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Taxpayer marital status and the QBI deduction

The law known as the Tax Cuts and Jobs Act (TCJA),1 enacted in 2017, made significant changes to the corporate and individual tax structures. Corporate tax rates were reduced from a maximum rate of 35% to a flat rate of 21%, the corporate alternative minimum tax (AMT) and the domestic production activities deduction were eliminated, and provisions were enacted to shift the U.S. corporate tax structure from a worldwide tax system to more of a territorial system.

Individual tax rates were lowered, with the top rate falling from 39.6% to 37%, standard deductions, and child credits increased, and personal exemptions were eliminated. Some additional limitations were imposed on itemized deductions, including on qualified residential interest and state and local tax deductions. Some charitable contribution limitations were relaxed, while miscellaneous itemized deductions (including unreimbursed employee business expenses and investment expenses) were eliminated altogether.

In addition, to ensure equity and parity for U.S. businesses taxed as conduit entities (e.g., sole proprietorship, S corporations, limited liability companies, and limited/general partnerships), Congress created Sec. 199A, which provides for a 20% qualified business income (QBI) deduction. This provision was enacted in direct response to the corporate tax rate reduction from 35% to 21%. Simply stated, the QBI deduction serves to potentially reduce a conduit entity’s effective tax rate from 37% to 29.6%. Unlike the corporate tax rate reduction (which is permanent), the QBI deduction, along with the majority of TCJA-enacted individual tax modifications, is scheduled to sunset on Dec. 31, 2025.

Concurrent with any major tax reform is consideration of how it impacts marriage penalties/bonuses. A marriage penalty or bonus is the difference in a couple’s total tax liability resulting from a change in filing status from single or head of household to married filing jointly (MFJ). The extent of such a penalty or benefit is a function of various factors, such as the amount of combined income and how it is earned (e.g., approximately evenly between spouses or significantly disparately), the credits to which the taxpayers are eligible, and whether the couple is subject to the AMT, net investment income tax, and/ or the additional Medicare tax.

Amir El-Sibaie2 argues that marriage penalties and bonuses violate neutrality and that analyses show that marriage penalties/bonuses tend to have little to no effect on whether a couple will marry. More recently, however, Christine Cheng et al.,3 analyzing a sample of 43,587 same-sex couples from the 2012–2016 American Community Survey (ACS) Public Use Microdata Sample, found that an impending marriage tax penalty did, in fact, have an economically-significant effect on a same-sex couple’s decision to marry, while a marriage bonus did not have a corresponding impact. The study provides evidence that same-sex couples may weigh tax and financial considerations differently in rendering their decision to marry, as compared with opposite-sex couples. That said, the U.S. Census Bureau4 indicated that, as of 2019, an extensive number of opposite-sex, cohabitating couples (about 8 million, or approximately 11.5% of the number of all opposite-sex couple households — a figure that has increased in the last decade) had opted to forgo legal marriage, suggesting that this subgroup of the population may also elevate consideration of tax/financial factors in their marriage decisions.

Other researchers examined the TCJA’s impact on marriage penalties/ bonuses and found that various aspects of the TCJA attempted to equalize the tax burden between the single and MFJ filing statuses, but other provisions, such as more restrictive limitations on certain deductions, ultimately had the opposite impact.5

Existing research, however, does not include an examination of Sec. 199A through the lens of the marriage penalty/bonus. On the surface, Sec. 199A appears relatively immune to marriage penalties/bonuses, in large part because the income ceilings under which a full QBI deduction is allowed are logically paired (i.e., $163,300 for single taxpayers versus $326,600 for MFJ (2020 limits)). A deeper investigation reveals this is not the case and that the QBI deduction may significantly affect marriage bonuses/penalties.6

One might ask whether tax planning strategies linked to a decision to marry are moot, given that a 1997 Congressional Budget Office study,7 using data from 1969 to 1995, finds that marriage penalties/bonuses have little effect on whether a couple will marry. The answer is no, for two reasons. First, the 1997 study did not analyze same-sex couples, who were granted the legal right to marry only in 2015,8 and who Cheng et al.9 found do consider factors such as marriage penalties in their marital decisions. Second is the upward trend in the number of opposite-sex couples opting to forgo legal marriage, likely for a host of reasons that include tax/financial considerations. More specifically, Robin Fisher et al.,10 Mike Schneider,11 and the U.S. Census Bureau12 found in their 2018, 2020, and 2021 studies that the number of same-sex joint filers is estimated to be about 58% to 59% of the total number of self-reported same-sex couples, while the same ratio for different-sex couples is 88.5% to 92%.

