Pass-Through Entities and Qualified Trade or Business
The new QBID in effect for 2018 should provide a tax benefit to individuals of Pass-Through entities which include sole proprietors, partnerships, single member LLC's and S corporations. The name Pass-Through refers to how the owners of these business structures are taxed. The income or loss is passed on to the owners individual tax return. Let's look at what each of these business structures are:
Pass-Through EntitY business structureS
C-Corporation (C-corp): This corporation is a separate legal entity from its owners and is taxed at the entity level. All corporate income and equity distributed to the company’s shareholders are also taxed. This is referred to "double taxation".
S-Corporation (S-corp): This corporation avoids double taxation and is referred to as a Pass-Through entity where the owners report the profit and loss on their individual tax returns.
Sole Proprietorship: This business is not a separate legal entity from its owner. It is a Pass-Through entity and income and losses are taxed on the individual business owner’s personal income tax return.
Limited Liability Company (LLC): An LLC. is not a separate tax entity like a corporation and is also a Pass-Through entity. An LLC. has limited liability protection for owners and the income tax responsibility depends on whether the LLC has 1 member (single member) or more members and whether the LLC elects to be treated as a different business form for tax purposes. A single member is taxed as a sole proprietorship and a multi member LLC typically pays income taxes as a partnership which passes the income or losses to the individual partners.
For simplicity, we are only referring to a “partnership” classification related to a multi member LLC. This LLC. Partnership files an information return with the IRS on Form 1065 and a Schedule K-1 is prepared for each partner with their share of the profit/loss of the partnership which is reported on the individual 1040 tax return as a gain/loss.
Qualified Trade or Business (QTB) - Qualified Trade or Business is synonymous with Specified Service Business.
A QTB is a business or trade that qualifies for the QBID, involving the performance of services in the fields of:
Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and "any trade or business where the principal asset of such trade or business is the "reputation or skill of one or more of its employees".
Architects and engineers are eligible regardless of personal taxable income amount. Most other professional services income is ineligible when the owner’s taxable income is above the applicable thresholds (for 2018 $415,000 married / $207,500 single).
Professional service trades or businesses have thresholds to qualify while other industries do not. Many professional service activities are excluded from the term "generating qualified business income".
Qualified Business Income (QBI)
1. Guaranteed payments or amounts paid by an S corporation as reasonable compensation.
2. Specified investment
Qualified Business Income Deduction (QBID)
Qualified Business Income (QBI)
Anyone who generates "qualified business income" will be entitled to take a deduction of 20% of that qualified business income on their tax return unless limitations exist.
QBID is also called Section 199A:
The deduction equals 20% of qualified business income (QBI) *. The reason for this deduction is to keep the tax rates between C-Corporations and pass through entities consistent. The deduction will show up on the owner’s Form 1040 personal return as a reduction to taxable income.
QBI must be U.S. sourced recognized by a business owner from a qualified trade or business (QTB). Services rendered by an employee are excluded from a QTB with a result that W-2 compensation won't count as QBI eligible for the new deduction.
What is considered a QTB:
Note: Businesses currently taxed at the 15% rate will be taxed at 21% under the new law for 2018. That is a tough one to overcome for these smaller businesses.
* As with any major revision to the tax code, there will be modifications and interpretations which will change how Section 199A can be used.
The deduction is to be claimed on individual owners’ tax return Form 1040 and is taken “below the line”, reducing taxable income (not AGI). It does not matter whether this Taxpayer itemizes deductions or uses the standard deduction.