The recent tax reform act created a new deduction for owners of certain pass-through businesses that could potentially create significant tax savings for many of our business owner clients who receive a substantial amount of their income from a pass-through entity. This new deduction is referred to as Section 199A, of the Internal Revenue Code that established the deduction. Unlike the C Corporation rate deduction, which is permanent, Section 199A will sunset at the end of 2025 unless it is extended in the future. Section 199A provides a 20% deduction for owners of S corporations, partnerships, limited liability companies and sole proprietorships on their “qualified business income.” The 20% deduction can result in a taxpayer who is otherwise taxed at the highest marginal rate of 37%, having his or her effective tax rate reduced to 29.6% on his or her qualified business income. The deduction is available to any individual, trust or estate that earn qualified business income.
This new pass-through deduction is subject to many caps, adjustments and limitations so let’s take a closer look. We will start with a few new definitions on which the limitations are based.
QUALIFED BUSINESS INCOME (QBI): Any ordinary trade or business income earned from a qualified business. The income must be earned within the United States. Investment income, such as capital gain or loss, dividend and interest, is excluded. Also excluded are any wages or guaranteed payments paid to the owners/members.
SPECIFIED SERVICE BUSINESS (SSB): Any business in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading and dealing in securities or any business where the principal asset is the reputation or skill of one or more of its owners. Architects and engineers are currently excluded from this definition. Owners of an SSB are subject to separate taxable income limitations in order to be entitled to the deduction. Taxable income from all sources after deductions of an owner of a SSB must be less than $315,000 for MFJ and $157,000 if single to take full advantage of the deduction. The deduction is phased out for income between $415,000 and $315,000 for MFJ and $257,000 and $157,000 if single.
QUALIFED PROPERTY: Tangible depreciable property for which the depreciation period has not expired, which is owned and used by the business at year end and used for the production of QBI during that year. The depreciation period for Section 199A is the greater of 10 years or the actual remaining MACRS depreciation period. Inventory is not qualified property. The value of qualified property is its unadjusted basis, generally its acquisition cost.
W2 WAGES: Includes cash and non-cash consideration paid to an employee as reflected on returns filed with the Social Security Administration. It does not include any amounts paid to contractors or for management fees.
HOW IS THE DEDUCTION COMPUTED: The starting point of the computation is the determination of the net business income for each qualified business of the taxpayer. For those taxpayers with multiple businesses, each business is calculated separately. This amount could be income or a loss. Simply multiply this amount by 20%. Next, the limitations based on W2 wages and qualified property are applied. The deduction cannot exceed the greater of (1) 50% of their share of W2 wages paid with respect to the QBI or (2) the sum of 25% of their share of W2 wages plus 2.5% of the unadjusted basis of qualified property. Where a K-1 is received, the allocable share of W-2 wages and unadjusted basis of the entities’ assets should be provided on the K-1.
This limitation does not apply to taxpayers with taxable income not exceeding $315,000 MFJ or $157,000 for other filers. The limitation is phased in for taxpayers with taxable income between $415,000 – $315,000 MFJ and $207,000 – $157,000 for other filers.
The result for each qualifying business is added together. The deduction is increased by 20% of the taxpayer’s qualified REIT dividends, qualified publicly traded partnership income and cooperative dividends. The net result could be income or a loss. If it is a loss, the loss carries over indefinitely.
The final limitation is the deduction cannot exceed 20% of the taxpayer’s taxable income before the deduction reduced by the amount of any net capital gain. This limitation will come into play for taxpayers who have more itemized deductions than they have non-business income. This limitation prevents the deduction from creating an overall loss for the year.
The resulting deduction will be taken on a new line on page 2 of form 1040 for individuals, reducing taxable income.
In closing, many questions remain to be answered regarding this new deduction. Tax savings are available; however, it appears clear that in order for the owners of many businesses to benefit, the business must either pay significant wages or have significant investment in depreciable property.
To learn more about this complex deduction and how it impacts your individual situation, please contact us.