One of the most talked about and widely misunderstood provisions of the Tax Cuts and Jobs Act of 2017 is Section 199A, a section which allows individuals, trusts, and estates a deduction of up to 20% of their “qualified business income” from sole proprietorships, partnerships, and S corporations if certain requirements are satisfied. Remember that, the Tax Cuts and Jobs Act permanently lowered the tax rate for corporations to 21% while rates typically remained higher for individuals -- not an ideal situation for sole proprietors and owners of pass-through businesses. As a workaround, Congress created a deduction of up to 20% (Section 199A) to bring the rate lower for those taxpayers. Section 199A is confusing but important. This new deduction can provide significant tax savings beginning right now.
To address the questions plaguing the calculation and applicability of the deduction, IRS in August issued proposed regulations under Section 199A -- some 184 pages long. To further provide clarity, we’ve compiled a list of the most frequently asked questions we’re getting from clients. Feel free to use it as a guide, but also reach out to us for personal help. No article or online guide can substitute for the personal attention of your CPA.
When does the new deduction take effect?
Section 199A is available for tax years beginning after December 31, 2017. Eligible taxpayers can, therefore, claim the deduction on their 2018 federal income tax return (the one you’re about to file).
Am I eligible?
The deduction is generally available to sole proprietors and business owners with pass-through businesses. The deduction also applies to certain trusts and estates.
What is a pass-through business again?
A pass-through business is one that does not pay corporate income tax at the entity level but instead passes income and expenses through to the owners. The owners then report their share of income and expenses on their personal tax returns and pay any resulting tax at their individual income tax rates. Examples of pass-through businesses include sole proprietorships, partnerships, limited liability companies (LLCs), trusts and S corporations.
Are there pass-throughs that won’t qualify?
Yes. Excluded from the deduction are Specified Service Trades or Businesses (SSTB) -- businesses that perform services in the fields of health, law, 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.” SSTBs also include businesses where the performance of services consists of investing and investment management trading or dealing in securities, partnership interests, or commodities. This exception only applies if a taxpayer’s taxable income exceeds the specified limits (see below).
What if a taxpayer's business is only partly an SSTB?
In this case, the following apply:
- De Minimis Rules
The Regulations provide a de minimis rule for situations where only a minimal part of a taxpayer's trade or business is an SSTB. Specifically, a trade or business will not be treated as an SSTB if (1) the trade or business has gross receipts of $25,000,000 or less for the year and (2) less than 10% of the gross receipts of the trade or business is attributable to an SSTB. If the trade or business has gross receipts of more than $25,000,000, the de minimis rule still applies, but the gross receipts of the trade or business attributable to an SSTB cannot exceed 5%.
- Anti-Avoidance Rule
Prior to the issuance of the Regulations, commentators discussed whether an SSTB, such as a law firm or an accounting firm, could spin out its non-SSTB business functions in order to claim the Section 199A deduction with respect to the non-SSTB business. The Regulations attempt to deter this conduct by providing that an SSTB also include any trade or business that (1) provides 80% or more of its property or services to an SSTB and (2) is 50% or more commonly owned. In determining common ownership, related party attribution applies. The Regulations also provide, however, that a trade or business that has 50% or more common ownership with an SSTB and has shared expenses (including wage or overhead expenses) will not be treated as an SSTB if the gross receipts of the non-SSTB trade or business are no more than 5% of the total combined gross receipts of the SSTB and non-SSTB trades or businesses.
What is the effect of the Section 199A deduction on other Code provisions?
The proposed regulations confirm that the deduction does not affect a partner or shareholder's basis or an S corporation's accumulated adjustments account. Also, the deduction does not reduce net earnings from self-employment or net investment income.
Is being an employee a qualified trade or business?
Being an employee is not a qualified trade or business for purposes of Section 199A.
Are there any income limits?
Yes. The deduction is available to taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers (these limits referred to as threshold amounts). If you are above the threshold amounts, you are subject to limitations and exceptions which are determined by your occupation (SSTBs, as noted above) and a wage and capital limit.
What is QBI and why does it matter?
QBI, Qualified Business Income, is the net amount of income, gain, deduction. and loss from your qualified trade or business. Only items included in taxable income are counted, while items such as capital gains and losses, certain dividends and interest income are excluded. QBI is determined on a per business, not a per taxpayer, basis. We’ll use this to figure your deduction.
What if I have multiple businesses?