Interestingly, the percentage of unmarried same-sex couples has remained quite constant since marriage equality was granted by the Supreme Court in Obergefell v. Hodges13 in 2015, while the percentage of unmarried opposite-sex couples is on the rise, going from 8% to 11.5% in the latter part of the last decade. Overall, the data suggest that approximately 8.4 million unmarried couples are in the United States (i.e., 412,000 same-sex14 and 8 million opposite-sex15).

This article discusses a series of hypothetical tax scenarios designed to highlight the potential marriage bonuses or penalties that may be associated with Sec. 199A. It first briefly discusses the QBI deduction, with an explanation of key provisions of Sec. 199A, and then gives an overview of the TCJA’s impact on marriage penalties/bonuses.

Business taxation in the US as justification for Sec. 199A

For federal taxation purposes, U.S. businesses fall primarily into two categories: (1) conduit (disregarded or passthrough entities — e.g., sole proprietorships, partnerships, and S corporations) and (2) C corporations. Most businesses in the United States are taxed as a conduit, or passthrough, entities, as evidenced by the most recent data published by the IRS Statistics of Income (SOI) division for the years 1980–2015.16 The data indicate that in 2015, approximately 92.5% of all business returns were filed by passthrough entities, while only 4.6% were by C corporations. In terms of business net income for 2015, the disparity was not as extreme as the number of the returns filed but is still significant, in that conduit entity business net income was approximately 63.3% of the total, compared with 36.7% for C corporations. The significant prevalence of single-taxed conduit entities in 2015 is logical, given the maximum potential federal tax rate of 39.6%, compared with double-taxed C corporations, with a maximum combined federal tax rate of 50.47% (35% + 15.47% ([qualifying dividend tax rate of 20% + the net investment income tax rate of 3.8% = 23.8%] × 65% (i.e., available earnings and profits = corporate net income less federal income taxes at 35%))).17

Over the last 113 years, federal corporate tax rates have fluctuated from a low of 1% in 1909 to an all-time high of 52.8% in 1969 (to fund the Vietnam War). From 1993 to 2017, the top corporate tax rate remained stable at 35% for corporations with taxable income over $18.33 million.18 Individual tax rates have experienced similar variability. From 1987 to 2017, top individual marginal rates dropped to a low of 28% for tax years 1988–1990 to a high of 39.6% before the enactment of the TCJA.19 In 2017, the TCJA permanently reduced the corporate tax to a flat rate of 21%, effective for tax years 2018 and after.

A key element of the TCJA was the congressional focus on lowering business tax rates as a vehicle to expand the tax base while incentivizing job creation. During the congressional debate over the TCJA, conduit entity owners sought comparable tax relief.20 Heeding this request, in no small part because of the significant percentage of U.S. businesses structured as passthrough entities,21 Congress enacted Sec. 199A, which provided individuals, trusts, and estates that maintained conduit entity business income with the opportunity to deduct up to 20% of their QBI from their taxable income.

Sec. 199A QBI deduction

The QBI deduction under Sec. 199A was enacted for tax years beginning after Dec. 31, 2017, to ensure equity in the tax system for businesses taxed as passthrough entities, in direct response to the corporate tax rate reduction from 35% to 21%.22 Sec. 199A(a) provides that taxpayers other than corporations are entitled to a deduction for any tax year equal to the lesser of (1) the taxpayer’s “combined qualified business income amount” or (2) 20% of the excess of the taxpayer’s taxable income for the tax year over any net capital gain. A taxpayer’s combined QBI deduction is generally equal to the sum of (1) 20% of the taxpayer’s QBI with respect to each qualified trade or business, plus (2) 20% of the aggregate amount of any qualified real estate investment trust dividends and qualified publicly traded partnership income.

