Deduction for Qualified Business Income
The last from AGI deduction that we will cover is the deduction for qualified business income. If applicable, this deduction is allowed as a from AGI deduction in addition to the taxpayer’s itemized deductions or standard deduction. The deduction applies to tax- payers with qualified business income from a partnership, S Corporation, or sole propri- etorship. Specifically, a taxpayer may deduct the lesser of:
(a) 20 percent of the taxpayer’s qualified business income from a qualified trade or business (after application of the wage limit), plus 20 percent of the taxpayer’s qualified real estate investment trust dividends and qualified publicly traded partnership income, if any or
(b) 20 percent of the excess, if any, of taxable income over the taxpayer’s net capital gains (including qualified dividends).45
A qualified trade or business is any trade or business other than a specified service trade or business and other than the trade or business of being an employee. A specified ser- vice trade or business is any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or 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 or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in secu- rities, partnership interests, or commodities. Architecture and engineering services (their services build things) are specifically excluded from the definition of specified service trade or business.
For any year in which the taxpayer’s taxable income (before the deduction for qualified business income) is less than $157,500 ($315,000, if married filing jointly), the exclusion for specified service trades or business will not apply (the business will
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Answer: $5,400, computed as follows:
No Bunching Bunching
2018 2019 2018 2019
(1) Standard deduction* $13,600 $13,600 $13,600 $13,600
(2) Itemized deductions 11,500 11,500 19,000 4,000
Greater of (1) and (2) $13,600 $13,600 $19,000 $13,600
Total deductions $27,200 $32,600
(combined years) ($13,600 + $13,600) ($19,000 + $13,600)
Deductions gained $5,400
through bunching ($32,600 bunching deductions − $27,200 nonbunching deductions)
*For 2018, her standard deduction is the $12,000 standard deduction for single taxpayers plus an additional
$1,600 standard deduction amount for age. (See Exhibit 6-10.) For 2019, we assume she has the same standard deduction as 2018.
45The rules are a little more complex if the taxpayer receives cooperative dividends (known as patronage div- idends) paid from the cooperative’s profits to its members. Subject to limitations, cooperative dividends are eligible for the deduction for qualified business income.
THE KEY FACTS Deduction for qualified
business income
• The deduction for qualified business income is a from AGI deduction in addition to the taxpayer’s itemized de- duction or standard deduction.
• The deduction is limited to qualified trades or busi- nesses and is subject to a number of limitations.
be deemed a qualified trade or business). This means that a taxpayer operating a busi- ness that is not a qualified trade or business still gets the deduction for qualified busi- ness income if his or her taxable income is low enough. For taxpayers with taxable income above $157,500 ($315,000, if married filing jointly), the exclusion from the definition of a qualified business for specified service trades or businesses phases in over a $50,000 range ($100,000, in the case of a joint return). The exclusion from the definition of a qualified business for specified service trades or businesses is fully phased in for taxpayers with taxable income in excess of $207,500 ($415,000 in the case of a joint return).
46Qualified business income does not include any amount paid by an S corporation that is treated as reason- able compensation of the taxpayer or any guaranteed payment for services rendered with respect to the trade or business.
47Similar to a qualified trade or business that has a qualified business loss for the current taxable year, any deduction allowed in a subsequent year is reduced (but not below zero) by 20 percent of any carryover quali- fied business loss.
Example 6-25
As described in Example 5-7, Courtney performs architectural consulting services outside of her em- ployment with EWD. Will her income from the architectural services be considered qualified business income?
Answer: Yes. Architectural services are not a specified service or trade business. Thus, her income from the architectural services would be qualified trade or business income.
What if: Assume Courtney decides to establish a sole proprietorship to perform investment advising ser- vices. This year, Courtney reports $250,000 of taxable income before the deduction for qualified business income. Will her income from investment advisory services be considered qualified business income?
Answer: No. Investment advisory services fall within the definition of a specified service or trade busi- ness. Because her taxable income exceeds $207,500 ($157,500 + $50,000 phase-in range), the exclu- sion from the specified service trades or business rules based on taxable income does not apply. Thus, her investment advisory service income would not be considered qualified trade or business income.
Consequently, she is not eligible for the deduction for qualified business income on that income.
