By Ryan J. McDonell, Tax Supervisor, O’Connor & Drew, PC
Many dealerships are still trying to understand how H.R. 1, the Tax Cuts and Jobs Act of 2017, is going to affect their businesses. In a recent article, we discussed depreciation changes that affect (among other things) floor plan financing. This time, we’ll address the new 20 percent pass-through deduction available on qualified business income (QBI) from partnerships, S-corporations and sole proprietorships beginning in tax year 2018. Subject to certain limitations and phase-ins, this deduction is a must-use tool for eligible taxpayers, including auto dealers.
What Defines “Qualified Business Income”?
The qualified business income (QBI) deduction can be taken on the individual taxpayer’s return and is available to both those who itemize or take the standard deduction. While the specifics of what counts as “qualified business income” are open to debate, operating income will generally qualify. This means you could be deducting up to 20 percent of the ordinary income from your Form K-1.
Despite a lack of detailed guidance from the Treasury Department and the IRS, there is enough information available that your business and your accountant should start planning accordingly.
As an example, income in the form of wages is not eligible for the QBI deduction. This means that taking large year-end bonuses could be depriving you of a healthy deduction. Keep in mind though, S-corporation owners must still take reasonable compensation. There are also payroll tax and state tax considerations to weigh in.
If a 20 percent deduction off the top of your income sounds too good to be true, it’s because it is. The tax reform legislation includes several limitations. It’s easiest to illustrate the deduction by looking at a simple example:
Example 1. Taxpayer is a shareholder in a qualified business, Operating Co. Taxpayer receives wages of $100,000 and a Form K-1 from Operating Co. with $300,000 of qualified business income. Taxpayer’s maximum deduction is 20 percent of QBI, or $60,000 ($300,000 x .20).
If net QBI from all qualified trades or businesses is a loss for the year, the loss carries forward and reduces future years’ deductions.
Example 2. In Year 1, taxpayer has a loss of ($25,000) from Operating Co. and cannot take a QBI deduction. In Year 2, taxpayer has QBI of $100,000 from Operating Co. Taxpayer’s maximum Year 2 deduction is $15,000 ([$100,000 x .20] – [$25,000 x .20]).
A wage limitation phases in for taxpayers with taxable income of $315,000 for married joint filers, or $157,500 for others. The QBI deduction for these taxpayers is the lesser of 20 percent of QBI, or the limitation, which is the greater of:
- Fifty percent of the taxpayer’s allocable share of W-2 wages paid by the qualifying business; or
- The sum of 25 percent of the taxpayer’s allocable share of W-2 wages and 2.5 percent of the allocable unadjusted basis of the qualifying business’ qualified tangible property.
Example 3. Taxpayer fully owns Operating Co. and is subject to the wages limitation. Operating Co. pays W-2 wages of $800,000 and has qualifying property including buildings and machinery of $2,000,000. The wage limitation is $400,000, which is the greater of $400,000 ([$800,000 x .50] or $250,000 [($800,000 x .25] + [$2,000,000 x 0.025]).
Specified service businesses begin to phase out of the deduction at $315,000 for married joint filers, or $157,500 for other filers. These businesses include those in the fields of health, law, consulting, athletics, financial services, or any business where the reputation of the owner is the primary asset. The deduction is completely lost for married, filing jointly taxpayers with taxable income of $415,000, or $207,500 for other filers.
Example 4. Taxpayer has taxable income of $420,000. Taxpayer makes $80,000 as a sole proprietor doing consulting work and has QBI of $300,000 from Operating Co. No deduction is allowed on the consulting income because it is a specified service business, and Taxpayer’s taxable income exceeds $415,000. Taxpayer may still be able to take a deduction on the income from Operating Co.
As a final limit, Taxpayer may not deduct more than 20 percent of his or her taxable income after subtracting net capital gains, but before deducting the QBI deduction.
Quick Recap and Highlights
- Deduct up to 20 percent of qualified business income from pass-throughs and sole proprietorships.
- Deducted on individual’s tax return, after adjusted gross income.
- Available for both itemized and standard deduction filers.
- Computed on an entity-by-entity basis.
- Qualified business income (QBI) includes items of income, gain, deduction and losses from a qualified trade or business.
- Net negative QBI results in a carryforward loss that reduces future years’ credits.
- Wage limitation in place for married joint filers with taxable income above $315,000 (or $157,500 for other filers).
- Specified service businesses completely lose deduction for married joint filers with taxable income above $415,000 (or $207,500 for other filers).
- Deduction cannot exceed 20 percent of taxable income, less any capital gains.
The QBI deduction rules are complex, but it’s a powerful tool for those who understand it. Don’t miss out on this new opportunity for savings: consult with your accountant to discuss how this deduction may impact your taxes.
Ryan J. McDonell joined O’Connor & Drew in 2014 and became a tax supervisor in 2017. Ryan provides tax and accounting services for a variety of clients, focusing on individual and corporate taxation.