IRS pinches middle and lower income self-employed

The Tax Cuts and Jobs Act of 2017 reduced corporate and personal income tax rates. The main corporate tax rate was reduced from 35% to 21%. Not lowering tax rates for income from self-employment and pass-thru entities (Sub-S corporations, LLCs and partnerships) would have disadvantaged those kinds of income. (For ease of expression and brevity I shall call those kinds of income "qualified business income" or QBI.) Therefore, the TCJA also introduced the Qualified Business Income Deduction, or QBID. In many cases, the QBID is 20% of QBI.  However, there are caveats that result in the QBID being much less than 20% of QBI sometimes. (20% of QBI is the maximum.) The caveats especially pinch middle and lower income self-employed and others with QBI.

By "middle and lower income" I mean somebody with taxable income less than $315,000 if married filing jointly, or less than $157,500 if filing single or head-of-household. There is a worksheet in the IRS Form 1040 Instructions for such people. For those with incomes higher than those amounts, there is a different worksheet in IRS Publication 535.

In both worksheets 20% of taxable income after subtracting the filer's standard or itemized deductions may cause the QBID to be less than 20% of QBI. The 2018 standard deduction is $24,000 for joint filers both under age 65 and $12,000 for single filers under age 65. Since such amounts are higher as a percent of income for filers using the F1040 worksheet, the deduction can do more to reduce QBIDs than for filers using the Pub 535 worksheet.

The Pub 535 worksheet includes an entry for 50% of paid W-2 wages, i.e. wages paid to employees hired by the self-employed or pass-thru entity. It can preserve a QBID equal to 20% of QBI for higher income people when they have such employees. If somebody with taxable income more than $207,500 (single, head-of-household) or more than $415,000 (married filing jointly) has no such paid W-2 wages, then the QBID is $0. In contrast, the F1040 worksheet has no entry for 50% of paid W-2 wages, even if the self-employed or QBI person has other employees.

The implications and the worksheets are not simple, so some examples should help.

Bill has $50,000 taxable income from self-employment and no other income. He is married, files jointly, and takes the standard deduction of $24,000 (for 2018).  Hence, taxable income before QBID is $26,000. Therefore, his QBID is limited to 20% of $26,000, which equals $5,200 and is only 10.4% of his QBI. He does not get a QBID = 20%*$50,000 = $10,000.

If Bill had some employees whom he paid W-2 wages (and still netted $50,000 for himself), that would not raise his QBID. It would still be $5,200. Filers with much higher incomes using the Pub 535 worksheet can get a QBID = 20% of QBI by virtue of having paid W-2 wages to employees, but not Bill! That's even if Bill paid W-2 wages several times $50,000!

Jim has $20,000 taxable income from self-employment and no other income. He is single and takes the standard deduction of $12,000 (for 2018). Hence, taxable income before his QBID is $8,000. Therefore, his QBID is limited to 20% of $8,000, which equals $1,600 and is only 8% of his QBI. He does not get a QBID = 20%*$20,000 = $4,000.

There are other factors which could get Bill a higher QBID on his $50,000, such as taxable interest or Bill's wife having some W-2 wages, since these raise taxable income before QBID. For example, if Bill's wife had $24,000 of W-2 wages, Bill's QBID would be 20%*QBI. There are other factors which could get Jim a higher QBID on his $20,000 QBI. I mention these for fuller disclosure and choose to not address the complications.

There are millions of self-employed middle and lower income people in the USA. This page gives a glimpse of the numbers and jobs types.