What if: Assume Courtney decides to establish a sole proprietorship to perform investment advising ser- vices. This year, Courtney reports $100,000 of taxable income before the deduction for qualified business income. Will her income from investment advisory services be considered qualified business income?
Answer: Yes. Because her taxable income falls below the $157,500, the exclusion for specified service trades or businesses will not apply (the business will be deemed a qualified trade or business). Conse- quently, she is eligible for the deduction for qualified business income on that income.
What if: Assume Courtney decides to establish a sole proprietorship to perform investment advising services. This year, Courtney reports $187,500 of taxable income before the deduction for qualified busi- ness income. Will her income from advisory services be considered qualified business income?
Answer: If Courtney had $187,500 of taxable income (before the deduction for qualified business income), 60 percent of her investment advising income would not be considered qualified business income [{($187,500 taxable income − $157,500)/($50,000 phase-out range)} = 60%]. The remaining 40 percent of her investment advising income would be considered qualified business income.
Qualified business income is the net amount of qualified items of income, gain, de- duction, and loss with respect to the taxpayer’s qualified trade or business conducted within the United States. Qualified items do not include specified investment-related in- come, deductions, or loss (e.g., capital gains or losses, dividends, interest income not al- locable to a trade or business, etc.).46 If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business in the next taxable year.47
Limitations
The deduction for qualified business income cannot exceed the greater of:
(i) 50 percent of the wages paid with respect to the qualified trade or businesses, or (ii) the sum of 25 of percent of the wages with respect to the qualified trade or
businesses plus 2.5 percent of the unadjusted basis, immediately after acquisi- tion, of all qualified property in the qualified trade or businesses.48
For purposes of the wage-based limit, each partner or S corporation shareholder is treated as having wages for the year equal to his or her allocable share from the partner- ship or S corporation. The wage-based limits only apply to taxpayers with taxable in- come in excess of $157,500 ($315,000, in the case of a joint return)). The wage limit is phased in ratably over $50,000 ($100,000 for married filing joint returns) so that it fully applies to taxpayers with taxable income in excess of $207,500 ($415,000 for married filing joint return).
48Qualified property is tangible, depreciable property held and available for use at the end of the tax year, used in the production of qualified business income during the year, for which the depreciable period has not ended by the end of the tax year. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property under §168 [without regard to §168(g)].
Courtney reports taxable income this year of $148,670 ($187,000 AGI less $38,330 itemized deduc- tions, see Example 6-20) before the deduction for qualified business income, and she has no capital gains and $700 of qualified dividends included in her taxable income (see Exhibit 5-4). Her architec- tural consulting services generate $18,000 of qualified business income, and she paid no wages in this business. What is Courtney’s deduction for qualified business income?
Answer: $3,600. Because her taxable income before the deduction for qualified business income is less than $157,500, the wage limitation does not apply. Likewise, Courtney is not limited by the tax- able income limitation because 20 percent of her qualified business income ($18,000 × 20% =
$3,600) is less than 20 percent of her taxable income in excess of her qualified dividends and before the deduction [($148,670 taxable income − $700 qualified dividends) × 20% = $29,594]. Thus, Court- ney’s deduction for qualified business income is $3,600 ($18,000 qualified business income × 20%).
What if: Assume Courtney reports taxable income this year of $300,000 (before the deduction for qualified business income), has no qualified dividends or capital gains, and that her architectural con- sulting business generates $75,000 of qualified business income, has no qualified property and pays
$20,000 of wages. What is Courtney’s deduction for qualified business income?
Answer: $10,000. Before limitation, 20 percent of Courtney’s qualified business income is $15,000 ($75,000 × 20%), and the greater of:
(a) 50 percent of the wages paid by the qualified business ($20,000 × 50% = $10,000) or (b) 25 percent of the wages paid by the qualified business ($20,000 × 25% = $5,000) plus 2.5 per-
cent of the unadjusted basis of qualified property ($0 × 2.5% = $0)
is $10,000. Because her taxable income of $300,000 exceeds the $157,500 phase-in threshold by more than $50,000, the wage limit fully applies. Thus, Courtney’s deduction for qualified busi- ness income is limited to $10,000. Courtney is not limited by the taxable income limitation be- cause 20 percent of her qualified business income after application of the wage limitation ($10,000) is less than 20 percent of her taxable income before the deduction ($300,000 × 20%
= $60,000).
