Be Aware of the W-2 Limitation When Calculating the New Pass-Through Deduction

Introduction

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 safe guard to prevent high income taxpayers from abusing the new deduction. This safeguard can be referred to as the W-2 limitation.

W-2 Limitation

A taxpayer may only deduct 20% of QBI up to a certain limit. This limit is the greater of

1. 1. 50% of the W-2 wages paid by the qualified trade or business, or

2. 2. 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, attached to this provision is 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 taxpayer is afforded 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.

Disclaimer: Reading this blog post does not create an attorney-client relationship. This post should not be used as a substitute for the advice of a competent attorney or tax professional admitted or authorized to practice in your jurisdiction.