The Tax Cuts and Jobs Act of 2017 (TCJA) includes a new 20% deduction, known as the Qualified Business Income (QBI) deduction under IRC Section 199A, for sole proprietors and owners of pass-through entities for tax years beginning after December 31, 2017 and before January 1, 2026. For taxable years beginning after December 31, 2025, the provisions under IRC section 199A will expire unless extended by Congress. The overall effect created another source of income that receives preferential treatment similar to net capital gains and qualified dividend income. Because of the 20% deduction, the marginal tax rates on QBI for the seven individual income tax brackets will be as follows:
|Individual tariff||Effective marginal rate of QBI|
Although the QBI deduction is not allowed for certain services or businesses (SSTB), a taxpayer carrying out one or more of these activities may claim a modified QBI deduction depending on the taxpayer’s income level. (According to Treasury Regulations Section 1.199A-5, SSTBs include the fields of health care, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, commerce, trading securities, partnership interests or goods, or any trade or business the principal asset of which is the reputation or skill or one or more of its owners.) In 2022, however, the ability to claim a modified QBI deduction that due to SSTB, phased out over $100,000 taxable income over $340,100 if you file jointly ($50,000 taxable income over $170,050 if single or head of household). These taxable income amounts represent the start of the 32% brackets for these filing statuses and will be indexed for inflation each subsequent year.
Because the QBI deduction is a deduction from adjusted gross income (AGI) and is limited to taxable income after subtracting itemized deductions or the standard deduction minus net capital gains and qualified dividends, the tax planning involved with the QBI deduction is far different exercise than traditional tax planning for other deductions. Planning is also complicated because QBI is not the same as net self-employment income, it must be reduced by the self-employment tax deductible portion, contributions to various self-employment retirement plans, and the self-employment health insurance deduction .
Consider an unmarried, self-employed taxpayer paying medical insurance premiums of $10,000. Also, assume that the taxpayer has enough other medical expenses to exceed the 7.5% of AGI threshold, and other itemized deductions sufficient to exceed the standard deduction. Given that the taxpayer’s marginal federal income tax rate is 24%, that taxpayer wants to know whether it is better to claim the premiums as a self-employed health insurance deduction or as additional Schedule A medical expenses. The tax savings under each alternative are presented in Exhibit 1.
Self-Employed Health Insurance Deduction for Additional Medical Expenses
Another area of tax planning related to the QBI deduction involves SSTBs and taxpayers whose taxable income is within or above the thresholds to be able to claim a modified QBI deduction. Proper tax planning in this area can result in even more significant tax savings than simply comparing the results of making different choices under the law as described above.
Using the 2022 taxable income phase-out scope for the modified QBI deduction, consider a $1,000 increase in itemized deductions by making an additional charitable contribution (Example A) or a $1,000 increase in business deductions by increasing depreciation (Example B ) for a single taxpayer with a QBI compared to a taxpayer whose taxable income is at the top of the phase-out threshold and is not entitled to a QBI deduction.
An analysis of the $614 in income tax savings in Example A shows that $350 of that comes from multiplying the taxpayer’s regular marginal tax rate of 35% by $1,000. The remaining tax savings of $264 comes from the additional QBI deduction of $753 generated by the reduction in taxable income (ie 35% × $753). The tax savings are slightly less in Example B due to the tax effect of self-employment on taxable income and QBI. Because it’s not linear — because the QBI deduction is based on QBI and the phase-out is based on taxable income — it’s impossible to come up with an exact marginal rate of tax savings. However, the approximate rate will 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 (from 2022 to 2025) should also take into account that the QBI deduction expires at the end of 2025 — along with many of the 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 tax rates than it might be after 2025.
Depreciation is one area of tax law that allows significant flexibility in deferral of deductions and results in increased QBI. The various elective provisions due to depreciation provide multiple opportunities to maximize the QBI deduction. By electing bonus depreciation, taking less than the maximum expense elect, or simply electing straight-line depreciation instead of the Modified Accelerated Cost Recovery System (MACRS), taxpayers can take advantage of the QBI deduction at 20% while the TCJA is still in effect. While this would increase taxes now, the benefit would be to claim those same deductions in future tax years when they are supposed to be taxed at higher rates.
There is no crystal ball
It is difficult to predict what action Congress will take with the expiring TCJA provisions. Whether the QBI deduction is extended 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. Regardless, tax advisors will need to be vigilant and monitor the impact of the expiring regulations as 2025 approaches.
Additional charitable contribution against increased business depreciation