The new IRS code section allows tax payers other than corporations a deduction of 20% of qualified business income earned in a qualified trade or business.
Section 199a enacted with the passage of the Tax Cuts and Jobs Act provides for a deduction of up to 20% on qualified business income (QBI). That deduction, called the Section 199A deduction, raised a number of questions. The Internal Revenue Service (IRS) has issued 184 pages of proposed regulations for Section 199A intended to address some of those issues.
“ Tax Cuts and Jobs Act provides for a deduction of up to 20% on qualified business income”
The new deduction is available for tax years beginning after December 31, 2017. The deduction is generally available to sole proprietors and business owners with pass-through businesses. The deduction also applies to certain trusts and estates.
Pass-through businesses are those that do not pay corporate income tax at the entity level but instead pass income and expenses through to the owners. The owners then report their share of income and expenses on their own tax returns and pay any resulting tax at their individual income tax rates. Examples include sole proprietorships, partnerships, limited liability companies (LLCs), trusts and S corporations.
For purposes of the deduction, a taxpayer's qualified trade or business is any trade or business with two exceptions:
Specified service trade or business (SSTB). An SSTB is any business involving the performance of 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." I like to think of it this way: if the success of your business depends on you and not on something that you sell, you're pretty much included (except for engineering and architecture services, which were specifically excluded). The definition also includes a business 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 $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers.
Performing services as an employee.
The deduction is available to taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers. If your income is above the threshold amounts, you are subject to limitations and exceptions which are determined by your occupation (SSTBs),) and a wage and capital limit.
The deduction is intended to reduce the amount of taxable income attributable to your business. The deduction does not appear to reduce the income used to calculate self-employment tax.
The term qualified business income (QBI) is used throughout the proposed regulations. It's 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. It is used to figure your deduction.
If you have multiple businesses, you 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.
The deduction is generally equal to the lesser of:
20% of your qualified business income (QBI), plus 20% of your qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income; OR
20% of taxable income minus net capital gains.
If your taxable income is below the threshold amount, the deductible amount for each of your businesses is simply 20% of your QBI with respect to each business. For example, if your income is $100,000 and your QBI is $60,000, then your deduction is $12,000, or 20% of your QBI. You're under the threshold amount so no need to do any more math.
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.
If your business is an SSTB and you exceed the threshold amount plus the phase-in range, then you lose the deduction completely. If your business is not an SSTB, 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.
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.
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.
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.
Basis, at its most simple, is the cost paid for an asset. Figuring UBIA, or the unadjusted basis immediately after acquisition (UBIA) of qualified property used in your sole proprietorship shouldn’t be all that complicated. However, figuring basis for property in a partnership, like an LLC, can be complicated at the best of times. Section 199A doesn’t make any of this more simple, but here are the 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. Remember that the UBIA rules only apply to taxpayers over the threshold amount.
Finally, remember that these are proposed regulations – there will be more guidance to come!