Definition of ‘qualified trade or business’

As Congress crafted the provisions related to Sec. 199A, concerns surfaced about the potential for abuse of the QBI deduction by taxpayers engaged in certain personal service activities. More specifically, there was apprehension that personal service professionals might strategically opt to forgo salary-type payments in favor of having their services compensated through a consultancy payment to a passthrough entity in which they had an ownership interest. This concern gave rise to the specified service trade or business (SSTB) provisions of Sec. 199A.

Sec. 199A(d) provides that a qualified trade or business for purposes of the QBI deduction includes any trade or business other than an SSTB or the trade or business of performing services as an employee. Sec. 199A(d)(2) defines an SSTB as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners,23 or that involves the performance of services that consist of investing and investment management trading or dealing in securities, partnership interests, or commodities. Sec. 199A does, however, provide a workaround to the SSTB rules for taxpayers that fall below certain income levels.

SSTB exception based on taxable income

Sec. 199A(d)(3) provides for a full exception to the SSTB exclusion for taxpayers whose taxable income before consideration of any Sec. 199A deduction does not exceed certain thresholds. For 2022, the thresholds are $340,100 for married taxpayers filing jointly and $170,050 for all other filers. A partial SSTB exception is available for married taxpayers filing jointly with taxable income between $340,100 and $440,100 (i.e., with a phaseout ceiling of $100,000 above the threshold) and for other filing statuses with taxable income between $170,050 and $220,050 (a phaseout ceiling of $50,000 above the threshold).24 Taxpayers with taxable incomes exceeding the upper threshold will not be able to include any SSTB income as QBI for purposes of the Sec. 199A QBI deduction.

In computing the QBI with respect to an SSTB, the taxpayer only factors in the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 wages and qualified property. In summary, taxpayers who fall below the income thresholds have relatively unfettered access to the 20% QBI deduction regardless of the type of entity in question (e.g., SSTBs). The Sec. 199A marriage bonus/penalty analyses that are presented later in this article focus predominantly on taxpayers that fall within the Sec. 199A(d)(3) income limits.

The TCJA’s impact on marriage penalty vs. bonus

The existence and size of a marriage penalty or benefit is a function of a variety of factors, such as the amount of combined income, how much income can be attributed to each individual (e.g., approximately evenly or significantly disparately), the additional tax systems to which the taxpayers are subject (e.g., the net investment income tax or the additional Medicare tax), as well as the eligibility to claim a variety of deductions (e.g., for deductible individual retirement account (IRA) contributions and itemized deductions) and tax credits. Due to the federal tax system’s progressive tax rate structure that varies by filing status, marriage benefits are more likely to surface when individuals with disparate income amounts marry, while marriage penalties are more likely to occur when two individuals with equal incomes marry.

Various researchers examined the TCJA’s impact on marriage penalties/ bonuses.25 Three studies found that, while the TCJA attempted to mitigate marriage penalties by providing greater parity in the tax rate tables (i.e., the MFJ tax rate tables were made double the single rate table up to combined taxable incomes of $400,000 for the tax year 2018), other factors clearly perpetuated the marriage penalty for some couples. Some of these factors preceded the TCJA, such as: (1) threshold and/ or exemption amounts for long-term capital gain/qualifying dividend tax, the net investment income tax, the additional Medicare tax, and the AMT not being double those of single filers; (2) inequity in the limitations imposed on certain itemized deductions (e.g., the state and local tax deduction cap of $10,000 is not doubled for married joint filers); (3) rules related to the inclusion of Social Security income and deduction of IRA contributions; and (4) access to the earned income tax credit and other credits. While the TCJA imposed statutory modifications to many of the common factors impacting marriage penalties and bonuses (e.g., state/ local taxes), a new factor in the marriage penalty/bonus game was created through the enactment of the Sec. 199A QBI deduction.