What if: Assume that Courtney reports taxable income this year of $177,500 (before the deduction for qualified business income), has no qualified dividends or capital gains, and that her architectural consulting business generates $75,000 of qualified business income, has no qualified property, and has $20,000 of wages. What is Courtney’s deduction for qualified business income?
Example 6-26
Taxable Income Summary
We now have enough information to calculate Courtney’s and Gram’s taxable income.
Exhibit 6-11 shows Courtney’s taxable income calculation and Exhibit 6-12 illustrates how this information would be displayed on page 2 of Courtney’s Form 1040.
Exhibit 6-13 provides Gram’s taxable income calculation.
Answer: $13,000. Before limitation, 20 percent of Courtney’s qualified business income is $15,000 ($75,000 × 20 percent), and the greater of:
(a) 50 percent of the wages paid by the qualified business ($20,000 × 50% = $10,000) or (b) 25 percent of the wages paid by the qualified business ($20,000 × 25% = $5,000) plus 2.5 per-
cent of the unadjusted basis of qualified property ($0 × 2.5% = $0)
is $10,000. Because her taxable income of $177,500 exceeds the $157,500 phase-in threshold by $20,000, the wage limit is phased in by 40 percent [{($177,500 − $157,500)/$50,000} phase- in range = 40 percent]. Courtney’s wage limit of $5,000 (the excess of (a) 20 percent of business income of $15,000 over (b) 50 percent of wages, $10,000 ($20,000 × 50%)) is phased in by 40 percent. Thus, her deduction for qualified business income is limited to $13,000 [$15,000 – ($5,000 × 40%)]. Courtney is not limited by the taxable income limitation because 20 percent of her qualified business income after application of the wage limitation ($13,000) is less than 20 percent of her taxable income before the deduction ($177,500 × 20% = $35,500).
EXHIBIT 6-13 Gram’s Taxable Income
Description Amount Reference
(1) AGI $15,590 Exhibit 6-6
(2) Greater of (a) itemized deductions ($11,500)
or (b) standard deduction ($13,600) (13,600) Example 6-24
Taxable income $ 1,990 (1) + (2)
EXHIBIT 6-11 Courtney’s Taxable Income
Description Amount Reference
AGI $187,000 Exhibit 6-5
Less: Greater of (1) itemized deductions ($38,330)
or (2) standard deduction ($18,000) (38,330) Example 6-21 Less: Deduction for qualified business income (3,600) Example 6-26
Taxable income $145,070
EXHIBIT 6-12 Courtney’s Taxable Income Computation as Presented on Form 1040, Page 2
Form 1040 (2017) Page 2
Tax and Credits
38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38 39a Check
if: { You were born before January 2, 1953, Blind.
Spouse was born before January 2, 1953, Blind.}Total boxes checked a39a b If your spouse itemizes on a separate return or you were a dual-status alien, check herea 39b Standard
Deduction for—
J&3=>:3E6=
check any box on line 39a or 39b or who can be claimed as a dependent, see instructions.
J::=B63@A Single or Married filing separately,
$6,350 Married filing jointly or Qualifying widow(er),
$12,700 Head of household,
$9,350
40 Itemized deductions (from Schedule A) or your standard deduction (see left margin) . . 40 41 Subtract line 40 from line 38 . . . . . . . . . . . . . . . . . . . 41 42 Exemptions. If line 38 is $156,900 or less, multiply $4,050 by the number on line 6d. Otherwise, see instructions 42 43 Taxable income. Subtract line 42 from line 41. If line 42 is more than line 41, enter -0- . . 43 44 Tax (see instructions). Check if any from: a Form(s) 8814 b Form 4972 c 44 45 Alternative minimum tax (see instructions). Attach Form 6251 . . . . . . . . . 45 46 Excess advance premium tax credit repayment. Attach Form 8962 . . . . . . . . 46 47 Add lines 44, 45, and 46 . . . . . . . . . . . . . . . . . . . a 47 48 Foreign tax credit. Attach Form 1116 if required . . . . 48
49 Credit for child and dependent care expenses. Attach Form 2441 49 50 Education credits from Form 8863, line 19 . . . . . 50 51 Retirement savings contributions credit. Attach Form 8880 51 52 Child tax credit. Attach Schedule 8812, if required . . . 52 53 Residential energy credit. Attach Form 5695 . . . . . 53 54 Other credits from Form: a 3800 b 8801 c 54
55 Add lines 48 through 54. These are your total credits . . . . . . . . . . . . 55 56 Subtract line 55 from line 47. If line 55 is more than line 47, enter -0- . . . . . . a 56
Other Taxes
57 Self-employment tax. Attach Schedule SE . . . . . . . . . . . . . . . 57 58 Unreported social security and Medicare tax from Form: a 4137 b 8919 . . 58 59 Additional tax on IRAs, other qualified retirement plans, etc. Attach Form 5329 if required . . 59 60 a Household employment taxes from Schedule H . . . . . . . . . . . . . . 60a
b First-time homebuyer credit repayment. Attach Form 5405 if required . . . . . . . . 60b 61 Health care: individual responsibility (see instructions) Full-year coverage . . . . . 61 62 Taxes from: a Form 8959 b Form 8960 c Instructions; enter code(s) 62
187,000
38,330 148,670 3,600 145,070 Deduction for qualified business income . . . .
