Qualified Business Income and the Wyden Proposed Changes – “SSTB” May Be Out, But There Is a $400,000 Catch!

On July 20, 2021, Senate Finance Committee Chairman Ron Wyden (D-OR) released the Small Business Tax Fairness Act.  The bill, if enacted, would make changes to the 20% deduction that is available under IRC Sec. 199A for income earned through partnerships, LLCs, S corporations and sole proprietorships that was created by the 2017 Tax Cuts and Jobs Act (“TCJA”). The bill is expected to phase out the deduction for those making more than $400,000 but retain, clarify and potentially expand it for some small businesses.

The TCJA created the 20% deduction essentially to create parity with the lowering of the corporate income tax rate from 35% to 21%.  IRC Sec. 199A allows a noncorporate taxpayer a 20% deduction on qualified business income (“QBI”).  Therefore, a noncorporate taxpayer in the 37% tax bracket would pay an effective income tax rate of 29.6% (80% X 37%) on QBI.  QBI is generally defined as U.S.-sourced income generated by a pass-through entity by certain businesses.

Phase-Out for Income over $400,000

Sen. Wyden has raised several issues with the deduction. According to Sen. Wyden, “Half the benefit of the pass-through deduction goes to millionaires, and because the benefit is so skewed toward the top, many Main Street small business owners are excluded.” To eliminate this benefit to wealthy business owners, the QBI deduction would begin to phase out for all taxpayers with income over $400,000 and would be completely phased out by $500,000.  Under current law, the amount a taxpayer could take for QBI is unlimited (subject to taxable income, wage and unadjusted cost limitations).

Elimination of SSTB

He also noted that the deduction is currently designed so that business owners in some industries can benefit more from the tax break than business owners in other fields. Owners of certain service businesses, known as “specified service trades or businesses” (SSTBs), such as health care, law and accounting firms, face restrictions on the deduction, that apply for 2021 to single filers with income of above $164,900 and married couples with income above $329,800.

Sen. Wyden’s bill would expand eligibility for the full deduction to businesses and professions not currently eligible by removing the SSTB designation and making the deduction available for all qualified businesses.  However, this is not all good news. as the proposed $400,000 phase-out would limit the benefit to those taxpayers.

Simplification of the QBI calculation

Sen. Wyden’s bill would also aim to simplify the calculation of the QBI deduction.  Under the bill, the calculation of a taxpayer’s QBI deduction would simply be an amount equal to 20% of

1. the qualified business income of the taxpayer,
2. the threshold amount {for 2021, taxable income under $329,000 married joint & $164,900 for all other taxpayers}, or
3. the taxable income of the taxpayer for the taxable year reduced by the net capital gain (as defined in IRC Sec. 1(h)) of the taxpayer for such taxable year.

This eliminates the wage and unadjusted cost requirements under current law that add complexity to the overall computation.

Changes to Eligible Taxpayers

Under current law, the QBI deduction is available to trusts, estates and taxpayers filing married separately.  Under Sen. Wyden’s proposed bill, the QBI would not be available to trusts, estates and taxpayers married filing separately.

The proposal comes after Senate Democrats reached an agreement on a $3.5 trillion budget plan, and it comes as some Democrats are discussing how to pay for their spending priorities. Changes to the pass-through deduction could be an appealing way for Democrats to raise revenue. However, Republicans are likely to argue that an overhaul of the tax break would amount to a tax increase on small businesses making the passage of the bill an upward battle.