The Tax Cuts and Job Act of 2017 (TCJA) included 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 tax years beginning after December 31, 2025, the provisions under IRC section 199A will expire unless they are 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 would be as follows:
|Individual Rate||Effective QBI Marginal Rate|
Although the QBI deduction is not allowed for specified service trades or businesses (SSTBs), a taxpayer carrying on one or more of these activities could claim a modified QBI deduction depending upon the taxpayer’s level of income. (Under Treasury Regulations section 1.199A-5, SSTBs include the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities, partnership interests or commodities, or any trade or business whose principal asset is the reputation or skill or one or more of its owners.) In 2022, however, the ability to claim a modified QBI deduction attributable to an SSTB is phased out over $100,000 of taxable income in excess of $340,100, if filing married jointly ($50,000 of taxable income in excess of $170,050, if single or head of household). These taxable income amounts represent the beginning of the 32% brackets for these filing statuses and will be indexed for inflation each succeeding year.
Because the QBI deduction is a deduction from adjusted gross income (AGI) and limited to taxable income after subtracting either itemized deductions or the standard deduction less net capital gains and qualified dividends as well, tax planning related to the QBI deduction is a far different exercise than traditional tax planning for other deductions. Planning is also complicated because QBI is not the same as net earnings from self-employment, having to be reduced by the deductible part of the self-employment tax, contributions to various self-employed retirement plans, and the self-employed health insurance deduction.
Consider a single, self-employed taxpayer who incurs medical insurance premiums of $10,000. Further assume that the taxpayer has sufficient other medical expenses to exceed the 7.5% of AGI threshold as well as other itemized deductions sufficient to exceed the standard deduction. Given that the taxpayer’s marginal federal income tax rate is 24%, this taxpayer wants to know whether it is better to claim the premiums as a self-employed health insurance deduction or as additional medical expenses on Schedule A. The tax savings under each alternative are presented in Exhibit 1.
Self-Employed Health Insurance Deduction vs. Additional Medical Expenses
Another area of tax planning related to the QBI deduction involves SSTBs and taxpayers whose taxable incomes are within or above the thresholds for being able to claim a modified QBI deduction. Proper tax planning in this area can yield even more substantial tax savings than simply comparing the results from making different elections available under the law, as described above.
Using the 2022 taxable income phase-out range for the modified QBI deduction, consider an increase of $1,000 in itemized deductions by making an additional charitable contribution (Example A) or an increase of $1,000 in business deductions by increasing depreciation (Example B) for a single taxpayer with QBI when compared to a taxpayer whose taxable income is at the top of the phase-out threshold and not entitled to the QBI deduction.
An analysis of the $614 of income tax savings in Example A shows that $350 of this comes from multiplying the taxpayer’s regular marginal tax rate of 35% by the $1,000. The remaining tax savings of $264 comes from the additional QBI deduction of $753 generated by the reduction in taxable income (i.e., 35% × $753). The tax savings is slightly less in Example B due to the self-employment tax effect on taxable income and QBI. Because it is not linear—due to the QBI deduction being based on QBI and the phase-out being based on taxable income—it is impossible to come up with an exact marginal rate of tax savings. The approximate rate, however, would 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 in the next four years (2022 through 2025) should also consider that the QBI deduction is set to expire 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 will be higher over the next four years when it will be taxed at lower rates than it may be after 2025.
Depreciation is one area of the tax law that allows considerable flexibility in deferring deductions and resulting in increased QBI. The various elective provisions attributable to depreciation provide for numerous opportunities to maximize the QBI deduction. By electing out of bonus depreciation, taking less than the maximum election to expense, or simply electing straight-line depreciation rather than the modified accelerated cost recovery system (MACRS), taxpayers can take advantage of the QBI deduction at 20% while the TCJA is still in effect. Although this would increase taxes currently, the benefit would be to claim these same deductions in later tax years when they would presumably be taxed at higher rates.
No Crystal Ball
It is difficult to predict what actions Congress will take with the expiring provisions of the TCJA. Whether the QBI deduction will be 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 have to be vigilant and monitor the impact of expiring provisions as 2025 approaches.
Additional Charitable Contribution vs. Increased Business Depreciation