If you have multiple businesses, we’ll calculate QBI for each and net the amounts. If you have a negative QBI after you net the amounts, you can carry that amount forward to the next tax year.
Figuring out the QBI deduction seems complicated. Do you have any resources to make it easier?
Yes. Check out our blog here explaining the deduction. A helpful chart is included for reference.
What if I’m over the threshold?
If you're over the threshold amount, your deduction may be limited based on :
Whether your business is an SSTB; W-2 wages paid by the business; and unadjusted basis (UBIA) of certain property used by the business. These limitations are phased in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500 (and will be adjusted for inflation in subsequent years). A phase-in range means that the benefit decreases as income increases.
I’m over the threshold amount, AND my business is an SSTB. Am I disqualified?
If your business is an SSTB and you exceed the threshold amount plus the phase-in range ($415,000 for joint filers and $207,500 for all other taxpayers), then you lose the deduction completely. In that case, the old pass-through rules apply (meaning you’ll just pay tax using your individual rate).
If I’m over the threshold amount, but my business is not an SSTB, what do I need to know?
Your deduction isn't subject to a cut-off, but may still be limited by the amount of W-2 wages paid by your business and UBIA.
Aren't W-2 wages just what is reported on a normal W-2?
Yes and no. Only W-2 wages which are properly allocable to QBI can be used to figure the deduction. The IRS has announced three ways to figure those wages:
- Unmodified box method. This method is the lesser of the total entries in box 1 of all forms W-2 filed with the Social Security Administration (SSA) by you with respect to your employees OR the total entries in box 5 of all forms W-2 filed with SSA by you with respect to your employees.
- Modified box 1 method. To use this method, total the amounts in of all forms W-2 filed with the SSA by you with respect to your employees. Next, subtract any amounts included in box 1 of forms W-2 that are not wages for federal income tax withholding purposes. Now, add to that the total amounts reported in box 12 of forms W-2 with respect to your employees that are properly coded D, E, F, G, and S.
- Tracking wages method. To use this method, total the amounts of wages subject to federal income tax withholding that are paid to your employees and that are reported on forms W-2 that you filed with SSA for the calendar year, and add the amounts reported in box 12 of forms W-2 with respect to your employees that are properly coded D, E, F, G, and S.
Do I figure W-2 wages for all businesses at the same time?
No. The W-2 wage limitation in section 199A applies separately for each trade or business. If W-2 wages are allocable to more than one trade or business, you have to figure the applicable share for each business (see proposed reg §1.199A-2).
So once I have the W-2 numbers, what happens next?
If you’re over the threshold amount, the wage and capital limit applies. That limit is the greater of 50% of W-2 wages or the sum of 25% of W-2 wages + 2.5% of the unadjusted basis (UBIA), immediately after acquisition, of all qualified property. Click here for more on the formulas, including some examples.
Pass-through entities don’t always issue a Form W-2. What about net earnings from self-employment and net investment income (like dividends)?
The proposed regulations provide that the section 199A deduction does not reduce net earnings from self-employment under section 1402 or net investment income under section 1411. Calculate those as though there is no section 199A deduction.
What else do I need to know about UBIA?
First, don’t panic. Remember that the UBIA rules only apply to taxpayers over the threshold amount.
Basis is basically the cost paid for an asset plus adjustments. Figuring UBIA, or the unadjusted basis immediately after acquisition (UBIA) of qualified property used in your sole proprietorship is typically fairly simple. However, figuring basis for property in a partnership, like an LLC, can be complicated. Section 199A provides some general rules:
- For purchased or produced qualified property, UBIA generally will be its cost under section 1012 as of the date the property is placed in service.
- For property contributed to a partnership in a section 721 transaction and immediately placed in service, UBIA generally will be its basis under section 723.
- For property contributed to an S corporation in a section 351 transaction and immediately placed in service, UBIA generally will be its basis under section 362.
- For inherited property immediately placed in service by the heir, the UBIA generally will be its fair market value at the time of the decedent’s death under section 1014.
- Some special rules apply, including a reduction in basis for non-business use of property, and a restriction on property acquired and disposed of near the end of the taxable year without having been used in a trade or business for at least 45 days.
UBIA is arguably the most complicated aspect of all of this. Given its fairly narrow scope, we won’t go into further detail on it here. Talk to your BGW teammate for more information if you think you’re impacted by UBIA rules.
Feeling overwhelmed? We don’t blame you. Section 199A is tricky. We’re here to help you through it. Please reach out.