Implications for a marriage penalty/bonus

The analysis below focuses primarily on couples with taxable income below the Sec. 199A(d)(3) income thresholds because the 2018 IRS Statistics of Income Report indicates that those amounts correspond to approximately 93% to 95% of all married couples.26 Studies from as early as 1995 to as recently as 201827 provide evidence that in only relatively few situations do marriage penalties or bonuses seemingly impact the timing of a couple’s nuptials. However, it was not until Obergefell28 was decided in 2015 that same-sex couples were uniformly allowed to legally marry in the United States. Furthermore, researchers find that opposite-sex and same-sex couples behave dissimilarly in terms of the considerations they factor into their choice to marry.29 The U.S. Census Bureau estimates that 41% to 42% of same-sex couples eligible to marry ultimately opt not to do so. This number is significant relative to the total population of same-sex couples as compared to their opposite-sex counterparts, where estimates suggest only 8% to 11.5% of couples choose to remain unmarried. Regardless, the most recent U.S. Census data suggests that over 8.4 million cohabitating unmarried couples are eligible to marry but have not yet done so. The following QBI tax planning strategies, therefore, focus on these taxpayers.

The fact that approximately 42% of same-sex couples choose to forgo legal marriage is likely a function of many factors. First, full access to legal marriage has only been available for seven years, while many same-sex couples have been together for much longer. Furthermore, prior to access to lawful marriage, the legal, financial, and medical obstacles same-sex couples encountered demanded proactive attention in terms of setting up documents such as wills, medical and general powers of attorney, physician’s directives, living trusts, and other financial structures to ensure that their life partners and their assets were protected.

This added level of legal and financial attention results in many same-sex couples being more in tune with tax and wealth-transfer planning. Cheng et al.30 in their 2021 study provide evidence that same-sex couples consider different factors in a decision to marry than do the majority of opposite-sex couples. This is not to say that the subset of opposite-sex couples opting out of formal marriage does so for reasons dissimilar to same-sex couples. In fact, the increase in the percentage of opposite-sex couples choosing not to marry likely suggests these couples are considering financial and tax incentives/ disincentives as part of their overall marriage decision process. It is these financial/tax-focused unmarried couples who are likely to be a receptive audience to the type of Sec. 199A marriage penalty/bonus analyses this article now presents.

Sec. 199A tax considerations for unmarried ‘partnered’ couples

Many studies identify the relative upside and downside of marriage as it relates to income tax, wealth-transfer tax, and retirement planning for both opposite- and same-sex couples, whether the couple is married under common law or civil law, and whether the couple is domiciled in community property states.31 Below are four scenarios designed to highlight marriage bonuses or penalties related to the QBI deduction. Additional factors not covered might come into play, such as passive loss limitations and itemized deduction limitations. The scenarios refer to an unmarried couple as partners, which should not be regarded as denoting a business partnership. The tax year 2020 amounts for income thresholds and ceilings and other amounts, including standard deductions, are used, which should be updated as adjusted for inflation since 2020 in any current analysis.

QBI marriage penalty/bonus scenarios

Scenario 1: Partner 1 is a shareholder in a legal practice classified as an S corporation. Owing to the nature of the business, the entity is classified as an SSTB. Partner 1 has $160,000 of wages reported on Form W-2, Wage and Tax Statement, and $15,000 of ordinary income from the S corporation reported on Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc. Partner 2 has W-2 wages of $125,000, interest income of $10,000, and Schedule K-1 ordinary income of $40,000 from a small retail business that is also taxed as an S corporation. Neither partner can itemize deductions, so the standard deduction is claimed for each (see the table “Scenario 1: Equal Incomes,” below).

