For taxable years beginning after December 31, 2017 and before January 1, 2026 individuals, estates and trusts are entitled to deduct 20% of their share of qualified business income from partnerships, S corporations and sole proprietorships (loosely referred to for these purposes as “pass-throughs”). . . Ahhh, if only § 199A were so simple. However this seemingly simple deduction is in fact layered with enough limitations, exemptions and phase-ins to make one’s head spin.
Determine the Qualified Business Income for Each Trade or Business
Qualified business income (“QBI”) on which the tentative deduction is based, consists of the taxpayer’s share of ordinary income, less ordinary deductions, from a trade or business other than capital gains and losses, dividends, interest and annuities not properly allocable to the trade or business, certain items of foreign income, gain or loss and any deduction or loss allocable to the foregoing items. Also excluded from QBI are amounts paid by the pass-through to the taxpayer in the form of wages or guaranteed payments for services the taxpayer provided to the pass-through as well as amounts from a trade or business of performing services as an employee. QBI must be computed separately for each trade or business in which the taxpayer has an interest.
Identify any Specified Service Trades or Businesses
Subject to a phase-in for taxpayers with taxable income in excess of $315,000 for married taxpayers filing jointly, or $157,500 for other taxpayers, indexed for inflation (the “threshold amounts”), income from certain specified service trades or businesses are also excluded from QBI. Specified Service businesses include businesses described in § 1202(e)(3)(A), including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services (but excluding engineering and architecture). Also excluded under the specified service exception are certain investment related services. However, just when you think you have dodged the bullet on the specified service exclusion, § 1202(e)(3)(A) contains a further broad category that includes any trade or business in which the principal asset is the reputation or skill of one or more of its employees or owners. While § 1202 has been in the Code since 1993 there is scant (as in no) authority as to what this final category includes, or any of the other categories for that matter. Folks are already clamoring for expedited guidance from the IRS as to how to determine on what side of the line a particular business falls.
Phase-In of the Specified Service Limitation
The phase-in of the exclusion for specified services trades or businesses applies over the next $100,000 of taxable income in excess of the threshold amount for married taxpayers filing jointly and the next $50,000 for other taxpayers. This phase-in is linear for such excess amounts. That is, generally the percentage of net income from the specified service business which is excluded will equal 1% for each $1,000 of taxable income in excess of the threshold amount up to $415,000 for married taxpayers filing jointly, or each $2,000 of taxable income above the threshold amount up to $207,500 for other taxpayers. For taxable incomes above $415,000 or $207,500, as the case may be, items of income and deduction from a specified services trade or business are completely excluded from QBI.
Example 1: Joe has $240,000 of QBI from his accounting practice (a specified service trade or business) and total taxable income (married filing joint) for the year of $380,000. Because Joes taxable income exceeds the threshold amount but is less than $415,000, he is limited to an applicable percentage of QBI, which in this case is 35%, computed as [( 1 - ($380,000 - $315,000)/$100,000]. Thus, Joe’s allowable QBI is reduced to $84,000 ($240,000 * 35%).
Make Sure That Activity is a Trade or Business
Note that QBI is limited to qualified ordinary items of income and deduction generated by a trade or business. While “trade or business” is not defined in § 199A it will likely be limited to a § 162 trade or business. Hopefully that will be clarified in regulations. Many trade or businesses may have to be restructured in order to meet the trade or business requirement. For instance, in the case of rental real estate there likely will be a requirement that the rental is accompanied by the provision of substantial services or the incurrence of substantial costs in the rental business. See Reg. §1.1362-2(c)(5)(ii)(B)(ii).
If a pass-through engages in more than one trade or business it appears that the QBI from each trade or business must be separately computed. Hopefully that will also be clarified in regulations. Section 199A(f)(4)(B) specifically provides that regulations are to be issued for guidance on how QBI is to be computed for tiered entities.
Wait . . . We’re Not Done Yet – Determine The Wage Limitation Amount
Having identified each of the taxpayer’s separate trades or businesses, and culled out net income from a specified service business (after applying the phase-in formula to determine how much, if any, of the income from a specified service business can be counted in QBI), the deductible amount for each trade or business must run the gauntlet of the Wage Limitation. The deductible amount for each trade or business cannot exceed the greater of: 50% of W-2 wages or the business or the sum of 25% of W-2 wages and 2.5% of unadjusted basis in tangible depreciable property (collectively referred to herein as the “Wage Limitation”). Unadjusted basis as determined immediately after acquisition of the property is includible in the Wage Limitation computation if a 10 year period commencing on the date the property was first placed in service has not expired prior to the end of the taxable year, regardless of the actual depreciation period. For instance, depreciable property which was fully expensed under §179 can still be included in determining the Wage Limitation, for periods up to the 10th anniversary of the date placed in service or the last day of the last full year in the applicable recovery period that would apply under § 168, excluding subsection (g), whichever is later.
Phase-in of Wage Limitation
The Wage Limitation on the amount deductible for each qualified trade or business is also phased-in using the same thresholds of taxpayer taxable income discussed above. Note that while wages and unadjusted basis are determined at the trade or business level, applicability of the phase-in is determined at the taxpayer level.
