(The Tax Cuts and Jobs Act’s Addition of Section 199A)
As part of the Tax Cuts and Jobs Act, Congress created Code Section 199A, providing owners of flow-through businesses and sole proprietors with a potential deduction, thereby allowing them to be more competitive with C Corporations, which under the Act saw tax rates reduced from 35% to 21%.
Effective for taxable years beginning after December 31, 2017 and before January 1, 2026, any individual taxpayer, trust, or estate that owns an equity interest in a flow-through entity (“FTE”) or is a sole proprietor engaged in a qualified trade or business may be eligible to deduct up to 20% of that taxpayer’s share of the entity’s qualified business income. While this sounds great and looks simple, the calculation of this deduction is rather complex and presents many gray areas open for interpretation.
Section 199A introduces a number of new terms. Let’s start with definitions of those terms, followed by the basics of the deduction, and then the limitations and phase outs of the deduction.
As much as 20% of a taxpayer’s qualified business income may be deducted from that taxpayer’s otherwise-taxable income.
Two important limitations exist for filers with taxable income over the threshold amounts of $315,000 for married couples, or $157,500 for others. This creates three distinct categories of eligibility, with very different computations based on which category a filer occupies:
- Certain personal service providers whose taxable income exceeds the threshold face a phaseout of the benefit. The benefit is partially phased out when taxable income is between $315,000 and $415,000 for married couples, or $157,500 and $207,500 for others. It is fully phased out (no deduction exists at all) if taxable income exceeds those ranges.
- Taxpayers other than certain personal service providers, but whose income exceeds the $315,000 or $157,500 threshold amounts, are not subject to the phaseout described above. (The $415,000 and $207,500 amounts are meaningless, because their deduction is not automatically wiped out at those levels.) They are, however, subject to additional potential limitations of the deduction based on the amount of W-2 wages paid out to the flow-through entity’s employees (higher is better), or the amount of certain qualifying assets held by the entity (generally fixed assets, and higher is better).
- Taxpayers whose taxable incomes do not exceed the $315,000 and $157,500 threshold amounts do not face the phaseout or wage/asset limitations described above. Some computational hurdles remain, but they stand the best chance of receiving a deduction equal to 20% of their share of the FTE’s qualifying income.
Qualified Trade or Business (“QTB”)
A QTB includes any trade or business conducted by a sole proprietorship (Schedule C and E) or owned through an S Corporation or partnership. It appears, from a reading of the law and Committee Reports, that an owner does not have to be actively involved with the business that generated the deduction in order to benefit from it. In other words, both passive and active owners appear to be eligible for the deduction. It also is reasonable to believe that the benefit is extended to owners of rental properties. Many types of income are listed as being ineligible, and rental income is not among them. Also, the last-minute inclusion of an asset-based component to the calculation certainly has the effect of benefiting rental operations that often pay no wages, as they otherwise would receive a deduction equal to $-0-.
- Observation: Frustratingly, the assumption that passive and rental activities are eligible could easily have been confirmed or denied with more clear language in the Code, but such clarity is absent. However, as is common with many sections of the Internal Revenue Code, Congress included language in Sec. 199A instructing the Treasury Department (the IRS) generally to provide Regulations to implement the new rules. While we have no assurance these particular questions will be answered, practitioners are hopeful more guidance will be provided to address 199A’s treatment of rental owners and passive investors.
Qualified Business Income (“QBI”)
QBI is the taxpayer’s allocable share of the net qualified items of income, gain, deduction, and loss from a QTB. QBI is determined separately for each QTB. Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the FTE’s conduct of a QTB within the U.S.
“Qualified items” exclude capital gains, dividends, and interest income (other than that which is properly allocable to a trade or business), and exclude items of deduction or loss allocable to such income.
Income consisting of wages received by an S corporation shareholder and “guaranteed payments” received by a partner for services rendered are not included in the recipient’s QBI.
Specified Service Trade or Business
Any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities, are known as “specified” services. However, a trade or business that involves the performance of engineering or architectural services is excluded from this definition.
- Observation: As explained later, specified service income is subject to significant restrictions that will often deny the service provider any benefit under Sec. 199A. Congress did this because it wanted to exclude wages from the pool of income that would generate a benefit, and remuneration earned by pure service providers – even if packaged as flow-through income – is viewed as wages in a different form.
