Authored by Paul Bishop
On Dec. 22, 2017, the Tax Cuts and Jobs Act (the TCJA) was signed into law, providing the first major overhaul of the tax system since 1986. The law created many significant changes, including a reduction in corporate and individual rates, the repeal of the domestic production activities deduction (DPAD or section 199) and the creation of the new section 199A deduction (i.e., flow-through deduction).
The new deduction allows a deduction of up to 20 percent on income from food and beverage companies that are taxed as partnerships, S corporations or sole proprietorships, known as flow-through entities, for U.S. tax purposes. These entities don’t pay federal tax directly, but instead pass through items of income and loss to their shareholders or partners who pay the tax at the individual level. The purpose of 199A was to keep tax rates on flow-through entities competitive with the new corporate rate, which dropped to 21 percent from 35 percent. The new 199A deduction results in a significant drop in the top rate to 29.6 percent from 37 percent.
Previously, food and beverage companies that manufactured in part or whole were able to take advantage of section 199 (not to be confused with 199A), which provided for a 9 percent deduction from their qualified production activities income (QPAI). Section 199 or DPAD, was narrowly constructed to apply only to manufacturers of tangible property and there were limitations on contract processing/manufacturing and distribution being qualified activities.
Section 199A provides a larger base of qualified companies that qualify for the deduction, while specifically excluding certain “specified trade or businesses.” A specified service trade or business is any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any trade or business the principal asset of which is the reputation or skill of one or more of its owners or employees, or any business that involves the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities. While the TCJA did not provide guidance as to the “skill and reputation” of owners, it is not expected that food and beverage companies would fall under this limitation.
The basic section 199A qualified business income pass-through deduction is 20 percent of net qualified business income (QBI). However, there are limitations to this deduction based upon the wages paid by the business.
A taxpayer’s QBI for a tax year is generally the lesser of:
- 20 percent of the taxpayer’s qualified items of income, gain, deductions and loss relating to any qualified trade or business of the taxpayer, or
- A W-2 wages/qualified property limit, which is the greater of:
- 50 percent of the W-2 wages with respect to the qualified trade or business, or
- The sum of 25 percent of the W-2 wages paid with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property of the trade or business.
A few examples to highlight some of the differences and applicability under the new tax law:
- Company A, a food packager and distributor that didn’t previously qualify for DPAD, has $1 million of taxable income in 2018 and W-2 wages paid to employees of $225,000. Under section 199A, this trade or business qualifies for the deduction and its QBI also equals its taxable income of $1 million. The QBI deduction before limitation would be $200,000 ($1 million x 20 percent). Next, the Company has to determine if the W-2 wage limitation applies. In this example, 50 percent of W-2 wages paid equals $112,500. The deduction is limited to 20 percent of QBI or 50 percent of W-2 wages, whichever is less. Therefore, the deduction in this case is $112,500. This results in a tax savings of $41,625, assuming a 37 percent individual tax rate.
- Company B, a food processor that previously qualified for DPAD, has $800,000 of taxable income in 2018 and W-2 wages of $400,000. The trade or business qualifies for the 199A deduction. Assuming 100 percent of taxable income is QBI, the deduction before the limitation is $160,000 ($800,000 x 20 percent). The W-2 limitation is $200,000, which is 50 percent of W-2 wages of $400,000. The deduction in this case is $160,000 (the lesser of 20 percent QBI or 50 percent W-2 wages), for a tax savings of $59,000 assuming a 37 percent tax rate. Under the previous DPAD rules, assuming all taxable income qualified as QPAI, the Company would have passed on a $72,000 deduction. Assuming a 39.6 percent tax rate, this resulted in a $28,510 tax savings.
As many businesses are structured to include subsidiaries or related entities (trucking or rentals), the new deductions provide planning opportunities to analyze overall structures and maximize the benefits across the entire group.
It is also important to note that this deduction expires after eight years, unlike the corporate rate reduction which is permanent.
Overall, even though the provisions are complicated, section 199A provides an opportunity for all companies involved in the food and beverage supply chain to reduce their tax liability.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.