The Tax Cuts and Jobs Act of 2017 implemented sweeping reforms to the Internal Revenue Code across the board, but one of its most exciting changes is the new Section 199A Qualified Business Income Deduction. The purpose of this new deduction is to provide tax breaks for pass-through income that is excluded from the substantial reduction in corporate tax rates (e.g. the top corporate tax bracket was reduced from 35% to 21%). Eligible taxpayers may take a deduction up to 20% of the income derived from their eligible trade or business.
Who May Take The Deduction?
- Individuals, trusts and estates with qualified business income (QBI), qualified real estate investment trust (REIT) dividends and/or qualified publicly traded partnership (PTP) income. Since partnerships and S-Corporations are pass-through entities that cannot take the deduction themselves, the individual partners and shareholder claim the Section 199A deduction form their portion of the entity’s QBI, qualified REIT dividends or PTP income.
- “Qualified business income” means “for any taxable year, the net amount of qualified items of income, gain, deduction and loss with respect to any qualified trade or business of the taxpayer.” 26 U.S.C. 199A(c)(1).
- “Qualified real estate investment trusts” are companies that own and/or operate income producing real estate and provides a way for individual investors to earn a share of the income through real estate ownership without buying the property themselves. To be qualified, the trust must hold the bulk of its assets in real estate and must distribute at least 90% of its income to its shareholders annually as dividends.
- “Publicly traded partnerships” are partnerships that have an interest that is regularly traded on an established securities market regardless of how many partners it has.
- NOTE: The Section 199A is considered a “between the lines” deduction, as it is calculated after other deductions or exemptions in the tax year to determine taxable income but before other “below-the-line” deductions affect adjusted gross income.
How Much Is The Deduction?
- A taxpayer is allowed a deduction for the tax year equal to the LESSER OF ONE OF THE FOLLOWING:
- 20% of the taxpayer’s income from a qualified trade or business plus 20% of the taxpayer’s qualified REIT dividends or PTP income. 26 U.S.C. 199A(a)(1).
- 20% of the excess of the taxable income of the taxpayer minus the taxpayer’s net capital gain. 26 U.S.C. 199A(a)(2).
- According to 26 U.S.C. 199A(b)(2), to determine the amount of income from a qualified trade or business, the taxpayer must use the LESSER OF ONE OF THE FOLLOWING:
- 20% of the taxpayer’s QBI from that qualified trade or business OR
- THE GREATER OF
- (a) 50% of the W-2 wages with respect to that qualified trade or business OR
- (b) The sum of 25% of the W-2 wages from that specified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property
- The following rules apply to the Section 199A deduction for a qualified trade or business
- If taxable income is $157,500 or less ($315,000 or less if married filing jointly), then the taxpayer can take the full 20% deduction of QBI without regard to W-2 wages or unadjusted basis in qualified property. 26 U.S.C. 199A(b)(3)(A).
- If taxable income is greater than $157,500 but does exceed $207,500 ($315,000 to $415,000 if married filing jointly), then the taxpayer can take a partial deduction of QBI with W-2 wages and unadjusted basis of qualified property calculated into it. 26 U.S.C. 199A(b)(3)(B).
- If taxable income is in excess of $207,500 (in excess of $415,000 if married filing jointly), then the 20% of QBI is compared to the full amount of W-2 wages and unadjusted basis of qualified property.
- “Qualified Business Income” does NOT include the following items:
- Items of short term capital gain, short term capital loss, loss term capital gain or long term capital loss. 26 U.S.C. 199A(c)(3)(B)(i).
- Interest income other than interest income property allocable to a trade or business. 26 U.S.C. 199A(c)(4)(D).
- Reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the taxpayer. 26 U.S.C. 199A(c)(4)(A). According to the proposed regulations, this rule was intended to clarify that the requirement of S-Corporations to pay reasonable compensation to shareholders for work performed applies towards calculating QBI even if the S-Corporation actually fails to pay these wages (individual shareholders must still exclude an amount from QBI equal to reasonable compensation). The reasonable compensation rule does NOT extend to partners in partnerships.
- Guaranteed payments paid by a partnership to partners for services rendered with respect to any trade or business. 26 U.S.C. 199A(c)(4)(B).
- Section 707(a) payments (payments made when partner engages in business with partnership but not in the capacity of partner). 26 U.S.C. 199A(c)(4)(C).
