Authored by Paul Dillon, Mike Schiavo and Patrick Balthazor
The Tax Cuts and Jobs Act (TCJA) was enacted Dec. 22, 2017. Among the many provisions included in the TCJA is new code section 199A, which allows a deduction of 20 percent for certain pass-through income. For this purpose, pass-through businesses include partnerships, S corporations and sole proprietorships. Due to uncertainty as to the types of businesses that may qualify for the deduction, and the many limitations and exceptions, this code section is one of the more complex provisions in the TCJA. Guidance from Congress or the Treasury Department is needed to clarify a number of issues. Given the complexity, this article focuses on the basics of the deduction. The goal is to provide enough information to enable an understanding of the deduction, without providing an overwhelming amount of detail.
Most of the calculations – i.e., the preliminary deduction, limitations and limitation phase-ins – take place at the trade or business level. Once the trade- or business-level math is complete and the deduction for each trade or business is determined, the amounts are combined at the taxpayer level and tested against the overall taxable income limitation.
For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, noncorporate taxpayers (individuals, trusts and estates) may take a deduction equal to 20 percent of qualified business income (QBI) from partnerships, S corporations and sole proprietorships. Qualified dividends from cooperatives and real estate investment trusts as well as qualified income from publicly traded partnerships (PTP) may also qualify for the deduction. (For the sake of simplicity, we will not focus on these items in this alert.)
In general, qualified items of income, gain, deduction and loss with respect to each qualified trade or business qualify for the deduction. Qualifying income must come from U.S. sources and excludes various investment-related items, such as capital gains and losses, dividends and nonbusiness interest income. Reasonable compensation paid to the taxpayer as well as all guaranteed payments for services rendered to a partnership also are excluded from QBI. As drafted, it appears that each business will pass through the allocable share of income or loss to the partners or shareholders. The taxpayer will calculate the deduction separately for each trade or business, then combine the deductions from each trade or business.
If the net amount of QBI is less than zero, the loss will be carried to the next taxable year and included in the calculation of qualified trade or business income for that year. For example, if the combined loss from all trades or businesses in 2018 is ($100,000) and the qualifying income from all businesses in 2019 is $300,000, the $100,000 loss from 2018 must be carried to 2019 and reduce the qualifying income in 2019 to $200,000. Thus, a deduction of $40,000 (20 percent of $200,000) may be allowed in 2019, subject to the limitations described below.
The deduction is not allowed in computing adjusted gross income; instead, it is a deduction that reduces taxable income. Therefore, the deduction does not affect limitations based on adjusted gross income. Further, the deduction does not reduce net investment income (NII) or self-employment (SE) income; however, the deduction is allowed for the alternative minimum tax. In addition, the deduction is allowed regardless of whether a taxpayer itemizes his or her deductions.
Limitations on types of qualifying income – service businesses
Congress specifically excluded certain “specified service trade or business” income from qualifying for the deduction. For purposes of the 20 percent deduction, specified service trades or businesses are those that involve 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 where the principal asset is the reputation or skill of one or more of its employees or owners. The last part of this definition will likely need additional guidance and will almost certainly lead to disputes between taxpayers and the IRS. For example, in theory, an individual providing plumbing and heating services could fall into this definition if it is determined that this person’s skill or reputation is the principal asset of the business. Specified services also include trades or businesses involving investment, trading activities and investment management.
While specified service trade or business income generally does not qualify for the deduction, there is an exception based on taxable income. For example, joint filers with taxable income below $315,000 (before factoring in this deduction) would be eligible for the deduction. If taxable income is between $315,000 and $415,000, only a percentage of specified service income is eligible. If taxable income is more than $415,000, specified service trade or business income does not qualify. The table below summarizes these limits as well as the W-2 wage/basis limits.
Another type of income that bears mentioning is rental income. The deduction is allowed for qualified trade or business income. Questions often arise as to whether a rental is a trade or business. For example, a rental activity where the owner’s activity is limited to simply collecting rents and paying the real estate taxes (triple net lease situations) may not be considered a trade or business. This is an area where clarification as to what constitutes a “trade or business” will be needed.
Wage and basis limitation
Once 20 percent of the qualifying income from the trade or business (including the specified service trade or business limitation) is determined, a further limitation arises. The deduction cannot exceed the greater of a) 50 percent of the W-2 wages from the trade or business, or b) 25 percent of the wages from the trade or business, plus 2.5 percent of the unadjusted basis of depreciable assets from the trade or business. Each owner of the business will use the owner’s allocable share of wages and basis of depreciable assets from the business to calculate this limitation. These limits are phased in based on taxable income.
|Specified service income and W-2 wage/basis limitations|
|Trade or business is not a specified service||Trade or business is a specified service|
|Taxable income less than or equal to $157,500 (single), $315,000 (joint)||W-2 wage/basis limitations do not apply||W-2 wage/basis limitations do not apply; specified service income is eligible|
|Taxable income greater than $157,500 (single), $315,000 (joint) but less than $207,500 (single), $415,000 (joint)||W-2 wage/basis limitations are phased in over the $50,000/$100,000 range||"Applicable percentage" of specified service income is eligible; AND W-2 wage/basis limitations are phased in over the $50,000/$100,000 range|
|Taxable income greater than $207,500 (single), $415,000 (joint)||W-2 wage/basis limitations apply in full||Specified service income not eligible|
The W-2 wage limitation will be especially problematic to businesses that have few employees. For example, rental real estate entities tend to have few, if any, employees at the property level; instead, they are employed by management companies. Sole proprietorships without employees will also be unable to utilize this deduction (unless taxable income is under the threshold). The capital component described above (2.5 percent of unadjusted basis) may help mitigate this situation for the real estate industry.
Taxable income limitation
After determining 20 percent of the combined business income for all trades or businesses (subject to the specified service trade or business limitation and the wage and basis limitations), one more limitation is based on taxable income. The deduction cannot exceed 20 percent of taxable income in excess of net capital gains. Net capital gain for this purpose includes capital gains and dividends that qualify for a favorable tax rate (such as the maximum 20 percent rate for capital gains).
This is a significant potential tax break for business owners, but it comes with a great deal of complexity and uncertainty (until further guidance is issued). It is unclear how the tax forms will be modified to accommodate the new deduction or what information will be required to be reported by partnerships and S corporations to their owners in order to calculate the deduction. We will issue further guidance on the deduction as it becomes available.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.