By Jim Chinn, CPA | Tax Manager
Congress promised us a simpler and more streamlined tax code, but, as you will see, the new Section 199A deduction for pass-through entities is anything but simple or streamlined. Despite the plethora of new terms and complicated calculations, many owners of pass-through businesses will benefit from the deduction. Generally, for tax years beginning after December 31, 2017, businesses operating as “pass-through” entities for tax purposes will receive a deduction equal to 20% of the taxpayer’s “qualified business income;” however, there are several limitations and phase outs that need to be considered. Before getting into the phase-outs and limitations, we will explore some of the new terminology and the calculation of the deduction.
Section 199A Deduction Overview
The section 199A deduction is available for individuals, estates, and trusts that own businesses operating as partnerships, LLC’s, sole proprietorships, or S corporations. The deduction is also available for those holding certain agricultural or horticultural cooperatives or investments in Real Estate Investment Trusts (REITS) and Publicly Traded Partnerships (PTPs). This is a “below-the-line” deduction (i.e. after AGI) that is ultimately taken on the individual, estate, or trust tax return. It is intended to bring the tax rate on income derived from these pass-through entities to a rate that is closer to the new 21% corporate tax rate. As the law stands now, the pass-through deduction is temporary and is set to expire for tax years ending after December 31, 2025.
As noted above, the deduction is based on “qualified business income,” a newly defined term in the Internal Revenue Code. Qualified business income (QBI) is the sum of items of income, gain, deduction, and loss from a qualified trade or business that are earned in the U.S. QBI does not include items of investment income such as capital gains, dividends, or interest income. In other words, QBI is the net taxable income from the operations of the pass-through entity. It also does not include reasonable compensation paid to the taxpayer by the business or guaranteed payments to partners. If total QBI is negative – i.e. a tax loss – it is carried forward and reduces QBI in future years. The deduction cannot exceed 20% of taxable income as reduced by net capital gains.
The deduction is not available for “specified service trade or businesses” (referred to hereafter as service businesses) unless the taxable income of the individual taxpayer is less than $207,500 for a single filer or $415,000 for a joint filer. Taxpayers operating a service business are entitled to the full 20% deduction if taxable income is less than or equal to $157,500 in the case of a single filer or $315,000 in the case of a joint filer. The deduction is phased out for service business owners with taxable income between $157,500 and $207,500 for single filers and between $315,000 and $415,000 for joint filers. The deduction is not allowed for service businesses once taxable income reaches $207,500 for single filers or $415,000 for joint filers. A service business is any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services (including investing and investment management, trading, or dealing in securities), or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The law specifically mentions that engineering and architecture services are not considered service businesses, meaning the deduction would be available to those types of businesses regardless of taxable income. We are expecting the IRS to issue guidance on which businesses would be considered a service business in future regulations because the term is rather ambiguous as the law stands now.
The pass-through deduction is equal to 20% of QBI for those taxpayers with taxable income less than $157,500 for single filers or $315,000 for joint filers. For business that are not classified as service businesses, the calculation of the pass-through deduction becomes a little more complicated once taxable income exceeds these amounts. When taxable income exceeds $207,500 for single filers and $415,000 for joint filers, the deduction is the lesser of (i) 20% of QBI, or (ii) the greater of (a) 50% of wages with respect to the qualified trade or business or (b) 25% of wages from the qualified trade or business plus 2.5% of unadjusted basis of the qualified property in the trade or business. In simple terms, this convoluted formula means that at higher taxable income levels the pass-through deduction may not equal 20% of QBI as it is limited to either a percentage of labor and/or business property costs within the pass-through entity.
Traditionally, it was almost always more beneficial for married taxpayers to file joint returns; however certain married taxpayers may find it more beneficial to file separate returns in order to maximize the pass-through deduction. For instance, let’s look at an example where Taxpayer T has a qualified business with $150,000 of QBI and Spouse S only has W-2 wage income of $300,000. If they filed jointly, their taxable income would be above the $415,000 threshold so the pass-through deduction for T’s business may be limited; however, if they filed separately T would be eligible for the entire 20% deduction. This may not be the case in all situations, but it is worth mentioning nonetheless. Each situation will need to be examined on a case by case basis.
Business Tax Planning Opportunities
There are a few other planning opportunities that a pass-through business owner may consider to maximize this deduction. First, you may consider converting workers currently classified as 1099 subcontractors to W2 employees to the extent possible. This will increase the wage base within the business which may lead to a larger pass-through deduction. Your individual facts and circumstances will have to be examined before making this change because it is not always possible to convert subcontractors to employees. Partnerships and LLCs that currently compensate service providing partners with guaranteed payments may consider offering a preferred return of partnership income instead. Guaranteed payments reduce partnership income and are specifically excluded from QBI and are therefore not eligible for the pass-through deduction. Under the current regulations, it seems that a preferred return would qualify for the pass-through deduction. You will want to speak with your attorney and tax advisor before making this change as it may require modifications to your operating agreement and there may be other unintended tax consequences.
We hope this article has provided some clarity on the new Section 199A deduction for pass-through businesses. As mentioned previously, each taxpayer’s situation is unique and you should speak with your tax advisor before making any decisions. We will continue to share our insights on the finalized tax changes in the coming months.
- New Tax Law: What You Need to Know
- Business Expense Changes: Reduced Meals and Entertainment Deductions
- Tax Cuts and Jobs Act: What you need to know about the Estate, Gift & Trust Provisions
- AMT Changes to Individuals and Businesses
- Excise Tax Changes Impact Tax Exempt Organizations
- Tax Cuts and Jobs Act Resource Guide
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.