PPB August 2018

2.5 percent of the unadjusted basis of qualified property. Let’s assume that of the $1.6 million in operating expenses, total labor is $800,000, of which $600,000 is W-2 and $200,000 is 1099 contract labor. The $200,000 of 1099 contract labor does not qualify as wages for the QBI deduction. Therefore, we can only use the W-2 wages paid to actual employees, which in this example is $600,000. Of the $600,000 in W-2 wages, $300,000 qualifies for the QBI computation ($600,000 x 50 percent). Additionally, let’s assume the business owns $1.3 million of manufacturing equipment that is qualified property. Our wage and capital factor is $182,500, 25 percent of W-2 wages $150,000 plus $32,500 for the capital factor ($1.3 million qualified property x 2.5 percent). Therefore, we use $300,000 of W-2 wages for the QBI computation since that is the greater of two. Typically, 50 percent of W-2 wages will be the greater amount to use for the wage and capital factor in computing QBI unless there is little or no W-2 wages. Now assume that Joe and Mary are homeowners with mortgage interest, property taxes and charitable donations totaling $32,000 for 2018. Their itemized deductions of $32,000 exceed the new standard deduction of $24,000; therefore, we will use the itemized deductions to compute taxable income. Joe and Mary have taxable income of $468,000 ($500,000 QBI pass- through fromK-1 minus $32,000 itemized deductions). Now that we know the taxable income, we must analyze to compute the 20 percent QBI deduction. Here are the figures for the taxable income and 50 percent of W-2 wages as the wage factor, which we will use for the 20 percent QBI deduction: • Joe and Mary's taxable income - $468,000 • 50 percent of W-2 wages - $300,000 IRC §199A states that we must take 20 percent of the lowest of the two components. The wage component is the lowest of the two amounts, which provides a $60,000 QBI deduction ($300,000 x 20 percent). Joe and Mary’s final taxable income for federal tax purposes will be $408,000 ($500,000 gross income minus $32,000 itemized deductions minus $60,000 QBI deduction). Joe and Mary will have a federal tax liability of $93,846. Assuming they had the same taxable income in 2017 under the old tax law, their tax liability would be $109,857, a difference of $16,011. With tax planning during the year, Joe and Mary can get their taxable income down to the ideal figure of $315,000 and have a much lower tax liability of $64,179, providing an additional tax savings of $29,667. Who wouldn’t want that? Service Business Case Example Let’s look at the impact of the law on specified service businesses. To illustrate, let’s assume Stephanie is single and operating a small marketing firm as an S corporation with three employees paid W-2 wages. Stephanie’s firm generates gross income of $470,000 and pays expenses of $289,000, of which $126,000 are W-2 wages paid to her employees. The net income from her business is $181,000 ($470,000 gross income minus $289,000), which on the surface looks like it will disqualify Stephanie from benefiting from the 20 percent QBI deduction. However, when we consider Stephanie’s deductions on her personal tax return, we realize that Stephanie owns a nice condo on Miami Beach, paying $16,400 for mortgage interest, $4,800 for property taxes and $4,700 in charitable donations. As a result, her 2018 itemized deductions total $25,900, which is greater than the $12,000 standard deduction for a single taxpayer under the TCJA legislation. Stephanie’s taxable income is $155,100, which gets her below the anti-abuse threshold of $157,500, allowing her to benefit from the 20 percent QBI deduction. Stephanie’s 20 percent QBI deduction is based on the lesser of the 20 percent QBI ($181,000) or her taxable income ($155,100). Based on the two variables, we must compute her 20 percent QBI deduction using the taxable income of $155,100, which provides her with a QBI deduction of $31,020 ($155,100 x 20 percent QBI deduction). Had Stephanie’s taxable income been more than $157,500 and under $207,500, she would be in the bubble range, and her opportunity to benefit from the 20 percent QBI deduction would be phased out due to the anti-abuse laws. In comparison with the 2017 tax law, Stephanie’s taxable income of $155,100 would Joe & Mary’s taxable income $468,000 50 percent of W-2 wages $300,000 66 | AUGUST 2018 | THINK