Recently proposed IRS regulations on the new deduction for qualified business income (QBI) provide guidance on how to compute limitations on the deduction based on W-2 wages. As you've probably heard, the QBI deduction is complicated, and numerous rules and restrictions apply.
Important note: While new QBI deduction regulations are in proposed form, taxpayers can rely on them until final regulations are issued.
In general, the limitations on the QBI deduction begin to phase in when the individual's (the pass-through entity owner's) taxable income (calculated before any QBI deduction) exceeds $157,500 or $315,000 for married couples who file jointly.
The limitations are fully phased in once taxable income exceeds $207,500 or $415,000 for married couples who file jointly. Above those thresholds, the QBI deduction for income from a non-service business is limited to the greater of:
The limitation based on the UBIA of qualified property is for the benefit of capital-intensive businesses. The UBIA of qualified property generally equals its original cost.
Qualified property means depreciable tangible property (including real estate) that:
Under a special disallowance rule for specified service trades or businesses (SSTBs), QBI deductions based on SSTB income are phased out between taxable income (before any QBI deduction) of: 1) $157,500 and $207,500 or 2) $315,000 and $415,000 for a married joint-filing couple. If the upper limit is exceeded, the individual cannot claim any QBI deduction based on income from any SSTB, regardless of how much QBI or W-2 wages the SSTB may have.
For purposes of calculating W-2 wages for the QBI deduction limitation, the term "W-2 wages" refers to the total amount of compensation paid to an employee, including salary-reduction contributions to retirement plans (elective deferrals) and designated Roth contributions to retirement plans. W-2 wages don't include any amounts that aren't properly reported to recipients on Forms W-2.
W-2 wages must be determined separately for each qualified trade or business that's owned directly:
If W-2 wages are allocable to more than one trade or business, the percentage of total W-2 wages allocable to each trade or business follows the percentage allocation of deductions associated with those wages to each trade or business.
W-2 wages paid by a pass-through entity must be separately determined for each qualified trade or business conducted by the entity and separately reported to owners. An owner's allocable share of W-2 wages for QBI deduction purposes is determined in the same manner as the owner's allocable share of those wages under the normal federal income tax rules.
The individual can then choose to aggregate one or more businesses, and the W-2 wages paid by those businesses, if such aggregation is allowed.
The IRS issued Notice 2018-64 on the same day as the proposed QBI deduction regulations were issued. Notice 2018-64 sets forth the following methods for calculating W-2 wages for QBI deduction limitation purposes:
Unmodified box method. This technique calculates W-2 wages by taking into account, without modification, the lesser of:
Tracking wages method. Here, the taxpayer tracks total wages subject to federal income tax withholding and makes appropriate modifications. Specifically, W-2 wages are calculated under this method by:
Any of these methods can be used by taxpayers that use a fiscal year end, rather than a calendar year end for federal income tax purposes. If the taxpayer doesn't use the calendar year, W-2 wages are calculated based on wages paid to employees during the calendar year that ends with or within the taxpayer's tax year.
The tracking wages method must be used to calculate W-2 wages for short years (years with less than 12 months). If the taxpayer has a short tax year, W-2 wages include only wages paid to employees during the short tax year plus employee salary-reduction contributions to retirement plans made during the short tax year.
Under the overall limitation, an individual's QBI deduction can't exceed the lesser of:
The proposed QBI deduction regulations are long and complicated. This article only covers one aspect of them, and not every detail has been covered. Your tax advisor can sort through your situation to help you maximize the QBI deduction.
Get in touch today and find out how we can help you meet your objectives.