Example 2: Bob has ordinary pass-through income of $350,000 from Bob’s Bakeries, LLC. His allocable share of wages is $100,000. Assume no qualified tangible depreciable property. If Bob’s taxable income were not in excess of the $315,000 threshold amount his deduction would have been 20% of $350,000, or $70,000. Conversely, had his taxable income been $415,000, or greater, the deduction would have been fully limited to 50% of wages, or $50,000. However, Bob is 35% through the $100,000 phase-in range, computed as [($350,000 – $315,000)/$100,000]. Thus, the $70,000 deduction is reduced by 35% of the difference between $70,000 and $50,000 ( 35% * $20,000 = $7,000). The resulting deduction is therefore $$63,000 ($70,000 - $7,000).
We are Getting Closer . . . Compute the Deductible Amount for Each Trade or Business
The deductible amount for each qualified trade or business in which the taxpayer has an interest is the lesser of: (a) 20% of the QBI of the trade or business, or (b) the applicable Wage Limitation amount as applied to that business.
At Last . . . The Final Computation
After determining the deductible amounts for each of the qualified trades or businesses of the taxpayer, the ultimate deduction (disregarding for these purposes certain qualified cooperatives) is the lesser of (a) the sum of the deductible amounts computed for each qualified trade or business, together with 20% of the aggregate amount of qualified REIT dividends and qualified publicly traded partnership income for the taxable year, or (b) 20% of the amount by which taxable income of the taxpayer exceeds capital gains. The deduction may not exceed the taxable income of the taxpayer (as reduced by net capital gain) for the taxable year. A similar deduction is allowed for certain agricultural or horticultural cooperatives.
- Taxpayers with taxable income that does not exceed the applicable threshold amount will generally be entitled to a deduction of 20% of their share of ordinary flow-through income. Taxpayers with taxable income in excess of the threshold income amounts may be limited by the Wages Limitation and may be completely excluded as to income from a specified service business.
- High income taxpayers may consider gifting interests in a pass-through to lower income relatives thereby freeing up deductions for the transferees who have taxable income under the applicable threshold which may have been limited to the transferor due to the Wage Limitation. However, the limitations of §704(e) should be considered in the planning process.
- The deduction is skewed in favor of trades or businesses which pay wages and/or make substantial capital expenditures for tangible depreciable property.
- An individual service provider who earns income as an independent contractor can include such income in QBI, whereas an individual performing the same type of services as an employee will not be able to treat such income as QBI from a trade or business.
- Contrast that with the service recipient who may resist recharacterization of the service provider as an independent contractor in order to bolster the service recipient’s deductible amount under the Wage Limitation.
- While wages or guaranteed payments to an owner of the business are excluded from QBI, W-2 wages paid to a shareholder of an S corporation will be includible in determining the amount allowed under the Wage Limitation.
- Some taxpayers who are compensated with guaranteed payments through their partnership may consider transferring their partnership interest to an S corporation, from which they then receive a salary, in order to increase the available deduction where the Wage Limitation applies. However, the disadvantages of operating as an S corporation compared to a partnership should also be considered (i.e. potential double taxation under §311(b), §1374 or §1375, where C corporation E&P exists, inability to make special allocations, limitations on inclusion of S corporation debt in a shareholder’s basis and no corporate analog to §754 basis adjustments, to name a few). Also there is a tension with the self-employment tax rules whereby one attempts to minimize the amounts paid to an S corporation shareholder as “reasonable compensation” in order to avoid self-employment tax. Care must be taken in transferring a leveraged partnership interest to an S corporation.
- The basis taken into account in determining unadjusted basis is just that, basis at the time of acquisition without reduction for depreciation deductions.
- Qualified trades or businesses may consider buying new equipment and taking a 179 deduction. The business gets an immediate write off of the cost which also adds to the unadjusted basis, increasing the deduction allowed under the Wage Limitation.
- The cost of property with a depreciable life of less than 10 years from the date first placed in service (such as automobiles, computer equipment, etc.) can still be included in unadjusted basis until the 10-year period expires.
- Performers and professional athletes may consider spinning out intellectual property rights to a separate pass-through and then leasing those assets back, generating income at the pass-through level which may qualify for a deduction free of the specified service limitation.
- Other specified services businesses may also consider segregating into a separate pass-through a portion of that business which would not, on its own, constitute a specified service business. However care must the taken to assure that the segregated activity thereafter constitutes a separate trade or business.
- If the net amount of qualified income, gain, deduction and loss with respect to all of the taxpayer’s qualified trades or businesses is less than zero (i.e. an aggregate net loss) the taxpayer is not allowed any 199A deduction for the taxable year. Rather, the taxpayer has a carryover qualified business loss to the next year. The taxpayer must reduce the 20% deductible amount for all of the qualified trades or businesses by 20% of the carryover loss in computing the final deduction in the carryover year.
- While no doubt many businesses will be restructured to try to optimize the availability of the § 199A deduction, keep in mind that the deduction only applies until 2026. It will be important to design any such restructuring in a manner that can be unwound in the future without significant tax cost.
I intend to add future blog posts which delve deeper into these and other planning opportunities under § 199A
If anyone has any questions regarding the new § 199A pass-throughs deduction or how it may impact a particular trade or business activity, please contact Tom Hineman at 214-744-3700.
§ 1202(e)(3)(A) only refers to employees but § 199A expanded that category to also include the reputation or skill of any owner.