Qualified property is tangible (either real or personal) property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, and used in the production of QBI. To be qualified, the “depreciable period” must not have ended before the close of the taxable year. The depreciable period is the period beginning with the date the qualified property is first placed in service and ending on the later of 10 years after such date, or the last day of the last full year in the applicable recovery period for the property. The asset’s “unadjusted basis” (gross undepreciated cost) is used in the calculations.
Example: Furniture with a 7-year tax life is acquired in Year 1 for $10,000. Although fully depreciated by then, the property remains “qualified property” under Sec. 199A rules through the end of Year 10, contributing the full $10,000 to the entity’s Sec. 199A “unadjusted basis of property” computations. In Year 11, it no longer is counted.
- Observation: The Code notes that additional guidance will be forthcoming regarding how to compute the appropriate “unadjusted basis” for properties acquired in a like-kind exchange or involuntary conversion.
W-2 wages includes wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to employment of its employees during the calendar year and reported on a return filed with the Social Security Administration.
- Observation: Nonemployee compensation, such as that paid to an independent contractor and reported on Form 1099-MISC, does not qualify as “wages” and provides no similar benefit under the Sec. 199A rules.
The threshold amount is the point above which both the limitation on specified service businesses and the wage and/or qualified property limit phase-in.
The threshold amount is taxable income of $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly (computed without the deduction of the Sec. 199A benefit itself). Income above these amounts will begin the phaseout of the Sec. 199A deduction for certain service providers, with such benefits being fully phased out at $207,500 for individual taxpayers and $415,000 for married taxpayers filing jointly. Income above these respective $157,500 and $315,000 amounts subjects other taxpayers (i.e. not the service providers described above) to limitations based on wages or property. None of these phaseouts/limits applies to taxpayers with income below the threshold amounts.
- Observation: Taxable income includes all sources of income on an individual’s tax return without regard to this deduction. For married couples filing jointly, income of a spouse, as well as any non-business income reported on the return, can serve to reduce the benefit of a taxpayer with flow-through income. The threshold amounts are indexed for inflation.
Armed with these definitions, let’s move on to how the deduction is computed.
The Deduction for Taxpayers under the Threshold Amount
In general, a taxpayer with taxable income below the threshold amount is allowed a deduction for any taxable year equal to the lesser of:
- Taxpayer’s “combined QBI amount” for the taxable year times 20%, or
- An amount equal to 20% of the excess (if any) of
- Taxpayer’s taxable income for the taxable year, over
- any net capital gain for the taxable year.
Example: Taxpayer A and B are married. A has QBI of $120,000 from an S corporation that paid a total of $80,000 of W-2 wages to him and that has no qualified property. A and B have taxable income of $235,000 (which is less than $315,000), with no capital gains. A simply takes a deduction equal to 20% of QBI or $24,000.
- Observation: Even for filers below the threshold, taxpayers with large capital gains relative to overall income may see their deductions limited.
The Deduction for Taxpayers over the Threshold
Now that the simple stuff is out of the way, let’s pour another cup of coffee or Red Bull and tackle the entire deduction formula with limitations.
A taxpayer over the threshold amount is allowed a deduction for any taxable year equal to the lesser of:
- Taxpayer’s “combined QBI amount” for the taxable year, or
- An amount equal to 20% of the excess (if any) of
- Taxpayer’s taxable income for the taxable year, over
- any net capital gain for the taxable year.
The combined QBI amount for the taxable year is equal to the sum of the deductible amounts determined for each QTB carried on by Taxpayer. Taxpayer’s deductible amount for each QTB is the lesser of:
- 20% of the Taxpayer’s QBI with respect to the QTB, or
- The greater of:
- 50% of the “W-2 wages” with respect to the QTB, or
- The sum of:
- 25% of the W-2 wages with respect to the QTB, plus
- 2.5% of the unadjusted basis, immediately after acquisition , of all “qualified property.”
Let’s break that down separately, depending on whether a taxpayer is involved in a “specified service” trade or not.
Treatment of “Specified Service Trades or Businesses”
Owners of specified service trades or businesses (defined above) are the first to feel the wrath of this deduction’s limitations. Once their taxable income exceeds the threshold amount, the deduction starts to phase out. When taxable income exceeds the threshold by a wide enough margin, the deduction is fully phased out. This phaseout from full benefit to none occurs between taxable income of $315,000 and $415,000 for a married couple filing a joint return, and between taxable income of $157,500 and $207,500 for other filers.
Example: A is partner in a law firm. A is married, and has taxable income of $500,000. A’s share of the income of the law firm is $550,000, his share of the W-2 wages of the law firm is $100,000, and his share of the unadjusted basis of the assets of the business is $20,000. A is entitled to no deduction, because a law firm is a specified service business and A’s taxable income exceeds $415,000.
