exceeds the $426,600 threshold, the W-2 Wages/Capital Investment Limit comes into play. Their QBI deduction is $75,000, computed as follows: 1. 20% of qualified business income ($400,000 × 20%) $ 80,000 2. But no more than the greater of: • 50% of W-2 wages ($150,000 × 50%), or $ 75,000 • 25% of W-2 wages ($150,000 × 25%) plus $37,500 • 2.5% of the unadjusted basis of qualified property ($500,000 × 2.5%) 12,500 $50,000 And no more than: 3. 20% of modified taxable income ($500,000 × 20%) $100,000
These criteria did not resolve all of the problems that continued to arise over corporate classification. And when the states allowed the creation of LLCs, the IRS was deluged with inquiries regarding its tax status.
The Code does not identify LLCs as a business form. And state LLC laws differed (e.g., some allowed centralized management, but others did not). So the question was how these entities would be treated under Federal tax law.
Disregarded entity
The Federal income tax treatment of business income usually follows the legal form of the taxpayer (i.e., an individual's sole proprietorship is reported on the Form 1040); a C corporation's taxable income is computed on Form 1120. The check-the-box Regulations are used if the unincorporated taxpayer wants to use a different tax regime. Under these rules, a disregarded entity is taxed as an individual or a corporate division; other tax regimes are not available. For instance, a one-member limited liability company is a disregarded entity.
Phase-In of W-2 Wages/Capital Investment Limit
The W-2 Wages/Capital Investment Limit does not apply to taxpayers with taxable income before the QBI deduction less than the threshold amount ($326,600 for married taxpayers filing jointly; $163,300 for singles and heads of household). And if taxable income before the QBI deduction exceeds the threshold amount by more than $100,000 (married filing jointly) or $50,000 (all other taxpayers), the W-2 Wages/Capital Investment Limit must be used.
Limitations on the QBI Deduction
The basic application of § 199A becomes more complex once a taxpayer reaches certain taxable income thresholds. These taxable income thresholds—determined without regard to the QBI deduction—are $326,600 for married taxpayers filing jointly and $163,300 for single and head-of-household taxpayers in 2020.
Employment Taxes The net income of a proprietorship is subject to the self-employment tax (15.3 percent), as are some partnership allocations of income to partners. Alternatively, wages paid to a shareholder-employee of a corporation (C or S) are subject to payroll taxes.
The combined corporation-employee payroll tax burden must be compared with the self-employment tax in the proprietorship and partnership business forms. This analysis should include the benefit of the deduction available to a corporation for payroll taxes paid, as well as the deduction available to an individual for one-half of the self-employment taxes paid.
Taxpayers with Multiple Businesses
The deduction for qualified business income must be determined separately for each qualified trade or business.30 These independent calculations are then aggregated (becoming the "combined qualified business income amount"). This combined amount is then compared to the overall modified taxable income limit.
S corporation
The designation for a corporation that elects to be taxed similarly to a partnership.
Corporate versus Noncorporate Forms of Business Organization
The form of business organization is an important tax planning consideration. It affects the application of various tax rules including tax rates, deductions, tax accounting methods, and tax years. The decision on what form to use can change as a business grows. For example, in the early years of a business (when it is more likely to generate losses), a pass-through entity is usually desired so that individual owners can utilize the losses generated by the business. If instead the entity was a C corporation from the beginning, it would not be able to use the losses until later years when it generates taxable income.
The limited liability company (LLC) is a business form that blends some corporate form advantages into a flow-through entity. All 50 states and the District of Columbia have passed laws that allow LLCs, and thousands of companies have chosen LLC status. As with a corporation, operating as an LLC allows its owners (called "members") to avoid unlimited liability exposure, which is a primary nontax consideration in choosing a business form.
The tax advantage of LLCs is that qualifying businesses may be treated as proprietorships or partnerships for tax purposes, thereby avoiding the problem of double taxation associated with regular corporations.
Effectively, the QBI deduction—a from AGI deduction—is the last deduction taken in determining taxable income.16 Further, the deduction is available whether a taxpayer uses the standard deduction or itemizes deductions.
There are three limitations on the QBI deduction: an overall limitation (based on modified taxable income), another that applies to high-income taxpayers, and a third that applies to certain types of services businesses. The second and third limitations only apply when taxable income before the QBI deduction exceeds, in 2020, $326,600 (married taxpayers filing a joint return) or $163,300 (single and head-of-household taxpayers).
To ease this problem, the Check-the-box Regulations were issued by the Treasury Department.9 The Regulations enable taxpayers to choose the tax status of a business entity without regard to its corporate (or noncorporate) characteristics.
