Tax Prep Dispatch: Let's Keep It Simple: QBID

This filing season preparers and reviewers have the additional task of explaining to taxpayers how the Tax Cut and Jobs Act affects their returns. This is the third Tax Prep Dispatch that explores how this might be accomplished. The first two discussed exemptions and deductions, and the child tax credit and the new credit for other dependents. This week we’re looking at the qualified business income deduction also known as QBID.

Please be aware that regulations posted January 19, 2019, modified the calculation of the QBID. Originally, the QBID was, in most cases, 20% of AGI less the standard deduction (or itemized deductions) or 20% of net business income, whichever was less. But the regulations stipulate that for the part of the calculation based on business income, instead of using just net business income, the qualified business income is net business income minus the following three adjustments to income: ½ of self-employment tax, self-employed health insurance and contributions to qualified retirement plans. If you have a printed copy of IRS materials with a revision date before January 19, the information about the QBID calculation is probably not complete and correct. For the IRS correct QBID information and worksheet, go online to the latest version of the 1040 instructions.

For most VITA taxpayers, the QBID is computed in the following three parts. (Most VITA taxpayers have no adjustment for self-employed health insurance or contributions to qualified plans, and the taxable income before QBID is less than $157,500, $315,000 for married filing jointly.)

1. Take the net income from Schedule C and subtract ½ self-employment tax. Multiply the answer by 20%.

2. Take the AGI and subtract the standard (or itemized) deduction. From that, subtract any qualified dividends and net capital gains. Multiply answer by 20%.

3. Compare the results of part 1 and part 2. The smaller is the QBID.

Note: For the following examples, assume everyone is under age 65, had health insurance all year, there is no other income or deductions, and no other complications.

Situation – Schedule C income is less than taxable income before QBID.

Example 1: Married filing jointly, net income on taxpayer’s Schedule C is $11,000. Spouse earned $32,000 wages.

1. Take the net income from Schedule C and subtract 1/2 self-employment tax. Multiply the answer by 20%.

  • $11,000 - $778 = $10,222
  • $10,222 X 20% = $2,044

2. Take the AGI and subtract the standard (or itemized) deduction. From that, subtract any qualified dividends and net capital gains. Multiply answer by 20%.

  • $42,222 - $24,000 = $18,222
  • $18,222 X 20% = $3,644

3. Compare the results of part 1 and part 2. The smaller is the QBID.

  • $2,044 is less than $3,644 so their QBID is $2,044.
  • So their taxable income is $18,222 - $2,044 = $16,178

Taxpayer: The preparer is very nice, but she made a mistake. I read somewhere that since I’m self-employed, I get a deduction for 20% of my income. 20% of $43,000 is $8,600. That’s the new law. I didn’t get any deduction like that.

Reviewer: You’re right, there is a new 20% deduction for self-employed taxpayers. But it’s not 20% of the total income.  It’s generally 20% of your business income after all your deductions and adjustments. And it just applies to your business income – not your wife’s wage income.

Taxpayer: Good grief. That sounds complicated. So, what do I actually get?

Reviewer: In your case, you get 20% of your business income after all of your deductions, including the deduction for self-employment taxes. It comes out to $2,044 less in taxable income, so it does lower the income tax you are paying.

Taxpayer: I thought it sounded too good to be true. But it’s something.

Keep in mind that the QBID just applies to business income – for VITA taxpayers, we’re talking about Schedule C income.

Situation – Taxable income before QBID is zero.

Example 2: Married filing jointly, net income from Schedule C is $21,000 and wage income is $1,500.

1. Take the net income from Schedule C and subtract ½ self-employment tax. Multiply the answer by 20%.

  • $21,000 - $1,484 = $19,516
  • $19,516 X 20% = $3,903

2. Take the AGI and subtract the standard (or itemized) deduction. From that, subtract any qualified dividends and net capital gains. Multiply answer by 20%.

  • $21,016 - $24,000 = $0
  • $0 X 20% = $0

3. Compare the results of part 1 and part 2. The smaller is the QBID.

  • $0 is less than $3,903 so their QBID is $0.
  • And their taxable income is $0.

Taxpayer: The preparer is very nice, but he made a mistake. I read somewhere that since I’m self-employed, I get a deduction for 20% of my business income. 20% of $21,000 is $4,200. That’s the new law. The preparer said that I didn’t get this deduction at all!