- Observation: The phaseout is somewhat proportionate, based on how far through the $100,000 or $50,000 range the taxpayer’s income has progressed. The resulting fraction is not multiplied by the benefit itself to determine how much is lost, though. (That would be far too easy for Congressional liking.) Instead, the phaseout involves frustratingly complex computations that are beyond the scope of this article, essentially involving computing the benefit in a couple alternative ways, and applying the percentage to the difference – a staged computation that involves phaseouts of some of the components used in the rest of the phaseout.
Treatment of Qualified Businesses
Taxpayers NOT involved in a specified trade or business, but who ARE above the threshold amounts, need to determine the deduction after carefully analyzing the W-2 wages and qualified property limitations that may reduce the 20% QBI deduction.
Example: C is a member of XYZ, LLC that is treated as a partnership for tax purposes. XYZ, LLC is engaged in a QTB that is not a specified service trade or business. C’s taxable income for 2018 is $750,000, which includes a guaranteed payment from XYZ, LLC of $250,000, for services rendered to XYZ, LLC during 2018, and C’s allocable share of QBI from XYZ, LLC for 2018 of $400,000. C has no investment income for 2018. C’s allocable share of W-2 wages with respect to XYZ, LLC’s business for 2018 is $300,000. During 2018, XYZ, LLC purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). C’s allocable share of the purchase price is $500,000.
C is allowed a deduction for the taxable year of an amount equal to the lesser of:
- “Combined QBI amount” for the taxable year (the guaranteed payment of $250,000 is not included in QBI), or
- 20% of C’s taxable income of $750,000 for the taxable year, or $150,000.
C’s combined QBI amount for 2018 is equal to its “deductible amount.” The deductible amount is the lesser of:
- $80,000, 20% of C’s QBI (20% of $400,000), or
- The greater of:
- $150,000, 50% of the W-2 wages with respect to the QTB (50% of $300,000), or
- $87,500, the sum of ($75,000 + $12,500): 25% of the W-2 wages with respect to the QTB (25% of $300,000), plus 2.5% of the unadjusted basis of all qualified property (2.5% of $500,000)
Thus, C’s deductible amount is $80,000, because this amount is less than $150,000 (20% of C’s taxable income of $750,000 for the taxable year).
Other Comments and Takeaways
Type of deduction
The 199A deduction is not an itemized deduction, but is not deducted in arriving at adjusted gross income (AGI), either. Instead, it is deducted from AGI in arriving at taxable income. (Congress quietly sneaked in the complete elimination of personal exemptions in the new law, so there appears to be a new vacancy on page 2 of Form 1040 that this deduction could occupy.)
It should be clear that qualified business income needs to exist for a Sec. 199A deduction to result; a loss, mathematically, will produce no such benefit. However, any losses must be carried forward to offset the following year’s qualified business income, thereby reducing the benefit in that second year.
For about a dozen years, certain taxpayers have taken advantage of the Sec. 199 (not 199A) “domestic production activities deduction” (DPAD). The Tax Cuts and Jobs Act eliminated Sec. 199, but a number of similarities in its application and purpose are evident in the new Sec. 199A. Among them appears to be the need for lower-tier entities to provide supplemental information on Schedules K-1, such as each respective owner’s proper share of the lower-tier’s eligible assets and wages.
Difficulty in predicting income
Things like tax return extension calculations and quarterly estimated tax computations just became significantly more difficult under these new rules. If taxable income (at the 1040 level) is low enough, the math is relatively straightforward. However, if the threshold levels are exceeded, even by one dollar, suddenly the need to perform significantly more calculations exists, requiring analysis of portions of a company’s income statement, balance sheet, and payroll records that previously had no direct bearing on the entity owner’s tax.
The new Sec. 199A deduction provided by the Tax Cuts and Jobs Act is proving to be one of the most complex areas of the new law, raising unanswered questions that will undoubtedly require clarification and guidance from the IRS. It creates entirely new variables and circumstances that will be part of the discussion of entity choice for new and existing businesses, and will make tax planning a more difficult exercise. Should you hire a sub-contractor on as an employee? Should you consider converting your Schedule C to an S Corporation in order to pay yourself W-2 wages? Analysis and optimization of this deduction is complex and different for each taxpayer’s situation. However, it can provide a meaningful benefit, and qualifying business owners and their accountants should become familiar with it.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.