Tax Cuts and Jobs Act – New Section 199A Deduction
The Tax Cuts and Jobs Act passed on December 22, 2017 introduced a new deduction referred to as the Section 199A deduction for qualified business income. However, it has limitations in terms of eligibility, the types of activities that qualify, and the amount that can be deducted.
Beginning with tax year 2018 and up through 2025, Section 199A allows a deduction of up to 20% of qualified business income (QBI) for passthrough entities including partnerships, LLCs, S-corporations, and some trusts and estates. It also applies to sole proprietorships. However, the full calculation involves a multi-step process that may phase out some or all the deduction.
Qualified Business Income
The initial step in calculating the Section 199A deduction begins with determining QBI. QBI is determined separately for each of the taxpayer’s qualified businesses and includes the net domestic business taxable income, gain, deduction and loss with respect to any qualified trade or business. QBI specifically excludes the following items: 1) investment-type income such as dividends (other than REITs and patronage dividends), interest (unless properly allocable to a trade or business), short and long-term capital gains and other similar type items, 2) any guaranteed payments paid in compensation for services performed by the partner to the partnership, 3) payments for reasonable compensation received from an S corporation.
A taxpayer may have qualified business income from more than one qualified trade or business. If, after combining QBI from all qualified businesses, the net amount is less than zero, such amount shall be treated as a loss from a qualified trade or business in the succeeding tax year.
For married filing joint tax return filers with less than $315,000 in taxable income and single filers with less than $157,500 of taxable income, the calculation of the deduction is fairly straightforward. The taxpayer first calculates the deductible QBI amount for each qualified business and then combines them to determine the combined QBI amount. The taxpayer’s Section 199A deduction is equal to the lesser of 1) 20% of the combined QBI amount or 2) the overall limitation which equals 20% of the taxpayer’s taxable income in excess of any capital gain.
Example: A married filing jointly taxpayer operates a sole proprietorship with $200,000 of taxable income, of which $20,000 is net capital gain and $120,000 of ordinary net income from operating a sole proprietorship. The taxpayer’s Section 199A deduction is equal to the lesser of (20% x $120,000 QBI, or $24,000) or (20% x ($200,000 taxable income less $20,000 net capital gain) or $36,000). Therefore, the taxpayer’s QBI deduction is $24,000.
However, once taxable income exceeds the $315,000 taxable income threshold for married filing jointly taxpayers and $157,500 for single filers, the calculation of the deduction can become more complicated as there are four possible categories below in which the taxpayer may be categorized based on the amount of their taxable income and type of qualified business income:
- Above the phase-in range for a qualified trade or business
- In the phase-in range for a qualified trade or business
- Above the phase-out range for a specified service trade or business
- In the phase-out range for a specified service trade or business
For a single taxpayer, the taxable income phase-in, phase-out range is the $50,000 between $157,500 and $207,500. For the married filing jointly taxpayer, the taxable income phase-in, phase-out range is the $100,000 between $315,000 and $415,000.
A qualified trade or business includes any trade or business other than a “specified service trade or business” or the trade or business of performing services as an employee. A specified service trade or business involves the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. The definition explicitly excludes engineering or architecture from the list.
1. Above the Phase-in Range for a Qualified Trade or Business
For a taxpayer whose business income is not from a specified service trade or business and whose taxable income exceeds $207,500 (single filers) or $415,000 (married filing jointly), the formula to calculate the qualified business income deduction is the lesser of:
- 20% of qualified business income, or
- 20% of taxable income, or
- The greater of a) 50% of that business’s W-2 wages or b) the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of all that business’s qualified property (which is generally tangible property subject to depreciation under IRC §167).
A shareholder or partner may only take into consideration 2.5% of his or her allocable share of the unadjusted basis of the qualified property. Qualified property must have been used at any point during the tax year in the production of qualified business income and be held by, and available for use in, the qualified business at the close of the tax year. A taxpayer may take into consideration the unadjusted basis of property only for a year for which the depreciable period of the property has not ended before the close of the tax year. The depreciable period begins on the date the property is placed in service and ends on the later of 10 years after the date placed in service, or the last day of the full year in the applicable recovery period that would apply to the property under Section 168.