Reviewer: You’re right, there is a new 20% deduction for self-employed taxpayers. But it’s limited to be no more than 20% of your total income after you subtract your standard deduction. In your case, your standard deduction is $24,000, which is more than your total income. Your taxable income is zero and that means your new business income deduction is also zero.

Taxpayer: But that preparer said that I owe almost $3,000. How could that be if I don’t even have any taxable income?

Reviewer: You’re not paying any income tax, but you do have to pay self-employment tax – your social security and Medicare taxes.  It’s about 15% of your business income. The new business deduction can’t help with that, I’m afraid.

Taxpayer: OK. I know you told me last year, but why is it I also have to pay self-employment tax?

Reviewer: Everybody with earned income has to pay about 15% of their income into social security and Medicare. When you are an employee, your employer pays half and the other half is withheld from your wages. When you are self-employed, you have to pay the whole thing at tax time.

Taxpayer: OK. Got it.

Keep in mind, whenever the standard deduction is more that the AGI, the QBID will be zero. Also, it is important to remember that the QBID does not help with self-employment tax. It only reduces income tax.

Situation – Schedule C is the only income.

Example 3: Single, net Schedule C income $30,000.

1. Take the net income from Schedule C and subtract ½ self-employment tax. Multiply the answer by 20%.

  • $30,000 - $2,119 = $27,881
  • $27,881 X 20% = $5,576

2. Take the AGI and subtract the standard (or itemized) deduction. From that, subtract any qualified dividends and net capital gains. Multiply answer by 20%.

  • $27,881 - $12,000 = $15,881
  • $15,881 X 20% = $3,176

3. Compare the results of part 1 and part 2. The smaller is the QBID.

  • $3,176 is less than $5,576 so her QBID is $3,176.
  • Her taxable income is $15,881 - $3,176 = $12,075

Taxpayer: The preparer is very nice, but she made a mistake. Last year my income was about the same and I owed over $6,500. This year she says I just owe $5,575. I’m afraid she missed something. I don’t want to get into trouble with Uncle Sam.

Reviewer: I’m glad you brought a copy of your 2017 return. Last year you paid $4,238 in self-employment tax and that’s the same this year. The difference is income tax. There’s a new deduction based on business income. It reduced your taxable income by $3,176. On top of that, the income tax rates went down.

Taxpayer: You mean that $5,575 is all I owe? She’s right?

Reviewer: Yep. This return is correct.

Note that in this case, the QBID is based on taxable income before the standard deduction, rather than 20% of the Schedule C income.

Situation – Schedule C income is more than taxable income before QBID.

Example 4: Single, net Schedule C income $24,000, wages $1,000.

1. Take the net income from Schedule C and subtract ½ self-employment tax. Multiply the answer by 20%.

  • $24,000 - $1,696 = $22,304
  • $22,304 X 20% = $4,461

2. Take the AGI and subtract the standard (or itemized) deduction. From that, subtract any qualified dividends and net capital gains. Multiply answer by 20%.

  • $23,304 - $12,000 = $11,304
  • $11,304 X 20% = $2,261

3. Compare the results of part 1 and part 2. The smaller is the QBID.

  • $2,261 is less than $4,461 so her QBID is $2,261.
  • His taxable income is $11,304 - $2,261 = $9,043

Taxpayer: The preparer is very nice, but he made a mistake. He really seemed OK until he explained my return to me and then he sounded really confused. Something about 20% and whichever is less. What a chaotic jumble. It can’t be right. 

Reviewer: Sounds like he was describing the new qualified business income deduction. Since you’re self-employed, your income qualifies for this deduction. And, yes, it is 20% of two different income figures and you can deduct whichever is less.

Taxpayer: Huh. Whad‘ya know.

Note that in this case, the QBID is based on AGI less the standard deduction, rather than 20% of the Schedule C income.

Alert! Don’t start filing 1040-Xs yet! Some Schedule Cs were filed before the new regulations were fully understood and incorporated into tax preparation software. IRS is developing guidelines on how preparers should handle those cases.

Summary

Explaining the differences between one tax year and another is rarely easy. With all the changes in tax law, it is particularly difficult – even with the starkly simplified situations presented here. Here’s hoping that understanding these examples will help preparers and reviewers to understand and explain the more complex real-world situations.

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