by: Barry Ward, Director, OSU Income Tax Schools & Leader, Production Business Management
The new tax law known as the Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017 and will affect income tax returns for all of us for 2018 (to be filed in the next few months). The headline pieces of the new tax law include new tax brackets, higher standard deductions, elimination of personal exemptions and a new corporate flat tax rate of 21%. This will amount to lower total federal income tax for the large majority of taxpayers and C-corporations. Parts of the new tax law will make tax preparation simpler while parts will add complexity to the process.
With the new lower tax rate for corporations (specifically C-corporations) of 21% (a flat 21% rate) this replaces the old graduated tax brackets for C-corporations that started at 15% and topped out at 35%. The new lower tax rate for C-corporations may have created a decidedly uneven playing field if the new tax law hadn’t included a new deduction for all other businesses. This new Qualified Business Income Deduction (QBID) (sometimes referred to as the Pass-Through Deduction) is a 20% deduction of a businesses’ Qualified Business Income (QBI). Without this, businesses across the U.S. would have been strongly considering a change to a C-Corp structure for income tax purposes. With this QBID, the playing field between the different tax entities is mostly re-leveled. There may be inequalities that show up with the new tax law as it relates to business entity selection but it may take some time for these inequalities to reveal themselves.
The new Qualified Business Income Deduction is laid out in Section 199A of the Internal Revenue Code (IRC). This new deduction has also been referred to as the 199A Deduction, the §199A Deduction for Pass-through Entities, the Business Deduction, the QBI Deduction, the Pass-through Entity Deduction, the Pass-through Business Deduction and other names. Each of these names refers to the same new deduction.
The QBID is a deduction in the amount of 20% that is allowed for “pass through entities” – sole proprietorships, partnerships, and S corporations (Limited Liability Companies (LLCs) filing as one of the afore-mentioned are included).
To qualify for this 20% deduction, qualified business income must be earned from what is termed a “qualified trade or business.” The deduction reduces taxable income and is 20% of “qualified business income” (or 20% of taxable ordinary income, whichever is less). The deduction is claimed on the individual’s tax returns whether an individual itemizes or does not itemize personal deductions on Schedule A. This deduction is classified as a “below-the-line” deduction as it is taken after adjusted gross income is calculated.
Net Farm Income from Schedule F qualifies for this deduction. Depreciation recapture income and certain rental income also qualifies. Capital gains income does not qualify. The key consideration for farmers is that Net Farm Profit (if any) from Schedule F does qualify for the deduction.
For higher income filers there are limitation phase-ins for this deduction. This deduction is fully available for individuals with taxable income of less than $157,500 for single filers and less than $315,000 for joint filers. (Filers above these thresholds can also qualify if they meet certain criteria.) The deductible amount for EACH qualified trade or business is 20% of the taxpayers qualified business income (QBI) with respect to each trade or business or 20% of the taxpayer’s taxable income, whichever is less.
You are a sole-proprietor (married filing jointly) and you make $100,000 in net farm income (Schedule F Income) but with the new standard deduction ($24,000) your taxable income is $76,000 (assume the Schedule F net farm income is the sole source of income).
Your deduction is the lesser of:
20% of $100,000 = $20,000
20% of $76,000 = $15,200
Deduction is $15,200
Your taxable income in this simple example will be $60,800 ($100,000 -$24,000 – $15,200).
The QBID is limited for taxpayers with QBI over the threshold amounts of $157,500 for single filers and $315,000 for joint filers. Taxpayers with QBI over these need wages paid (W-2 wages paid) and/or depreciable property to qualify. This “depreciable property” is technically referred to as “Unadjusted basis immediately after acquisition of qualified property” or “UBIA of qualified property” or UBIA for short.
The limitation phase-in ranges are $50,000 for single filers and $100,000 for joint filers which means the limitation phase-in ranges for a single filer is $157,000 – $207,000 and the limitation phase-in range for joint filers is $315,000 – $415,000.
So….once $157,000 and $315,000 are reached, a limitation on the deduction is phased in over the ranges of $50,000 for single filers and $100,000 for joint filers. Taxpayers with taxable income that fall in this limitation phase-in range are subject to a ratable phase-in of the wage and capital limitation which we discuss next.
Once filers reach the top of the phase out ranges ($207,500 for single filers and $415,000 for joint filers) the calculations are relatively simple. The deduction is the lesser of:
- QBI for the trade of business (20% x Qualified Business Income) and:
- The greater of:
- 50% of the W-2 wages paid by the business or
- The sum of 25% of the W-2 wages with respect to the trade or business and 2.5% of the depreciable property (UBIA).
You are a sole-proprietor (married filing jointly) and you have $500,000 of Net Farm Income (Schedule F Income) but with the new standard deduction ($24,000) your taxable income is $476,000 (assume the Schedule F net farm income is the sole source of income). Assume they pay W-2 wages of $60,000 and have depreciable property of $1.2 million.
As they are above the top end of the limitation phase-in range ($415,000 for joint filers), their QBID will be limited to the lesser of 20% of the QBI ($500,000 x 20% = $100,000) or the greater of the two possible wage/UBIA limiting calculations. We can calculate the potential QBID using both methods and take the higher of the two.
- $60,000 * 50% = $30,000
- ($60,000 * 25%) + ($1,200,000 * 2%) = $39,000
We compare the greater of the two ($39,000) to the unlimited QBID of $100,000 and take the lesser of the two or $39,000.
The QBID deduction will be $39,000 for this farm business and for this taxpayer assuming 20% of the Taxable Income isn’t less than this. Taxable income of $476,000 * 20% equals $95,200 therefore the QBID for this tax return will be $39,000 and the Taxable Income will be $437,00 ($500,000 – $24,000 – $39,000).
For purposes of the QBID we provide more details on depreciable property to calculate the QBID in and above the phase-out ranges.
What is the depreciable property (UBIA) for purposes of the QBID? This is defined as tangible property, subject to depreciation (meaning inventory doesn’t count), which is held by the business at the end of the year and is used — at ANY point in the year — in the production of QBI. But there’s a catch: if you’re going to count the basis towards your limitation, the “depreciable period” of the period could not have ended prior to the last day of the year for which you are trying to take the deduction.
The depreciable period starts on the date the property is placed in service and ends on the LATER OF: 10 years, or the last day of the last full year in the asset’s “regular” (not ADS) depreciation period.
To illustrate, assume Ohio Farm purchases a piece of machinery on November 18, 2018 for 100,000. The machinery is used in the business, and is depreciated over 5 years. Even though the depreciable life of the asset is only 5 years, the owners of Ohio Farm will be able to take the unadjusted basis of $100,000 into consideration for purposes of this second limitation for ten full years, from 2018-2027, because the qualifying period runs for the LONGER of the useful life (5 years) OR 10 years.
The basis taken into consideration is “unadjusted basis,” meaning it is NOT reduced by any depreciation deductions. In fact, Internal Revenue Code Section (§) 199A(b)(2)(B)(ii) requires that you take into consideration the basis of the property “immediately after acquisition”. Any asset that was fully depreciated prior to 2018, unless it was placed in service after 2008, will not count towards basis.
Just as with W-2 wages, a shareholder or partner may only take into consideration for purposes of applying the limitation, 2.5% of his or her allocable share of the basis of the property. So if the total basis of S corporation property is $1,000,000 and you are a 20% shareholder, your basis limitation is $1,000,000 * 20% * 2.5% = $5,000.
If you are a partner in a partnership, you must allocate your share of asset basis in the same manner in which you are allocated depreciation expense from the partnership.
Special rules apply for sales to cooperatives and farmland lease income and will be covered in a subsequent articles.