- NOTE: The Section 199A deduction affects federal income taxes but does NOT reduce net earnings to be counted for the self-employment tax (26 U.S.C. 1402) or the net investment income tax (26 U.S.C. 1411).
What are Exceptions to Qualified Trades or Businesses?
- The following two exceptions are NOT considered a “qualified trade or business”:
- “Specified service trade or business” (SSTB) includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading or dealing in certain assets, or any trade or business where the principal asset is the reputation or skill of one or more of its employees. 26 U.S.C. 1202(e)(3)(A)(but excludes engineers and architects).
- Performing services as an employee.
- The following are limitations on the Section 199A deduction for specified service trades or businesses.
- If the taxpayer’s income is from a SSTB and his or her taxable income is $157,500 or less ($315,000 if married filing jointly), then the 199A deduction is the same as for a qualified trade or business.
- If the taxpayer’s income is from a SSTB and his or her taxable income is greater than $157,500 but does not exceed $207,500 ($315,000 to $415,000 if married filing jointly), then the 199A deduction is reduced.
- If the taxpayer’s income is from a SSTB and his or her taxable income is in excess of $207,500 ($415,000 if married filing jointly), then the 199A deduction cannot be claimed.
- NOTE: Patrons of horticultural or agricultural cooperatives may be subject to further reduction of the Section 199A deduction.
What Are Some Examples of the Section 199A Deduction in Practice?
- Rocky Hammer owns a hardware store where he earns $120,000 but only reports $100,000 of taxable income because of other deductions and exemptions. Since his taxable income is less than his earnings from a qualified trade or business, he takes a Section 199A deduction of $20,000 ($100,000 x 20%) from his taxable income, not his hardware store business earnings. Because his taxable income is below the $157,500 threshold, he can take the full 20% and will not have to make any calculations with respect to W-2 wages paid or the unadjusted basis of qualified property.
- Drew Goode is a partner in an architectural partnership who is paid $50,000 in guaranteed payments and $30,000 of net business income from his share of partnership earnings. Guaranteed payments do not count in calculating QBI but factor into his taxable income. Since his QBI ($30,000) is less than his taxable income ($50,000+$30,000 = $80,000), then he claims a Section 199A deduction of $6,000 ($30,000 x 20%), from his QBI, not his taxable income. Drew may reconsider how much guaranteed payments he would want to receive in the next tax year to maximize the deduction.
- Richard “Rich” Bossman owns a department store as a S-Corporation and earns $500,000 in qualified business income. He paid $100,000 in W-2 wages to his employees. Since his income exceeds the maximum threshold limit of $207,500 (or even $415,000 if he was married filing jointly), then his Section 199A deduction is limited to 50% of the total W-2 wage payments ($50,000) and NOT 20% of his QBI ($500,000 x 20% = $100,000).
- Alotta Money is a partner in a law firm who earns $250,000 and files as a single taxpayer. Since Alotta is in a specified service trade or business (e.g. law) and exceeds the maximum threshold amount of $207,500, then she is not entitled to any Section 199A deduction. If Alotta was married and filed jointly with a spouse that also reported $50,000 of income (for a total of $300,000), then she could claim the full Section 199A against her income because she would be under the $315,000 threshold for SSTB.
- Liv Solo is a sole proprietor whose plumbing business earned her $500,000 during the tax year but paid no W-2 wages. Since her QBI exceeds the threshold, she must use the LESSER of either her QBI ($500,000) or the W-2 wages she paid ($0). As a result of no W-2 wages, she will not be able to claim any Section 199A deduction. For high income earners, she should consider forming a S-Corporation (or an LLC taxed like a S-Corporation) and pay W-2 wages to herself or other employees to realize this tax benefit.
On August 8th, 2018, the Internal Revenue Service released 184 pages of proposed regulations to give taxpayers more guidance on claiming the Section 199A deduction. Form 1040, 1040A and 1040EZ will also be simplified before the 2019 tax filing season so that this deduction can be calculated. As the new statute is applied to federal tax returns for the first time, it is likely that the IRS and the U.S. Tax Court will make modifications and clarifications in how Section 199A is applied to unique situations. If you have questions about the Section 199A deduction or any other federal tax question, do not hesitate to contact the tax professionals at Kershaw, Vititoe & Jedinak PLC.