The new qualified business income (QBI) deduction provides shareholders and partners of pass-through entities with a tax rate reduction similar to what C corporations now receive under the Tax Cuts & Jobs Act (TCJA).

For tax years beginning January 1, 2018, or later, the TCJA has repealed the domestic production activities deduction (DPAD), an approximately 9% deduction unique to construction and other select industries. Consequently, contractors see an increase from the previous 9% with specific limitations under DPAD to a potential 20% with the QBI deduction,¹ with similar and different limitations.

While certain policy decisions related to the new deduction may still be adjusted, the proposed regulations² clarify many issues and raise others. This article will offer an overview of the new deduction and explore considerations for companies going forward.

Qualifying Business & Service Businesses

Unlike DPAD, which applied to corporate taxpayers and pass-through entities primarily in the construction and manufacturing industries, the QBI deduction is available to all non-corporate taxpayers³ engaged in “any trade or business other than a specified service trade or business” under Section 162.⁴

The reference to Section 162 is important for most industries due to the considerable history of cases defining what qualifies as a “trade or business.” For related multiple entities holding real estate, there is not a clear result from the Section 162 lines of cases.

Although it’s beyond the scope of this article, it is important to note that the QBI deduction also applies to real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income.⁵

What Income Qualifies for the QBI Deduction?

The QBI deduction applies to “qualified business income,”⁶ which is defined as “items of income, gain, deduction, and loss [that] are effectively connected with the conduct of a trade or business within the United States.”⁷

This affects contractors differently than the DPAD previously had, as the QBI deduction is not reduced for the proportion of revenues representing construction services such as service or repair revenue (i.e., activities under the DPAD regulations that are not directly related to the erection or substantial renovation of real property).⁸

However, certain non-ordinary income (i.e., capital gains and dividends) that is not properly allocable to a qualified business⁹ is excluded because it is generally taxed at lower marginal rates. Further, income not related to the qualified trade or business (i.e, certain interest income) is also excluded from QBI.

For example, capital gains and qualified dividends are taxed at more favorable capital gains rates from zero to 20% (or 23.8% when, in many cases, the 3.8% surtax on investment income applies). This compares to the new ordinary income tax rates that reach 37% for individuals.

How Is the QBI Deduction Calculated?

The QBI deduction provides a deduction for 20% of qualified income that is subject to several limitations. The following scenarios will illustrate how deductions can be calculated across different circumstances.

Scenario 1

Consider a taxpayer’s qualified taxable income, which is reduced by the net capital gain.¹⁰ For example, Contractor X, with $150,000 of taxable income, $20,000 of which is capital gain, would be limited to, at most, a QBI deduction of $26,000 (20% x [$150,000 taxable income – $20,000 capital gain]).

Second, a taxpayer’s QBI deduction is further limited to the greater of:

1. 50% of the qualified business’ W-2 wages; or
2. The sum of:

a)  25% of the qualified business’ W-2 wages plus

b)  2.5% of the taxpayer’s unadjusted basis immediately after acquisition of all qualified property (generally, the cost of fixed assets)^.11

The option to use Form W-2 wages plus the unadjusted basis in property may enable certain businesses to qualify for the new QBI deduction, even though they generally do not have Form W-2 wages.