Qualified Business Income Deduction & the Limitation on Service Businesses
If you are in business, you may have heard the 2017 tax reform law scuttlebutt about a new deduction called the qualified business income deduction (or 199A deduction). This provision allows up to a 20% deduction of qualified business income (QBI) from pass-through entities such as partnerships and S corporations (but not C corporations), as well as for the self-employed, from 2018 through 2025.
Needless to say, a potential 20% deduction is substantial, so there is great interest in who qualifies. While most typical businesses and many owners of rental property will qualify for the 199A deduction, an exception is made for some businesses known as specified service trades or businesses (SSTBs). For an SSTB, the answer to the question, "Do I qualify?" is a resounding "Maybe!"
An SSTB is any trade or business involving the performance of services in the following fields:
ï Health, law, accounting and actuarial science (heavy sigh here from your author),
ï Consulting,
ï Financial, brokerage, investing and investment management services,
ï Trading,
ï Dealing in securities, partnership interests or commodities,
ï Athletics and performing arts, and
ï Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
That last item is so vague that it caused concern about just who it might snare in its trap. For instance, could a popular self-employed fishing guide (hey, I live close to the Little Red River; don't judge me) be considered an SSTB since, after all, her skill and reputation is likely what make her in such demand?
Fortunately, subsequent regulations addressed this and limit the last item on this list to businesses that receive fees, compensation or other income for:
ï Endorsing products or services,
ï Using an individual's image, likeness, name, signature, voice, trademark or any other symbol associated with that individual's identity, and/or
ï Appearing at an event or on radio, television or another media format.
So, why does this matter, this classification as an SSTB?
The reason is that the 199A deduction for an SSTB begins to phase out when the SSTB owner's taxable income exceeds $157,500, or $315,000 for a married filing joint-filer.
Below these amounts, all is well and good, and the 199A deduction is fully allowed. But above these amounts, the deduction begins to phase-out, and is completely lost once taxable income exceeds $207,500, or $415,000 for the married filing joint-filer.
The loss of the deduction can be a major hit. I won't bore you with the math, but in certain cases, the simple increase of a married persons income by $100,000 coupled with the loss of the 199A deduction can result in extra income tax of over $47,000. That's almost a 50% effective tax rate on the extra income! Ouch!
Needless to say, that's a powerful incentive to do some planning to try to stay under the income threshold!
There are a couple of other caveats to know about in any discussion of this deduction.
First, even if you otherwise qualify for the full 199A deduction, there is an overall limitation that may come into play. An individual's allowable 199A deduction cannot exceed the lesser of:
ï 20% of QBI plus 20% of qualified real estate investment trust (REIT) dividends plus 20% of qualified income from publicly traded partnerships (PTPs), or
ï 20% of the individual's taxable income calculated before any QBI deduction and before any net capital gains amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).
Also, regulations provide an anti-abuse rule designed to keep SSTB owners from separating out parts of what otherwise would be an integrated business in an attempt to make the income from the separated part qualify for the deduction. In other words, maybe part of your business, if it was stand alone, would not be a SSTB, while the rest would be considered a SSTB.
For instance, a veterinarian may make retail sales of pet food and other pet supplies in addition to the service of providing medical care for animals. The anti-abuse rules serve to prevent the good doctor from claiming the 199A deduction on the nonservice segment of the business, but instead, all the vet's income is potentially subject to the SSTB disallowance rule depending on the vet's income level.
Got it? That's what I thought. If you are a taxpayer receiving business income through a pass-through entity or as self-employed (whether or not you are an SSTB), don't take a chance on running afoul of these complex rules or, more importantly, losing out on a valuable deduction. This is an area NOT to go it alone. Engage the services of a qualified tax professional to help you navigate the complex 199A rules!
