Last year’s tax overhaul created a new 20% deduction for small-business owners and the self-employed — but exactly who would qualify for it has remained something of a mystery.
Things have gotten a little clearer in the months since the Tax Cuts and Jobs Act became law in December 2017. If your total taxable income is under a certain limit, generally you’re good to go. The rules there are pretty straightforward. But if you’re over that limit, there are 184 pages of complicated IRS rules that determine whether your business qualifies and whether you get a full or partial deduction or none at all.
Here’s what you need to know:
You must have a ‘pass-through’ business
This deduction is for people who have “pass-through income” — that’s business income that you report on your personal tax return.
Qualified pass-through entities include:
- Sole proprietorship s.
- S corporations.
- Limited liability companies (LLCs).
You must have ‘qualified business income’
The deduction applies to what the new tax law calls “qualified business income,” or QBI, and which is defined as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business.” Broadly speaking, that means your business’s net profit.
But it also means that not all business income qualifies. QBI excludes:
- Capital gains or losses.
- Interest income.
- Income earned outside the U.S.
- Certain wage and guaranteed payments made to partners and shareholders.
Your income level matters
If your total taxable income — that is, not just your business income but other income as well — for 2018 is at or below $157,500 for single filers or $315,000 for joint filers, then you probably can help yourself to the 20% deduction on your taxable business income.
For taxpayers below the income limit, qualifying for the deduction ‘is fairly easy.’
“For those taxpayers, it actually is fairly easy,” says Jacob Kuebler, a certified financial planner and owner of Bluestem Financial Advisors in Champaign, Illinois.
But if your income is above these limits, now’s the time to reach for a bottle of aspirin.
Here’s why: Above those income limits, your ability to claim the pass-through deduction depends on the precise nature of your business. And even if your business qualifies, there’s a chance you won’t get to enjoy the full 20% tax break, as the deduction is phased out for some businesses.
“It’s once you start getting into those higher-income brackets that you have to start thinking more about the nature of your business,” Kuebler says.
If you’re over the income limit
If you’re over the $157,500 (or $315,000 for joint filers) limit, there are a few tests that determine whether you qualify for the deduction. One such test is this: Is your business a “specified service trade or business”?
If you’re a doctor, lawyer, consultant, actor, financial planner — and the list goes on — then your business is deemed a “specified service trade or business,” and many high earners in these fields won’t qualify for this tax break, because it disappears once you hit total taxable income in 2018 of $207,500 if you’re single, and $415,000 if you’re married filing jointly.
“It’s easier for the non-service businesses to qualify,” says Tim Steffen, director of advanced planning at Baird, a financial services company. “With a service business, you might lose access to the deduction just because of the nature of what you do.”
Tests for pass-through businesses over the income limit
If your business is a “specified service trade or business” and your income is from $157,500 to $207,500 (single filers) or from $315,000 to $415,000 (joint filers), there are some tests to determine whether you can claim the deduction, and, if so, whether it’ll be reduced.
The same goes if you own a business with pass-through income that’s not a “specified trade or business” and your taxable income tops $157,500 (single filers) or $315,000 (joint filers): There are tests that determine how much you can claim of the deduction.
Specifically, the amount of your deduction is based on a calculation tied to the amount of wages you paid to employees (including yourself), as well as the value of the property the business owns.
The higher those figures, the better your chances of being able to qualify for the deduction.
But it gets complicated, and fast. So if your tax situation falls into this area, now might be a good time to consult a tax professional. Or check out the IRS regulations for more details.
There are “enough complicated issues that it’s something you might want to discuss with your tax advisor rather than trying to figure out the deduction on your own,” says Mark Luscombe, a principal analyst at Wolters Kluwer Tax & Accounting.
How the deduction works
There are a couple of aspects of the new deduction to keep in mind:
1. There are actually two 20% figures. The deduction is worth up to 20% of your taxable business income. But it’s also true that when claiming this pass-through deduction, it can’t add up to more than 20% of your total taxable income.
Here’s how it works: You figure your business income and expenses on Schedule C, as normal. And you figure your adjusted gross income on Form 1040, as usual. Only after that do you start calculating this pass-through deduction.
On Form 1040, “the qualified business income deduction goes on Line 9, after adjusted gross income and separate from Schedule C,” Luscombe says. (One note: The IRS hasn’t yet published the final Form 1040 for 2018, so the actual line number could change.)
2. You can claim this deduction even if you don’t itemize. That is, if you use the standard deduction, this deduction is still available to you, Luscombe says. (Here’s how much the standard deduction is worth in 2018.)
Rules in flux
Note, too, that the rules governing this deduction are still just proposed rules. They aren’t yet final. Taxpayers are “allowed to rely on them until final regulations come out,” Luscombe says, “but there are also a number of points in there where the IRS is soliciting additional comments.”
Those points probably are of more concern for partnerships and other, more complex business structures, rather than sole proprietors.
But whatever the case, Steffen says, “The tax forms for this are going to be pretty complicated.”