February 10, 2020
At the end of 2017, Congress enacted the qualified business income (QBI) deduction to provide owners of pass-through entities with a 20% profit reduction. The deduction is awarded to taxpayers whose individual taxable incomes stay below a certain threshold. If incomes rise high enough, they will be subject to an asset and wage limitation that may prevent them from receiving the full deduction. Before the final Section 199A deduction regulations were implemented, many business owners were unsure how having leased employees would affect their limitation (and therefore their deduction). The good news is the final regulations provide important guidance on this topic. To help clients, prospects, and others, Wilson Lewis has provided a summary of key points below?
The QBI deduction limitation will not apply to all taxpayers. For the 2019 tax year, the limitation will only be a concern when taxable income reaches $160,700 for single filers or $321,400 for joint filers. At this level, taxpayers should determine their limitation by calculating the greater of (1) 50% of their business’s W-2 wages, or (2) the sum of 25% of their business’s W-2 wages plus 2.5% of the unadjusted basis of qualifying business assets.
If the limitation is more than the QBI deduction, taxpayers can take the full deduction, but if it is less, their deductions will be limited. The limitation will only partially apply when taxable incomes are at the lower thresholds, but as incomes rise, the limitations get phased in. When taxable incomes reach the law’s upper thresholds ($210,700 and $421,400 for single and joint filers, respectively), they will fully apply. Let’s look at an example.
Taxpayer A, a single taxpayer, has taxable income of $180,000, QBI of $300,000, and W-2 wages of $90,000. Because their taxable income breaches the lower threshold of $160,700 but is less than the upper threshold of $210,700, the W-2 wage limitations will apply – but only partially. To determine the amount that will apply, they must first calculate their QBI deduction and the full limitation:
QBI $300,000
x 20% x 20%
Potential QBI Deduction $60,000
W-2 Wages $90,000
x 50% x 50%
W-2 Wage Limitation $45,000
Full W-2 Wage Reduction ($60,000 – $45,000) is $15,000
They must then calculate how much of the wage reduction gets phased in.
Upper Limitation $210,700
Less: Lower Limitation $160,700
Phase-in Range $50,000
Taxable Income $180,000
Less: Lower Limitation $160,700
Amount Exceeding Lower Limitation $19,300
Phase-in Percentage ($19,300 / $50,000) 38.6%
Full W-2 Wage Reduction $15,000
x Phase-in Percentage x 38.6%
Phased-in Wage Reduction $5,790
Potential QBI Deduction $60,000
Less Phased-in Wage Reduction ($5,790)
Limited QBI Deduction $54,210
From this example, we can see that the taxpayer’s wage limitations reduced their QBI deduction. If their wages had been just a bit higher – $120,000 rather than $90,000 – they would have had no wage reduction.
QBI $300,000
x 20% x 20%
Potential QBI Deduction $60,000
W-2 Wages $120,000
x 50% x 50%
W-2 Wage Limitation $60,000
Full W-2 Wage Reduction ($60,000 – $60,000) $0
Business owners whose taxable incomes breach the lower threshold will seek to report high wages so they can more easily qualify for the full deduction. The wage limitation is especially worrisome to business owners whose workforce is comprised of contractors and leased workers. If businesses lease a large majority of their workforce, they may not have the W-2 wages necessary to earn the deduction.
The final regulations released by the IRS a year ago addressed this concern. Leased workers’ wages can count toward the W-2 threshold if they are considered “common law employees.” Common-law employees are workers whose jobs and actions are controlled by the organization.
This new definition of W-2 wages allows businesses to count consideration paid to workers they lease from a professional employer organization (PEO) or some other qualifying employment organization for purposes of Section 199A. The W-2 wages the PEO pays to the worker can be allocated to the organization as long as the PEO reduces their W-2 wages for purposes of Section 199A accordingly.
Contracted workers are a different story. Independent contractors are not considered common law employees because the companies they do business with do not have the authority to dictate how the work gets done or when it gets done. Contracted workers’ consideration will not count toward the W-2 threshold unless the business can transition those workers into employees of a PEO.
The final regulations alleviated many of the W-2 wage concerns for organizations that lease employees. Without the IRS’s input on this matter, these business leaders would have been at a disadvantage compared to their C corporation counterparts. The 20% profit deduction can help level the playing field, but only if workers have the W-2 wages necessary to take the full deduction. If you have questions about the information provided above or need assistance with tax planning or compliance, Wilson Lewis can help. For additional information call us at 770-476-1004 or click here to contact us.