Example: The taxpayer is married, filing jointly with taxable income of $500,000. His qualified business income is $350,000 and is not from a specified service trade or business. The business pays no wages and owns no property. His 20% qualified business income deduction would be zero.
Once the taxable income threshold is exceeded, a taxpayer needs either W-2 wages or property to claim any deduction.
Example: The facts are the same as in the example above except that the business paid $100,000 in W-2 wages and had $50,000 unadjusted basis in qualified property. Now the taxpayer’s deduction is the lesser of:
- $70,000 (20% of $350,000 qualified business income), or the greater of
- $50,000 (50% of W-2 wages), or
- $26,250 (25% of W-2 wages, or $25,000 plus 2.5% of unadjusted basis of qualified property, or $1,250)
In this situation, the taxpayer’s qualified business income deduction would equal $50,000.
As you can see, once a taxpayer’s taxable income exceeds the thresholds, the only way to qualify for this deduction is if the qualified business has W-2 wages and/or qualified property that may be factored into the equation.
2. In the Phase-In Range for a Qualified Trade or Business
When taxable income is within the phase-out range which is between $157,500 and $207,500 for single taxpayers and between $315,000 and $415,000 for married filing jointly taxpayers, a phase-in percentage must be factored into the calculation.
Example: The taxpayer is married, filing jointly with taxable income of $400,000. His qualified business income is $350,000 and is not from a specified service trade or business. The business pays $100,000 in W-2 wages and owns no property. Before considering the phase-in, the taxpayer’s tentative deduction is the lesser of:
- $70,000 (20% of $350,000 qualified business income), or
- $50,000 (50% of W-2 wages)
The taxpayer’s phase-in percentage is 85% since his taxable income is $85,000 over the $315,000 threshold. In order to calculate his deduction, he must take the $20,000 difference between the $70,000 and $50,000 calculated above and multiply that by 85% to get his phase-in amount of $17,000. Therefore, his qualified business income deduction is $53,000 ($70,000 – $17,000).
By applying this calculation, the taxpayer is phasing in the benefit of the wage and property calculation which does not apply when taxable income is below the threshold for applying the phase-in range.
3. Above the Phase-Out Range for a Specified Service Trade or Business
If a taxpayer has specified service trade or business income that is below the $157,500 taxable income threshold for single filers and $315,000 for those married filing jointly, the deduction is calculated by multiplying qualified business income from the specified service trade or business (doctor, lawyer, accountant, etc.) by 20% which is the same way as calculated for taxpayers with qualified business income from businesses which are not specified service trades or businesses.
However, if the taxpayer has taxable income above $207,500 (single) or $415,000 (married filing jointly) and has qualified business income from a specified service trade or business, the taxpayer cannot claim any qualified business income deduction under Section 199A.
4. In the Phase-Out Range for a Specified Service Trade or Business
When a taxpayer has business income from a specified service trade or business and taxable income that is within the phase-out range (between $157,500 – $207,500 for single taxpayers and $315,000 – $415,000 for married filing jointly taxpayers), the taxpayer must apply a phase-out percentage to their tentative deduction.
Example: The taxpayer is single and is a partner in a dentistry practice. He has taxable income of $180,000 and his share of qualified business income from the practice is $200,000. The practice also paid $100,000 in W-2 wages to its employees.
The taxpayer’s $180,000 in taxable income puts him $22,500 over the $157,500 single threshold and that $22,500 is 45% of the $50,000 single phase-out range, leaving the taxpayer with 55%. He must calculate his qualified business deduction by taking the lesser of the following:
- ($180,000 taxable income x 55% phase-out percentage x 20%) or $19,800, or
- ($100,000 W-2 wages x 55% phase-out percentage x 50%) or $27,500
In this situation, the taxpayer’s qualified business income deduction is $19,800.
