This is the third installment of our monthly tax blog about the Tax Cuts and Jobs Act. In our two previous posts, we discussed changes to individual tax rates, exemptions, the standard deduction, and itemized deductions.
In this post, we will conduct an overview of the Section 199A deduction, which is also known as the Qualified Business Income Deduction or pass-through deduction.
General Overview of Section 199A
Section 199A allows for a 20% deduction on Qualified Business Income (“QBI”). This deduction is available to owners of sole proprietorships, partnerships, and S Corporations. Although it is often referred to as the “pass-through deduction,” you should know that you do not need to set up a new pass-through entity like an S Corporation in order to qualify for the deduction. Individuals who report business income from a Schedule C can benefit from Section 199A.
The deduction will take effect for tax years beginning after December 31, 2017, and is scheduled to sunset on December 31, 2025.
Definition of a Qualified Trade or Business
For the pass through entities mentioned in the overview above, a qualified business refers to any trade or business except for:
- Services performed by employees. For example, if you receive wages for working as a professor at a university, you cannot take a Section 199A deduction on those wages.
- “Specified service” businesses. This includes businesses in the fields of health, law, accounting, consulting, brokerage or financial services, performing arts, and athletics. As an example, if you own a partnership interest in a law firm, you generally cannot take the deduction on your pass-through income from the firm. However, if your income from a “specified service” business is below the high income threshold covered in the limitations section below, this exclusion does not apply.
Definition of Qualified Business Income
QBI includes all of the income, deduction, gain, and loss items that are connected to running a trade or business. Investment-related income items such as capital gains and losses, dividends, and interest are excluded from QBI.
When calculating the Section 199A deduction, a taxpayer can only include their allocable share of QBI. For example, if a taxpayer owns 40% of an S Corp for the entire year, they would include 40% of the S Corp’s qualified income in their QBI.
Limitations on Deduction Amount
There are two ways that a taxpayer’s initial 20% deduction can be limited to a lower amount. The first limitation applies to higher income taxpayers, and the second limitation applies to all taxpayers.
Higher Income Taxpayers
For single taxpayers with income above $157,500 or married taxpayers with income above $315,000, the deduction is limited based on the W-2 wages paid by the business and the basis of depreciable property owned.
The taxpayer will first calculative a tentative deduction by taking 20% of their QBI. That amount will then be limited to the greater of their share of:
- 50% of W-2 wages paid, or
- 25% of W-2 wages paid, plus 2.5% of the unadjusted basis of depreciable property
For example, a married individual has $500,000 of QBI from their partnership and no other taxable income. Their share of W-2 wages paid by the partnership is $120,000, and their share of the partnership’s depreciable property is $900,000.
A’s tentative deduction is 20% of the $500,000 in QBI, or $100,000. However, because A has income above $315,000, the deduction is limited to the greater of:
- 50% of W-2 wages: $120,000 x 50% = 60,000
- 25% of W-2 wages plus 2.5% of the unadjusted basis in depreciable property:
• $120,000 x 25% = $30,000, plus
• $900,000 x 2.5% = $22,500
A’s deduction will be limited to $60,000 in this example.
Regardless of income level, all taxpayers must limit their deduction to 20% of taxable income less their net capital gain. This was included in the legislation to ensure that taxpayers do not take a Section 199A deduction on income that is already taxed at the preferential capital gains rates.
There are still a few areas of Section 199A that are uncertain and will require further guidance from the IRS. These include:
- Rental Properties: The IRS has not specifically stated whether rental properties will count as a qualified trade or business, so it is not yet certain whether owners of these properties can count rental income as QBI.
- Sale of Section 1231 Assets: These are assets used for over a year in a trade or business. Due to language in the legislation that does not specify whether the capital gains exclusion applies at the business or individual level, it is not yet clear whether owners can include net gains from the sale of Section 1231 assets in QBI.
- Fiscal Year Businesses: The final version of the legislation does not distinguish between the individual taxpayer’s tax year and the tax year of the business generating the QBI. Since there is no specific language about fiscal-year businesses in the Act, it seems likely that calendar-year individual taxpayers will be allowed to claim the deduction for fiscal-year businesses. For example, a calendar-year taxpayer owns part of an S Corp with a June 30 fiscal year end. The taxpayer should be able to claim a QBI deduction on their 2018 return for the S Corp’s tax year beginning July 1, 2017 and ending June 30, 2018. However, there is no guidance from the IRS yet confirming that this will be allowed.
If you have any questions about how you will be impacted by the Section 199A deduction, please reach out to us at Isler. We look forward to answering your questions and assisting with your tax planning.