Source: Form1040
Note that because Gram’s gross income of $16,000 (Exhibit 5-6) is more than her basic standard deduction amount ($13,600), she is required to file a tax return.
CONCLUSION
We started this chapter with Courtney’s and Gram’s gross incomes. In this chapter, we first identified the duo’s separate deductions for AGI and computed their AGI. We then determined their from AGI deductions. Courtney deducted her itemized deductions be- cause they exceeded her standard deduction. Gram, on the other hand, deducted her stan- dard deduction. Finally, Courtney was able to take advantage of the deduction for qualified business income, while Gram did not have any qualified business income. By subtracting their from AGI deductions from their AGI, we determined taxable income for both Courtney and Gram. With this knowledge, we proceed to the next two chapters and address issues relating to investments and determining the amount of tax Courtney and Gram are required to pay on their taxable income.
Summary
Identify the common deductions necessary for calculating adjusted gross income (AGI).
• Deductions for AGI may be categorized into those that are directly or indirectly business- related and those that address specific policy issues.
• The business-related deductions for AGI include business expenses, rent and royalty ex- penses, self-employment taxes, medical and health insurance by self-employed taxpayers, and forfeited interest.
• Other common deductions for AGI include the deductions for interest on student loans and early withdrawal penalties.
Describe the different types of itemized deductions available to individuals.
• The medical expense deduction is designed to provide tax benefits to needy individuals but is subject to significant floor limitation.
• The itemized deduction for interest is limited to home mortgage interest and investment interest, and the latter is limited by net investment income.
• The deduction for charitable contributions extends to contributions of money and property to qualifying charities. The charitable deduction is subject to ceiling limitations, which are more restrictive for donations of property.
• The deduction for taxes is subject to a cap and includes state income and property taxes.
Sales taxes can be deducted in lieu of deducting state and local income taxes.
Determine the standard deduction available to individuals.
• Taxpayers generally deduct the greater of their standard deduction or their itemized deductions.
• The amount of the standard deduction varies according to the taxpayer’s filing status, age, and eyesight.
Calculate the deduction for qualified business income.
• The deduction for qualified business income is a from AGI deduction in addition to the taxpayer’s itemized deduction or standard deduction.
• The deduction is limited to qualified trades or businesses and is subject to a number of limitations.
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bunching itemized deductions (6-25) business activities (6-2)
capital gain property (6-17) ceiling (6-18)
deduction for qualified business income (6-26)
excess business loss (6-6) floor limitation (6-13)
investment activities (6-2) miscellaneous itemized
deductions (6-21) ordinary and necessary (6-4) ordinary income property (6-17) private nonoperating
foundations (6-19)
private operating foundations (6-19)
qualified educational loans (6-8) qualified business income (6-26) qualified trade or business (6-26) specified service trade or
business (6-26) standard deduction (6-22) trade or business (6-2)
KEY TERMS
DISCUSSION QUESTIONS
Discussion Questions are available in Connect®.
1. It has been suggested that tax policy favors deductions for AGI compared to item- ized deductions. Describe two ways in which deductions for AGI are treated more favorably than itemized deductions.
2. How is a business activity distinguished from an investment activity? Why is this distinction important for the purpose of calculating federal income taxes?