Carryover of Losses
A taxpayer may have qualified business income from more than one qualified trade or business. If, after combining QBI, the net amount is less than zero, the taxpayer’s net loss generated in one year will be carried forward and reduce the subsequent year’s Section 199A deduction.
Example: In Year 1, the taxpayer has QBI of $10,000 from qualified business A and a qualified business loss of $20,000 from qualified business B. The taxpayer cannot take the deduction in Year 1 and has a carryover loss of $10,000 to Year 2. In Year 2, the taxpayer has $15,000 QBI from business A and $5,000 QBI from business B.
QBI Business A 10,000
QBI Business B (20,000)
Combined Total (10,000)
No QBI deduction available for Year 1.
QBI Business A 15,000
QBI Business B 5,000
Combined Total 20,000
Ignoring application of other potential limitations and deductible amounts, the taxpayer would be entitled to a Year 2 deduction of $2,000.
($20,000 Year 2 QBI x 20%) – (10,000 Loss Carryover x 20%), or
$4,000 – $2,000 = $2,000
The Section 199A deduction is available to both taxpayers who itemize deductions and those who claim the standard deduction. For purposes of determining a taxpayer’s alternative minimum taxable income, qualified business income is computed without any adjustments or preference items under Sections 56 through 59. Therefore, a taxpayer’s Section 199A deduction for alternative minimum tax purposes will be the same as that computed as a deduction against regular tax.
More administrative guidance will most likely be issued in the future to further define and clarify the law’s parameters. The law’s many yet unclear points include its application to rental property, determining the deduction for tiered entities, allocating W-2 wages among businesses, and whether compensation paid to an S corporation shareholder is included in W-2 wages for purposes of that limitation. In addition, for “Specified Service” trades or businesses, the inclusion of those trades or businesses whose principal asset is the reputation or skill of its employees or owners needs more clarification in order to determine exactly what type of businesses are includable as specified service trade or businesses.
The Internal Revenue Code imposes a 20% accuracy-related penalty on underpayment of tax due to a substantial understatement of tax. Generally, the understatement is substantial if the amount for such tax year exceeds the greater of 10% of the tax required to be shown on the return for the tax year or $5,000. The new law amends the accuracy-related penalty language to provide that any taxpayer who claims a Section 199A deduction is subject to a lower threshold before a substantial-understatement penalty is applied, equal to the greater of 5% of the tax required to be shown on the return for the tax year or $5,000. Given the lack of guidance surrounding several key areas of the qualified business income deduction, this lower threshold for incurring the accuracy-related penalty is particularly harsh. In addition, the changes to the accuracy-related penalty do not require the substantial understatement to be attributable to the Section 199A deduction. Therefore, any taxpayer who claims the deduction will be subject to the lower threshold, even if the understatement is unrelated to Section 199A.
While the qualified business income deduction will undoubtedly result in significant tax savings for owners of pass-through entities, it is still important to consider C-corporations in choice of entity decisions due to the decrease in corporate tax rates from the previous maximum rate of 35% to the new flat rate of 21%. There are several factors to be considered in making such a decision, but one key factor is the likelihood of the entity distributing versus retaining operating earnings. This factor could delay the second level of tax applicable to shareholders of a C-corporation.
In summary, the new Section 199A qualified business deduction provides owners of pass-through entities a deduction of up to 20% of their qualified business income on their tax returns. However, there are many complexities and limitations to be aware of when calculating this deduction. In addition, there are still many gray areas which should become more clearly defined once more administrative guidance is issued. Until then, taxpayers and tax preparers should proceed with caution when claiming this deduction on tax returns.
Acting IRS Commissioner David Kautter has reportedly said on June 8 at the University of Virginia announced that the release of the proposed regulations would likely be earlier than originally expected “couple of weeks.”