These rules simplified tax administration considerably and eliminated much of the litigation related to association (i.e., corporation) status.
A business can take into account any W-2 wages paid by another business provided that the W-2 wages were paid to "common law employees or officers" of that business.
This means that a business using a professional employer organization (PEO) to manage parts of its business (e.g., human resources) or to lease employees can use an allocable portion of the PEO's W-2 wages in determining its total W-2 wages. The business that actually paid and reported the W-2 wages must then reduce its § 199A wages by the same amount.
Corporations are governed by Subchapter C or Subchapter S of the Internal Revenue Code.
Those governed by Subchapter C are referred to as C corporations or regular corporations . Corporations governed by Subchapter S are referred to as S corporations.
Qualified trade or business
Used in determining the deduction for qualified business income (§ 199A). In general, it includes any trade or business other than providing services as an employee. In addition, a "specified services trade or business" is not a qualified trade or business. § 199A(d)(1)(B).
These limitations, discussed in more detail below, are fully phased in once taxable income (before the QBI deduction) exceeds $426,600 for married taxpayers filing jointly and $213,300 for single and head-of-household taxpayers.
Within the phase-in ranges ($100,000 for married taxpayers filing jointly; $50,000 for all other taxpayers), the limitations are each applied by comparing the amount of taxable income that exceeds the threshold amount to the appropriate phase-in range.
Qualified business income does not include certain types of investment income, such as:
•Capital gains or capital losses (including any net § 1231 gain included in capital gain and loss computations),27 •Dividends, •Interest income (unless "properly allocable" to a trade or business, such as lending), or •Certain other investment items. Nor does qualified business income include:28 •The "reasonable compensation" paid to the taxpayer with respect to any qualified trade or business, or •Guaranteed payments made to a partner for services rendered.
It was determined that an entity would be treated as a corporation if it had a majority of characteristics common to corporations.
•Continuity of life. •Centralized management. •Limited liability. •Free transferability of interests.
As noted in a few of the QBI deduction examples, some planning is possible to increase the deduction or perhaps to avoid losing the deduction.
•For taxpayers with taxable income above the pertinent thresholds, consider converting any contractor payments to employee wages to increase the 50 percent of W-2 wages limitation. •For a married couple who does not reside in a community property state and has "specified services" business income above the thresholds that allow a QBI deduction, determine whether it might be better to file separate tax returns, enabling the spouse with QBI to qualify for the QBI deduction. •Consider how businesses can be combined or separated, including perhaps placing one or more in separate legal entities, to increase the QBI deduction. •Employees might consider whether they can become self-employed in their field (which would enable the QBI deduction). As part of this consideration, the employee will need to consider whether it is possible to generate greater income tax savings via the QBI deduction (and other business deductions). Also important will be considering the effect of self-employment taxes and the need to provide health insurance and other benefits, as well as potentially incurring additional business expenses.
Nontax considerations may override tax considerations and lead owners to conclude that a business should be operated as a corporation. Here are some of the more important nontax considerations.
•Sole proprietors and general partners in partnerships face the danger of unlimited liability. That is, business creditors can file claims against the assets of the business and the personal assets of proprietors or general partners. State corporate law protects the personal assets of shareholders. •The corporate form of business provides a vehicle for raising capital through widespread stock ownership. Most major businesses in the United States are operated as corporations. •Shares of stock in a corporation are freely transferable; a partner's sale of his or her partnership interest must be approved by the other partners. •A corporation continues to exist even when a shareholder dies. Death or withdrawal of a partner, on the other hand, may terminate the existing partnership and cause financial difficulties that result in dissolution of the entity. This continuity of life is a distinct advantage of the corporate form. •Corporations have centralized management. All management responsibility is assigned to a board of directors, who appoint officers to carry out the corporation's business. Partnerships often have decentralized management, in which every partner has a right to participate in the organization's business decisions. Limited partnerships , though, may have centralized management.
Business operations can be conducted in a number of different forms including:
•Sole proprietorships. •Partnerships. •Trusts and estates. •S corporations. •Regular corporations. •Limited liability companies.
When comparing C corporations to other business forms, there are a number of factors to consider including:
•Tax rates, •Character of business income, •Business losses, •Employment taxes, and •State taxes. Each of these is discussed below.
For high-income taxpayers (in 2020, $426,600 for married taxpayers filing jointly; $213,300 for single and head-of-household taxpayers), § 199A excludes any "specified service trade or business" from the definition of a qualified trade or business.40 A specified service trade or business includes those involving:
•The performance of services in certain fields, including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; •Services consisting of investing and investment management, trading or dealing in securities, partnership interests, or commodities; and •Any trade or business where the business's principal asset is the reputation of one or more of its employees or owners.