United States: Learning The Basics Of The QBI Deduction For Pass-Through Entities

Last Updated: September 17 2018
Article by Adam Guldan

The Tax Cuts and Jobs Act (TCJA) decreases the federal income tax rate for C corporations to a flat 21%, starting in 2018. However, manufacturers that are structured as sole proprietorships and pass-through entities (partnerships and S-corporations) are not eligible for this reduced tax rate. Instead, they may be eligible for a qualified business income (QBI) deduction for 2018 through 2025 – not made permanent with the new legislation. The goal of this deduction is to help mitigate some of the disparity between the tax rates applied for C corporations and pass-through entities.

Some manufacturers that are set up as sole proprietorships and pass-through entities are considering the advantages of potentially operating as a C corporation given the changes in legislation. Even though the corporate rate has been reduced, this should not be the ultimate decision driver. The answer depends greatly on the facts and circumstances of your tax situation. This decision should be carefully analyzed as there is a multitude of factors to consider.

Why are pass-through entities popular in manufacturing?

Many small and midsize manufacturers operate as sole proprietorships or one of the following types of pass-through entities:

  • Partnerships;
  • Limited liability companies (LLCs) that are treated as sole proprietorships or partnerships for tax purposes; and
  • S corporations.

These structures allow a business to avoid double taxation. Income from C corporations is taxed when it is earned and again when a C corporation pays dividends. Income from sole proprietorships and pass-through entities is reported on an owner's individual tax return and taxed just once at the owner level. The new law lowered the highest individual rate from 39.6% to 37%, as well as raising the tax bracket thresholds.

How are rates changing under the TCJA?

C corporations are still subject to double taxation under the new tax law. But, the TCJA substantially lowers the income tax rate and eliminates the alternative minimum tax (AMT) for C corporations, starting in 2018.

Individual income tax rate cuts are less significant and only temporary (from 2018 through 2025) under the new tax law. In addition, individual AMT still exists under the TCJA, although the exemption amount and phaseout thresholds have been temporarily increased. It is anticipated fewer individuals will subject to AMT during this period given the changes enacted.

The new law also creates a new QBI deduction for sole proprietorships and pass-through entities. The rules for this special deduction are complex. The IRS just recently released proposed regulations on this topic, which are extensive and include a specific set of anti-abuse rules.

What's QBI?

The QBI deduction will be available to noncorporate owners of qualified businesses such as manufacturing. The deduction generally equals 20% of QBI; however there are various restrictions. The deduction will be taken on the owner's tax return. For an individual, the QBI deduction can be taken regardless whether the taxpayer itemizes.

QBI is defined as the noncorporate owner's share of taxable income, gain, deductions and loss from a qualified business. QBI does not include investment-related items, reasonable owners' compensation and guaranteed payments from a pass-through business to its owners.

The QBI deduction and applicable limitations are determined at the owner level. Each owner must track his or her share of qualified items of income, gain, deductions and loss from the qualified business, as well as his or her share of W-2 wages paid by the entity.

What are the restrictions?

There are no additional limitations on the QBI deduction unless an unmarried owner's taxable income exceeds $157,500 or $315,000 for a married joint filer. Above those income levels, the following restrictions are phased in over a $50,000 taxable income range ($207,500) for unmarried filers or over a $100,000 taxable income range for married joint filers ($415,000):

Service Business Limitation

This targets professional services providers, such as doctors, athletes and investment advisors. It does not generally affect manufacturers, unless a principal asset of the business is the reputation or skill of one or more of its employees.

W-2 Wage Limitation

This limits the QBI deduction to the greater of the noncorporate owner's share of:

  • 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year; or
  • The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.

Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of QBI.

Taxable Income Limitation

QBI deduction cannot exceed 20% of taxable income calculated before the deduction and without counting capital gains and certain other income.

Need help?

These are just the basics. The rules for calculating the QBI deduction are complex. Contact your trusted ORBA advisor to discuss how the QBI deduction impacts your business.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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