W-2 wages and Sec. 199A
By Jin Dong Park, CPA, Ph.D., and Zhen Zhang, CPA, Ph.D.
Under new Sec. 199A, taxpayers other than C corporations can deduct up to 20% of their qualified business income (QBI) from taxable income. The deduction benefits many taxpayers, but its calculation is complex. This column provides visual and mathematical aid for the calculation and suggests strategies that may help maximize the deduction.
The calculation can be broken down into three layers:
Layer 1: Sec. 199A deduction = the lesser of the taxpayer's combined QBI deduction amount or 20% of the excess of the taxpayer's taxable income above net capital gain.
Layer 2: Combined QBI deduction amount = the sum of:
The aggregate of the deductible amounts for each of the taxpayer's qualified trades or businesses, plus
20% of the aggregate of the amount of the taxpayer's qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
To calculate the first component of Layer 2, the aggregated deductible amount, taxpayers need to analyze each business and calculate the deductible amount for each business.
Layer 3: Deductible amount of each qualified trade or business.
Taxpayers are generally entitled to a deduction of up to 20% of QBI for each qualified trade or business. QBI is the net amount of the qualified items of business income, gain, deduction, and loss of the taxpayer that are effectively connected with conducting the trade or business within the United States. The deductible amount may begin to phase out when taxpayers' taxable income reaches $321,400 for a married couple filing a joint return, $160,725 for married taxpayers filing separately, and $160,700 for single and head-of-household taxpayers (for 2019). The amount of the deduction and the amount of the phaseout depend on the taxpayer's taxable income, the type of business, the amount of W-2 wages paid by the business, and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the business. The table "Deductible Amount of Each Trade or Business" summarizes the deductible amount by taxpayers' taxable income and filing status.
Deductible amount of each trade or business
Qualified trades or businesses do not include specified service trades or businesses (SSTBs). An SSTB refers to any trade or business described in Sec. 199A(d)(2) — (1) one that involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, financial services, or brokerage services; (2) has as its principal asset the reputation or skill of one or more owners or employees; or (3) involves performing services of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.
Taxpayers in Group II in the table (i.e., with taxable income in the phaseout range) are subject to a phase-in of the wage and capital (W&C) limitation: The deductible QBI amount for a trade or business other than an SSTB is 20% of QBI, less an amount equal to a reduction ratio (taxable income less the applicable phaseout threshold amount divided by $100,000 for married filing jointly (MFJ) or $50,000 for other taxpayers), multiplied by the trade or business's excess amount (20% of QBI less the W&C limitation amount). The deductible QBI amount for an SSTB is calculated by (1) multiplying the SSTB's qualified items of income, gain, deduction, or loss, W-2 wages, and UBIA of qualified property by an applicable percentage to determine the amount of QBI, W-2 wages, and UBIA of qualified property for purposes of calculating the SSTB's deductible QBI; (2) calculating the SSTB's deductible QBI using these amounts in the same way as described above for a qualified trade or business.
For taxpayers in Group III in the table with income from an SSTB, the deduction for the SSTB is completely phased out. For qualified businesses other than an SSTB, the deductible amount for Group III taxpayers is 20% of QBI up to the W&C limitation. Specifically, the W&C limitation of each business equals the greater of (1) 50% of W-2 wages of the business or (2) 25% of the W-2 wages plus 2.5% of the unadjusted basis of qualified property of the business. For Group II taxpayers, the deductible amount for a qualified business is 20% of QBI reduced by a certain amount. This certain amount becomes zero when the W&C limitation is more than 20% of QBI. Therefore, for both Group II and Group III taxpayers, the W&C limitation constrains the QBI deduction when it is below 20% of QBI.
When 50% of W-2 wages is below 20% of QBI, or W-2 wages are below 40% of QBI, the deductible amount is subject to the W&C limitation. Group III taxpayers are allowed no deduction for income from SSTBs.
In the graph "Relationship Between QBI Deduction and W-2 Wages for a Group III Taxpayer," at the point where the W-2 wages are zero, i.e., the business has no employees, the deductible amount would also be zero. As the W-2 wages increase, the deductible amount increases until the W&C limitations reach 20% of QBI. When the W&C limitations are greater than 20% of QBI, further expanding W-2 wages would yield no incremental tax benefits.
Relationship between QBI deduction and W-2 wages for a group III taxpayer
If a qualifying business hires additional employees, the increase in W-2 wages will reduce net business income proportionally, and by 7.65% for Federal Insurance Contributions Act (FICA) taxes. Alternatively, businesses might increase W-2 wages by hiring their current independent contractors as employees. This strategy has no impact on business income except for FICA taxes.
In practice, expanding recruitment may have a broader impact on businesses, such as business growth and recruiting expenses, including searching for and training of new employees. Expanding recruitment may also be subject to some constraints, such as the business's infrastructure and production capacity. Therefore, although expanding employment can be tax-beneficial to the business under Sec. 199A, other factors and concerns may eclipse the tax benefits.