There’s been a lot of talk about the new tax law changes imposed under the Tax Cuts and Job’s Act (TCJA) Trump signed into office last year and rightfully so, considering it’s the largest tax reform signed into law since 1986. The most notable change for businesses was the decrease of the corporate tax rate to a flat 21%. This change buzzed into the ears of many business owners, making them wonder if they should change their business structure to a C Corporation.
But not so fast everyone; Congress leveled the playing field. In addition to decreasing the C Corporation tax rate, the TCJA slipped in a brand new individual tax deduction for owners of pass-through entities and sole proprietorships called the Section §199A Deduction. This deduction allows a 20% deduction of the lesser of Qualified Business Income or taxable income for owners of S corporations, partnerships, and sole proprietors (schedule C and schedule E owners). But like anything with tax law, this new deduction cast many shades of grey in terms of who qualifies and what strategies are allowed when calculating, leaving the public looking for guidance. Luckily, in August 2018, the IRS issued proposed regulations to help us navigate this deduction for the upcoming 2018 tax year.
Here’s what we know to date:
Qualified Business Income
If the deduction is 20% of Qualified Business Income, then what is that? Basically, Qualified Business Income (QBI) includes all ordinary income, deduction, gain or loss attributable to any qualified trade or business that is effectively connected with the United States. Unfortunately, this means your rental income from your vacation home in the Bahamas would not qualify. QBI also does not include interest, dividends, or capital gains/losses (including 1231 gains or losses to the extent they are capital). This means if you sold your rental property for a gain, the portion of the gain treated as capital would not be included in your QBI for purposes of your 20% deduction. Other items not includable are W-2 income and guaranteed payments the taxpayer receives from the business. Lastly, it should be noted that the Section 199A deduction is not based on the taxpayer’s level of involvement in the trade or business. This means both active and passive owners may be entitled to the 199A deduction.
Thresholds, Phase-ins and Limitations
If a taxpayer’s taxable income is less than the threshold amount, $157,500 for single or $315,000 for married filing joint, then his or her §199A deduction is the lesser of (1) 20% of QBI, or (2) 20% of taxable income over their net capital gain. For taxpayers with taxable income above the threshold amounts, two limitations are imposed:
1.Specified Service Trade or Business (SSTB) exclusion or reduction
2.W-2 Wages and UBIA Limitation
There is a phase-in range of $50,000 for single filers and $100,000 for married filing joint filers. This means if you fall into the phase-in range, your deduction is partially limited. If you are over the phase-in range, the full amount of limitations kicks in.
The chart below illustrates the levels of limitations imposed for 2018:
*Taxable income is taxable income over net capital gains
Specified Service Trade or Business Limitation or Exclusion
The first limitation is for those taxpayers with QBI from specified service trade or businesses (SSTB). For individuals above the phase-in range, no §199A deduction is available for SSTB qualified income. However, not all businesses engaged in services are considered SSTBs. Proposed regulation §1.199A-5 define an SSTB as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, or trading and dealing in securities. It also goes on to add others such as celebrities and musicians. Additionally, the proposed regulations provide more stipulations on taxpayers that commonly own trade or businesses and SSTBs, which could result in all or a portion of taxpayer’s trade or business to be classified as an SSTB. Keep in mind, this limitation is only imposed on those who have taxable income above the threshold amount. Those in the phase-in range will still receive a deduction but it will be proportionately limited by the percentage that their taxable income that exceeds the threshold amount.
W-2 Wages and UBIA Limitation
The second limitation is based on the W-2 wages paid and the unadjusted basis immediately after acquisition (UBIA) of qualified property used in the trade or business. This limitation starts with W-2 wages and essentially limits a taxpayer’s §199A deduction to 50% of the W-2 wages the business paid. However, being that most real estate entities are owned in partnerships that pay no W-2 wages, the TCJA added an additional optional limitation called the UBIA limitation. This allows businesses to calculate their limitation on the greater of:
1.50% of W-2 wages OR
2.25% of W-2 wages plus 2.5% of UBIA of qualified property
The UBIA of qualified property is essentially the cost basis immediately after purchase (regardless of 179 or bonus deductions) and it includes all property subject to depreciation that is used in the trade or business, including real property, personal property, improvement property, etc. You are entitled to use UBIA in the limitation calculation as long as the depreciable period has not ended before the close of the taxable year. Again, keep in mind, this limitation is for those whose taxable income exceeds the threshold amounts and for those in the phase-in range, the limitation will have to be phased-in based on their excess of taxable income over the threshold.
Qualified Business Losses
A loss from a qualified trade or business must be carried over to the next year to offset future QBI. Taxpayers with multiple businesses must combine income and losses to get to a net income or loss from qualified businesses. If the netted number is a loss, it is carried over to offset future income. If the netted number is income, the net loss must be apportioned among the businesses with positive income. The W-2 wages and UBIA from trades or businesses with losses are not taken into account when calculating the limitation.
Proposed §1.199A-4 discusses aggregation rules for taxpayers with multiple businesses. This allows taxpayers to group separate businesses into one for purposes of the limitations mentioned above. Aggregation is permitted but not required. There are requirements that must be met in order to be able to aggregate. Taxpayers wishing to aggregate must attach a statement to their return each year identifying the business names and EINs. Aggregation must be consistent for all subsequent tax years.
Other Notable Items
Other notable items listed in the proposed regulations:
-The §199A deduction does not reduce net earnings from self-employment or net investment income. Even though a deduction for the income is allowed on the 1040, it does not reduce the amount of income subject to self-employment tax or net investment income tax.
-There will be no differences for AMT purposes.
-The §199A deduction does not affect a partner’s basis or shareholder’s stock basis.
-Real estate investment trust dividends and qualified publically traded partnership income are maintained separately from other qualified trade or business income for determination of the deduction.
-The burden for QBI calculations and SSTB identification falls on the reporting pass-through entity. Each pass-through must provide a statement on Schedule K-1s showing each owner’s allocable share of QBI, W-2 wages paid, and UBIA of qualified property. These statements must also identify whether the business or any activities in the business are specified service trades or businesses. Failure to report this information will result in the IRS presuming QBI is zero. In the case of sole proprietorships, the burden falls on the individual.
Overall, the new §199A deduction will benefit many taxpayers but great care must be taken when calculating QBI and limitations, and identification of specified service trade or businesses. It is important that the proper reporting takes place or a deduction could be lost. Contact us today to see if you qualify for this new deduction.
Article Contributed by Stephanie Walsch, CPA.