In this situation, both partners have adjusted gross income (AGI) of $175,000, a portion of which is QBI-deduction-eligible business income, and both partners are fully allowed the 20% QBI deduction, as their taxable incomes are each below the Sec. 199A income threshold of $163,300 in 2020. If they married, the couple’s AGI would be $350,000, and their taxable income would be $314,200, which falls below the QBI threshold of $326,600 for 2020. As a result, there is no limitation on the QBI deduction. In terms of taxes, the sum of Partner 1 and Partner 2’s ordinary income taxes imposed, if they each filed as single, is exactly what they would pay if they filed as MFJ. This couple would, however, experience a marriage penalty of $695 owing to the imposition of the net investment income tax and the additional Medicare tax.

The reason for this outcome is that, as single taxpayers, Partners 1 and 2 both individually fall below the income thresholds (i.e., $200,000) for the imposition of these taxes. When combined, the couple’s income would exceed the $250,000 MFJ income threshold, triggering the imposition of the net investment income tax on the $10,000 interest income and the additional Medicare tax on $35,000 wages. Previous studies, such as those by Amy Yurko et al.32 and Allen Rubenfield and Ganesh Pandit33 have also raised this outcome as an issue of concern.

Scenario 2: This situation factors in a relatively extreme income disparity between the two unmarried partners. Assume in this case that Partner 1 is a shareholder in a legal practice taxed as an S corporation (an SSTB) and has W-2 wages of $130,000, along with Schedule K-1 ordinary income from the S corporation of $200,000. Partner 2 has $20,000 of long-term capital gain income. Neither partner can itemize, so the standard deduction is claimed for each.

Scenario 2 suggests that post-TCJA, a significant marriage incentive continues to exist for couples with disparate incomes (see the table “Scenario 2: Disparate Incomes,” below). This situation combines elements of both a marriage bonus and a marriage penalty. The marriage bonus is two-pronged, in that a major portion of the marriage tax savings in ordinary income tax (i.e., $24,549 of the $34,149) occurs as a direct result of how the tax rate tables are configured, with the added tax savings surfacing because of the Sec. 199A marriage benefit (i.e., $9,600 of the $34,149). The Sec. 199A marriage benefit arises because Partner 1 when filing single, is precluded from taking a QBI deduction because the income in question is SSTB income and his or her income exceeds the threshold over which SSTB income cannot be considered for the deduction. If the couple were to marry, a full QBI deduction would be allowed, resulting in an added marriage tax savings of $9,600 ($40,000 QBI deduction × 24% marginal tax rate).

There is also a two-pronged marriage penalty because the long-term capital gain from Partner 2, which was not taxed when filing single, is now taxed at a rate of 15%. In addition, the married couple would also have to pay net investment income tax on the long-term gain at a rate of 3.8%. Overall, the couple in this scenario would still experience a significant marriage bonus of $30,389, a savings of almost 35.4% (i.e., $30,389 savings ÷ $85,955 (combined single tax liability)).

Scenario 3: This situation introduces a fact pattern where one partner’s QBI deduction is partially phased out because the underlying business activity is an SSTB and the partner’s income exceeds $163,300 (i.e., the 2020 maximum income for full deduction) but is less than $213,300 (i.e., the point at which no QBI deduction would be allowed for any SSTB) (see the table “Scenario 3: Partial QBI Phaseout,” below). Assume Partner 1 is a shareholder in a legal practice taxed as an S corporation (an SSTB) and has W-2 wages of $95,700, along with Schedule K-1 ordinary income from the S corporation of $100,000. Partner 2 earns W-2 wages of $154,300. Neither partner can itemize, so the standard deduction is claimed for each.

In this situation, Partner 1’s taxable income exceeds by $20,000 the $163,300 level at which a full deduction would be allowed (i.e., $195,700 AGI – $12,400 standard deduction = $183,300). Owing to the relatively complex mechanics of how the phaseout of the QBI deduction is computed for taxpayers whose income exceeds the full deduction threshold, it is now necessary to consider the taxpayer’s allocable share of W-2 wages and qualified property (i.e., information that is provided by the passthrough entity as part of the Schedule K-1 reporting process). For simplicity’s sake, in this instance, assume Partner 1’s allocable wages are high enough that no further limitation to the QBI deduction would occur beyond that mandated by Sec. 199A(b) (3)(B)(ii). More specifically, for single taxpayers, the amount of the reduction is calculated by taking the ratio of the amount by which the taxpayer’s taxable income for the year exceeds the threshold amount (i.e., $20,000) relative to $50,000 (the base amount provided in Sec. 199A(b)(3)(B)(iii)(II)). This would result in a reduction in Partner 1’s QBI deduction of 40% ($20,000 ÷ $50,000). Stated differently, 60% of the full QBI deduction of $20,000 (20% × $100,000 SSTB income) would be allowed. The tax benefit associated with the $12,000 QBI deduction for the single partner is $3,840 ($12,000 × 32%).

