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Consideration of 20 Percent Deduction for Qualifying Business Income is a Must for Business Owners

September 25, 2018

There have been sweeping changes as a result of the new tax law and this is one that should not be overlooked by business owners. Congress reduced the top tax rate for “C” corporations from 35% to a flat tax rate of 21%, so it felt certain types of business
income from pass-through entities (e.g., S Corporations, Partnerships, Sole Proprietors, Trusts, and Estates), and the income of certain Cooperatives, should also get some form of tax rate reduction. However, instead of providing a lower tax rate for this type of business income, effective for tax years beginning after 2017, the New Law creates a new 20% deduction that is generally provided to noncorporate taxpayers receiving qualifying income. The provision was added under §199A of the Internal Revenue Code as
revised.

NOTE: While most new tax provisions primarily impacting businesses under the New Law
do not have an expiration date, this 20% deduction does expire after 2025!

Income Qualifying for the 20% Deduction

The following types of income generated by partnerships, S corporations, sole proprietorships, trusts, and estates may qualify for the 20% deduction: “Qualified Business Income,” “Qualified Cooperative Dividends,” “Qualified REIT Dividends,” and “Qualified Publically-Traded Partnership Income.” Please note that, of these four types of qualifying income, the most common will, in all likelihood, be “Qualified Business Income” (QBI). Consequently, the remainder of this discussion focuses only on QBI.

 

“Qualified Business Income.”

“Qualified Business Income” (QBI) is generally defined as the net amount of qualified items of income, gain, deduction, and loss with respect to “any” trade or business other than:

  1. Certain personal service businesses known as “Specified Service Trade Or Businesses” (described in more detail below), and
  2. The trade or business of performing services “as an employee.”

QBI does not include:

  • Dividends, investment interest income, short term capital gains, long term capital gains, income from annuities, commodities gains, foreign currency gains, etc.,
  • Reasonable compensation paid by a Qualified Trade of Business for services rendered to the taxpayer claiming the 20% deduction,
  • Any “guaranteed payment” paid to a partner for services actually rendered to or on behalf of the partnership, or
  • To the extent provided in regulations, any amount allocated or distributed by a partnership to a partner who is acting other than in his or her capacity as a partner for services rendered to a partnership.

Determining The Amount Of A Taxpayer’s 20% Deduction for a “Qualified Trade or Business Income”

Step 1 – Calculate the initial deduction amount with respect to the taxpayer’s share of each “Qualified Trade or Business.” The initial deduction amount for each “Qualified Trade of Business interest” is the lesser of:

1. 20% of the owner’s share of “Qualified Business Income” (QBI) from the owner’s interest in each “Qualified Trade or Business,” or

2. The owner’s share of the W-2 Wage and Capital Limitation (if applicable) for each such trade or business interest.

Step 2 –Total the initial deduction amounts from each “Qualified Trade or Business” interest. Add the initial deduction amounts in Step 1 for each “Qualified Trade or Business” interest. This is the taxpayers’ tentative deduction.

Step 3 – Apply overall limitation. The aggregate deductions computed in Step 2 cannot exceed 20% of the excess of the taxpayer’s “taxable income” over the taxpayer’s “net capital gains.”

To view the entire white paper published on the Davis & Hodgdon website please click here.

Davis & Hodgdon Associates CPAs has been assisting Vermont individuals and business owners with tax consulting and retirement planning for more than 25 years. Call our office in Williston 802.878.1963 or Rutland 802. 775-7132 to schedule a tax planning strategy session today.