I wish high schools and colleges would teach personal finance. They could show young people things like how to do their taxes, which it seems like maybe 3-4% of the population knows how to do (and that’s being generous).
The U.S. federal tax code is around 4 million words and almost 75,000 page long. To say it can be confusing would be an understatement. Changes from the latest tax overhaul throw another wrench into this equation because now people must figure out how it affects them.
Whenever I have questions on these things I go to our firm’s resident tax expert, Bill Sweet.
I earn some income on the side through various avenues so one of the newest changes I’m most interested in is the Qualified Business Income (QBI) deduction rules for small businesses.
Bill was kind enough to provide the latest information on the topic along with some examples and a few clarifications on some questions I had.
This is Bill’s summary:
- Maximum deduction: 20% of net business income (after expenses), or 20% of taxable income (less capital gains), whichever is lower
- Applies to pass-through businesses (sole proprietor, partnership, LLC, S-corporation)
- If your taxable income (after deductions) is <$315,000 (married) / $157,500 (single) anyone with a small business can participate
- If your taxable income (after deductions) is > $415,000 (married) / $207,500 (single), you cannot participate if your business is engaged in:
5) Performing Arts
8) FINANCIAL SERVICES
9) Brokerage Services (securities only – does NOT include INSURANCE, REAL ESTATE)
10) Investment Management
11) Trading (of securities)
12) Appearance / Licensing / Endorsement Fees & Compensation
- If your taxable income (after deductions) is > $415,000 (married) / $207,500 (single), your deduction is limited to the extent of 50% of wages paid OR 2.5% of depreciable property placed in service (like a building for a real estate rental)
- If your taxable income is between $315,000 – $415,000 (married) / $157,500 – $207,500 (single), a phase-out applies
- QBI is calculated by each business, but then nets together for a total QBI deduction (this means that QBI is calculated at the business level, but the deduction is taken at the individual level)
- QBI losses carry forward (this is new) into future tax years
- Forming a separate business entity to hold support functions (admin, IT) won’t work — if >50% of the revenue for an entity comes from a prohibited business, it too is prohibited
- For a business that has different types of business (a software company that ALSO provides consulting services), there is a 10% threshold that applies, in that if a software business is 89% software sales & 11% consulting, all of the business income is ineligible for QBI because consulting makes up >10%
- If an employee from prior years is reclassified as a contractor ONLY to take advantage of QBI, the QBI may be denied under a creative interpretation of anti-abuse rules
Now for a few examples:
EXAMPLE A: A single client owns an RIA in an LLC, and is the sole owner. Earns $100,000 gross income vs. $20,000 expenses, for a $80,000 net income. Client can take $16,000 QBI tax deduction (20% of $80,000).
EXAMPLE B: Married client owns an RIA in an LLC, and is the sole owner. Earns $600,000 gross income vs. $100,000 expenses, for a $500,000 net income. Client is not eligible for QBI because their taxable income exceeds $415,000 ($500,000 net – $24,000 standard deduction = $476,000) and their industry (wealth management) is prohibited from QBI.
EXAMPLE C: Married client owns a restaurant in an S-corporation, and is the sole owner. Earns $1,000,000 gross income vs. $300,000 expenses, of which $100,000 is W-2 wages, for a $700,000 net income. Client can deduct a QBI of $50,000 which is the lesser of 20% of net income ($140,000) AND 50% of wages paid ($100,000 = $50,000), and restaurants are not prohibited.
EXAMPLE D: Married client owns a rental property. Earns $50,000 gross rents vs. $20,000 expenses, for a $30,000 net income. The property’s depreciable value is $500,000. Taxpayer’s other income is $470,000 for a total of $500,000. Client can deduct a QBI of $12,500 which is the lesser of 20% of net income ($30,000) AND 2.5% of depreciable property ($500,000 x 2.5% = $12,500), and real estate management is not a prohibited business.
And here are a couple of follow-up questions I had for Bill:
What group would be considered the biggest winner from this legislation?
I’d guess that rental real estate owners are going to be the largest single category of beneficiary because (a) there is a lot of valuable real estate out there, (b) lots of wealthy people own real estate, and (c) real estate entities appear to have a special provision in the code allowing them to participate.
There are limits to who can take the deduction making north of $415,000 since the 20% deduction was supposedly meant for small business. For many types of business, the deduction above the income limit is limited to 50% of wages paid, meaning that a business without any employees wouldn’t receive a deduction. But a second test that highly favors real estate allows for a deduction equal to 2.5% of depreciable property. For example, an owner of a $2M rental building would be eligible for a $50,000 deduction, even if they did not have any employees, while someone earning income from a non-prohibited service business such as an architect or engineer would not.
Real estate makes up about 12% of private GDP so this isn’t a small sector. Only manufacturing (20%) and professional services (13%) are larger.
What type of person/business would qualify for this who may not be aware of it?
One new category of workers that may not realize they qualify would be from the gig economy. So people who drive for Lyft or Uber and even Airbnb renters would be included.
So if you have a day job but supplemental income from self-employment, your side gig should be eligible for the 20% deduction as long as your income is below $315,000 (joint) or $157,500 (single).
Be sure to follow Bill on Twitter.
Now here’s what I’ve been reading this week:
- Adventure capital (kc roi)
- Something for a mid-life or market crisis (A Teachable Moment)
- Is this the longest bull market of all-time? (Irrelevant Investor)
- My yoga teacher decided to become a doctor (Belle Curve)
- A dozen lessons from Michael Batnick (25iq)
- Is loss aversion a fallacy? (Big Picture)
- Stock and bond correlations are regime dependent (Alpha Architect)
- What people will pay for (Reformed Broker)