3. Explain why Congress allows self-employed taxpayers to deduct the cost of health insurance above the line ( for AGI) when employees can only itemize this cost as a medical expense. Would a self-employed taxpayer ever prefer to claim health insurance premiums as an itemized deduction rather than a deduction for AGI? Explain.
4. Explain why Congress allows self-employed taxpayers to deduct the employer portion of their self-employment tax.
5. Using the Internal Revenue Code, describe two deductions for AGI that are not discussed in this chapter.
6. Explain why Congress allows taxpayers to deduct interest forfeited as a penalty on the premature withdrawal from a certificate of deposit.
7. Describe the mechanical limitation on the deduction for interest on qualified educational loans.
8. Explain why the medical expense provisions are sometimes referred to as
“wherewithal” deductions and how this rationale is reflected in the limit on these deductions.
9. Describe the type of medical expenditures that qualify for the medical expense deduction. Does the cost of meals consumed while hospitalized qualify for the deduction? Do over-the-counter drugs and medicines qualify for the deduction?
10. Under what circumstances can a taxpayer deduct medical expenses paid for a member of his family? Does it matter if the family member reports significant amounts of gross income and cannot be claimed as a dependent?
11. What types of taxes qualify to be deducted as itemized deductions? Would a vehicle registration fee qualify as a deductible tax?
12. Explain the argument that the deductions for charitable contributions and home mortgage interest represent indirect subsidies for these activities.
13. Cash donations to charity are subject to a number of very specific substantiation requirements. Describe these requirements and how charitable gifts can be substantiated. Describe the substantiation requirements for property donations.
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14. Describe the conditions in which a donation of property to a charity will result in a charitable contribution deduction of fair market value and when it will result in a deduction of the tax basis of the property.
15. Jake is a retired jockey who takes monthly trips to Las Vegas to gamble on horse races. Jake also trains racehorses part time at his Louisville ranch. So far this year, Jake has won almost $47,500 during his trips to Las Vegas while spending $27,250 on travel expenses and incurring $62,400 of gambling losses. Explain how Jake’s gambling winnings and related costs will be treated for tax purposes.
16. Frank paid $3,700 in fees for an accountant to tabulate business information (Frank operates as a self-employed contractor and files a Schedule C). The accountant also spent time tabulating Frank’s income from his investments and determining Frank’s personal itemized deductions. Explain to Frank whether or not he can deduct the
$3,700 as a business expense or as an itemized deduction, and provide a citation to an authority that supports your conclusion.
17. Contrast ceiling and floor limitations, and give an example of each.
18. Identify which itemized deductions are subject to floor limitations, ceiling limita- tions, or some combination of these limits.
19. Describe the tax benefits from “bunching” itemized deductions in one year.
Describe the characteristics of the taxpayers who are most likely to benefit from using bunching and explain why this is so.
20. Explain how the standard deduction is rationalized and why the standard deduction might be viewed as a floor limit on itemized deductions.
21. Determine whether a taxpayer can change his or her election to itemize deductions once a return is filed. (Hint: Read about itemization under Reg. §1.63-1.)
22. Describe what is meant by qualified business income for purposes of the deduction for qualified business income.
23. Under what circumstances would business income from an accounting practice qualify for the deduction for qualified business income?
PROBLEMS
Select problems are available in Connect®.
24. Clem is married and is a skilled carpenter. Clem’s wife, Wanda, works part-time as a substitute grade school teacher. Determine the amount of Clem’s expenses that are deductible for AGI this year (if any) under the following independent circumstances:
a) Clem is self-employed and this year he incurred $525 in expenses for tools and supplies related to his job. Since neither were covered by a qualified health plan, Wanda paid health insurance premiums of $3,600 to provide coverage for herself and Clem (not through an exchange).
b) Clem and Wanda own a garage downtown that they rent to a local business for storage. This year they incurred expenses of $1,250 in utilities and $780 in depreciation.
c) Clem paid self-employment tax of $15,300 (the employer portion is $7,650), and Wanda had $3,000 of Social Security taxes withheld from her pay.
d) Clem paid $45 to rent a safe deposit box to store his coin collection. Clem has collected coins intermittently since he was a boy, and he expects to sell his collection when he retires.
25. Don Juan, a single taxpayer, is the sole owner of DJ’s Inc., an S Corporation.
This year, DJ’s Inc. incurred a massive $600,000 business loss, all of which is
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