If the couple were to marry, the full $20,000 QBI deduction would be allowed at an MFJ tax rate of 24%, for a total tax benefit related to Sec. 199A of $4,800. The Sec. 199A marriage benefit in this situation amounts to $960 ($4,800 – $3,840), while the total marriage benefit for this fact pattern amounts to $2,560. In this case, the remaining marriage benefit comes from eliminating the portion of the income of the unmarried single partner that would have been taxed at a 32% marginal tax rate. Again, in this scenario, the couple’s combined AGI, as it was in Scenarios 1 and 2, is $350,000. In this instance, the income disparity is much smaller than in Scenario 2, such that the overall marriage benefit only approximates 4%.

While the above examples demonstrate situations where Sec. 199A can contribute to marriage bonuses, Scenario 4 highlights how Sec. 199A can trigger a marriage penalty as well.

Scenario 4: Partner 1 earns W-2 wages of $50,000 in addition to receiving a Schedule K-1 from a real estate partnership reflecting $75,000 of income. Partner 2 has W-2 wages of $200,000 and a passthrough loss from a service industry of $75,000. Assume that Partner 2 has sufficient basis to use the loss, and the passive activity rules do not apply (see the table “Scenario 4: Equal Incomes With Passthrough Effects,” below).

Scenario 4 returns to a situation where each partner makes the same AGI (i.e., $125,000). Recall that the TCJA modified tax rate tables were designed to eliminate a marriage penalty for couples earning similar incomes whose combined taxable income was less than $400,000. On the surface, this is clearly the case in Scenario 4, except that Partner 1 has passthrough income that would qualify for a full Sec. 199A QBI deduction if he or she filed single. In this fact pattern, though, Partner 2 has a passthrough loss that would reduce his or her taxable income but does not result in any adverse impact from Sec. 199A. This scenario highlights a situation where the “netting” rules of Sec. 199A result in a marriage penalty for this couple because the QBI deduction would be eliminated when filing jointly. The couple would experience a marriage penalty of $3,599, all of which is attributable to the “netting” rules of Sec. 199A.

To summarize, Scenarios 1, 2, and 3 identify how marriage bonuses attributable to the Sec. 199A QBI deduction could vary from pure marriage neutrality to outcomes where significant marriage incentives surfaced, depending on the composition of the couple’s finances. More specifically, Scenarios 2 and 3 emphasize ways in which the SSTB limitations of Sec. 199A can be effectively overcome for some unmarried couples. Scenario 4, on the other hand, highlights a situation where the netting rules required in Sec. 199A result in a significant marriage penalty.

An important area for tax planning

As shown in the scenarios, much potential planning when facing a marriage penalty or bonus depends on the relative income of each partner and whether passthrough business income is considered SSTB income. The scenarios nonetheless highlight some potentially significant tax planning strategies for some unmarried couples whose fact patterns resemble those presented.

As to whether couples can rely for the long term on a provision that is scheduled to sunset on Dec. 31, 2025, it would seem highly unlikely that Congress would allow the provision to expire if the corporate tax rate remains unchanged, as doing so would result in a tax increase on over 93% of businesses. Any changes in the corporate tax rates would more likely be accompanied by a corresponding change to the QBI deduction percentage. Although many couples may not over-rely on forecast marriage bonuses/penalties as a major factor in determining whether to legally marry or remain single, being aware of the tax implications can be helpful.

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