The new Section 199A provides self-employed taxpayers with a new pass-through deduction. For many, this deduction will be simple to calculate – 20% of Qualified Business Income (QBI). However, Congress included a safeguard to prevent high-income taxpayers from abusing the new deduction. You can refer to this safeguard as the W-2 limitation.
A taxpayer may only deduct 20% of QBI up to a certain limit. This limit is the greater of
- 50% of the W-2 wages paid by the qualified trade or business, or
- The sum of 25% of the W-2 wages paid by the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
For example, if a taxpayer has $200,000 of QBI, his pass-through deduction would otherwise be $40,000 (20% of QBI). Let’s assume that the taxpayer also has $20,000 of W-2 wages from the business. This taxpayer’s may only claim a $10,000 (50% of W-2 wages is the lesser amount) pass-through deduction.
By now you should be wondering how anyone could take the full 20% deduction. Naturally, the rules attach to this provision an exception that makes the W-2 limitation only applicable to high-income taxpayer’s. See below.
Taxable Income Exception
The new law contains an exception to the W-2 limitation rule discussed above. This exception states that if a taxpayer’s taxable income is below a certain threshold the taxpayer can ignore the W-2 limitation rule.
For 2018, the threshold amount is $157,500 (or $315,000 if married filing joint). This threshold figure will be indexed for inflation in future years. Also, please note that taxable income should be factored without including any potential pass-through deduction.
Phase-ins and Phase-Outs
The taxable income exception threshold discussed above is not absolute. The regulations give the taxpayer an additional $50,000 (or $100,000 if married filing joint) to phase-out the deduction. Therefore, taxpayers may still receive a partial deduction if their taxable income is above the threshold amount, but within the phase-out range.
You can find out more information on the W-2 Limitations and the calculation of the W2 wages for purposes of this limitation on the IRS website.
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