Deduction of qualified and self-employed business income

The 2017 Tax Cuts and Job Act (TCJA) included a new deduction of 20%, known as the Qualified Business Income Deduction (QBI) under Section 199A of the IRC, for individual owners and owners of pass- through for tax years beginning after December 31, 2017 and before January 1, 2026. For tax years beginning after December 31, 2025, the provisions of section 199A of the IRC will expire unless extended by Congress. The overall effect created another source of income that receives preferential treatment, similar to net capital gains and qualifying dividend income. Due to the 20% deduction, the marginal tax rates on QBI for the seven individual income tax bands would be as follows:

Individual rate Effective QBI marginal rate
10% 8%
12% 9.6%
22% 17.6%
24% 19.2%
32% 25.6%
35% 28%
37% 29.6%

Although the QBI deduction is not allowed for specific services or business activities (SSTBs), a taxpayer carrying out one or more of these activities may require a modified QBI deduction depending on the taxpayer’s income level. (Pursuant to section 1.199A-5 of the Treasury Regulations, SSTBs include the sectors of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage, investment and investment management, trade, securities trading, equity or commodity trading, or any trade or business whose primary asset is reputation or skill or one or more of its owners.) 2022, however, the ability to apply for a modified QBI deduction attributable to an SSTB is phased out over $ 100,000 of taxable income greater than $ 340,100, if the return is jointly married ($ 50,000 of taxable income greater than $ 170,050, if single or householder). These taxable income amounts represent the start of the 32% bands for these filing states and will be indexed for inflation each subsequent year.

Since the QBI deduction is a deduction from the adjusted gross income (AGI) and limited to the taxable income after subtracting the detailed deductions or the standard deduction minus the net capital gains and also the qualified dividends, the tax planning related to the QBI deduction is a very different than traditional tax planning for other deductions. Planning is also complicated because QBI is not the same as net self-employment income, which must be reduced by the deductible portion of self-employment tax, contributions to various self-employed pension plans, and the deduction of health insurance for self-employed persons. self-employed .

Example 1.

Consider a single self-employed tax payer who claims medical insurance premiums of $ 10,000. Also assume that the taxpayer has other medical expenses that are sufficient to exceed the 7.5% AGI threshold as well as other detailed deductions that are sufficient to exceed the standard deduction. Given that the taxpayer’s marginal federal income tax rate is 24%, this taxpayer would like to know whether it is better to claim premiums as a deduction from health insurance for self-employed workers or as additional medical expenses in Appendix A. I Tax savings in each alternative are presented in Show 1.

Show 1

Deduction of health insurance for self-employed workers with respect to additional medical expenses

Another area of ​​tax planning related to the QBI deduction concerns SSTBs and taxpayers whose taxable income falls within or exceeds the thresholds in order to apply for a modified QBI deduction. Proper tax planning in this area can produce even more substantial tax savings than simply comparing the results of making several elections available under the law, as described above.

Example 2.

Using the 2022 taxable income phase-out interval for the modified QBI deduction, consider a $ 1,000 increase in detailed deductions by making an additional charitable contribution (Example A) or a $ 1,000 increase in corporate deductions by increasing depreciation (Example B) for a single taxpayer with QBI versus a taxpayer whose taxable income is above the phase-out threshold and is not eligible for the QBI deduction.

An analysis of the $ 614 income tax savings in Example A shows that $ 350 of this comes from multiplying the taxpayer’s regular marginal tax rate of 35% by $ 1,000. The remaining $ 264 tax savings come from the additional QBI deduction of $ 753 generated by the taxable income reduction (i.e., 35% × $ 753). Tax savings are slightly lower in Example B due to the effect of self-employment tax on taxable income and the QBI. Since it is not linear, as the QBI deduction is based on the QBI and the phasing out is based on taxable income, it is impossible to find an exact marginal rate of tax savings. The approximate rate, however, would be the taxpayer’s regular marginal tax rate plus 80% of the taxpayer’s marginal tax rate, in this case 63%. [35% + (80% × 35%)].

Tax planning over the next four years (2022-2025) should also consider that the QBI deduction will expire at the end of 2025, along with many other changes temporarily enacted by the TCJA. Taxpayers may want to consider deferring deductions so that their QBI is higher over the next four years when it will be taxed at lower rates than it could be after 2025.

Depreciation is an area of ​​tax law that allows considerable flexibility in deferring deductions and with a consequent increase in the QBI. The various elective reserves attributable to amortization provide numerous opportunities to maximize the QBI deduction. By eliminating bonus amortization, taking less than the maximum spending election, or simply electing straight-line amortization instead of the modified accelerated cost recovery system (MACRS), taxpayers can take advantage of the 20% QBI deduction while the TCJA is still in effect. While this would increase taxes currently, the benefit would be to require these same deductions in subsequent tax years when they would presumably be taxed at higher rates.

No crystal balls

It is difficult to predict what action Congress will take with the expiring provisions of the TCJA. The extent of the QBI deduction will also depend on which political party is in power when the decision is made, the state of the overall economy, and other economic and political factors. In any case, tax advisors will need to be vigilant and monitor the impact of expiring provisions as 2025 approaches.

Show 2

Charitable contribution additional to the increase in corporate depreciation

    At the threshold;  Example A;  Example B Net income from SE;  $ 200,000;  $ 200,000;  $ 199,000 Other ordinary income;  51,842;  51,842;  51,842 Total income;  251,842;  251,842;  250,842 Deductible part of the SE tax;  –11,792;  –11,792;  –11,779 Adjusted gross income (AGI);  240,050;  240,050;  239,063 Detailed deductions;  -20,000;  -21,000;  -20,000 Taxable amount before QBI deduction;  220,050;  219,050;  219,063 QBI deduction;  0;  -753;  –739 Taxable income;  $ 220,050;  $ 218,297;  $ 218,324 Income Tax;  $ 50,771;  $ 50,157;  $ 50,166 Income Tax Savings;  N / A;  $ 614;  $ 605 SE = self-employment

Phillip J. Korb, CPA, CGMA, MST, is an associate professor of accounting at the University of Baltimore.

Jan L. Williams, PhD, CPA, MST, is an associate professor of accounting at the University of Baltimore.

Arthur E. Flach, CPA, MST, is a retired executive associate and leader of Grant Thornton’s Northeast Tax Practice and adjunct professor at the University of Baltimore.

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