On August 8, 2018 the IRS issued regulations interpreting the new 20% deduction for qualified business income (QBI) created by the Tax Cuts and Jobs Act — signed into law on December 22, 2017 (“TCJA”), also known as the 199A Pass Through Deduction. Here’s a summary of the basic rules:
What is the 199A pass through deduction?
For tax years beginning January 1, 2018, taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income (QBI) from a domestic business operated as a sole proprietorship, or through a partnership, S-corporation, trust or estate. QBI is the ordinary, non-investment income of a business (the income the company was designed to generate, less its payroll). This deduction can be taken in addition to the standard or itemized deductions. The purpose is to give the owners of these businesses the benefit of the corporate income tax rates. In general, the deduction is equal to the lesser of:
- 20% of QBI plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, or
- 20% of taxable income minus net capital gains.
What is QBI?
QBI generally is the net amount of qualified items of income, gain, deduction, and loss, from any qualified trade or business. However, QBI doesn’t include capital gains and losses, certain dividends and interest income, reasonable compensation paid to the taxpayer by any qualified trade or business for services rendered for that trade or business, and any guaranteed payment to a partner for services to the business.
What are the limitations on the 199A pass through deduction?
For taxpayers with taxable income below the threshold amount ($315,000 for married individuals filing jointly, $157,500 for other individuals, indexed for inflation after 2018), there are no limitations on the deduction regardless of the type of business. If taxpayers have taxable income in excess of these thresholds, two limitations apply:
1. The first limitation is industry specific.
A qualified trade or business does not include a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. The ability to claim the deduction for owners of a specified service business with income over the threshold is phased out over the next $100,000 of taxable income (if married filing jointly; $50,000 for all other taxpayers), so that by the time taxable income exceeds $415,000 (if married filing jointly; $207,500 for all other taxpayers) the deduction is lost completely.
2. The second limitation takes into account the business’s payroll.
Generally, the deduction for QBI is limited to the greater of:
50% of the W-2 wages from the qualified trade or business; or
25% of the W-2 wages from the qualified trade or business plus 2.5% of the unadjusted basis of certain tangible, depreciable property held and used by the business during the year for production of QBI.
As mentioned above, this limit on the deduction for QBI does not apply to taxpayers with taxable income below a threshold amount ($315,000 for married individuals filing jointly, $157,500 for other individuals, indexed for inflation after 2018). The W-2 limitations are phased in over the next $100,000 of taxable income (if married filing jointly; $50,000 for all other taxpayers). Thus, by the time taxable income reaches $415,000 for a married taxpayer filing jointly ($207,500 for all other taxpayers), the W-2 limitations apply in full.
What are the planning opportunities under the 199A pass through deduction?
The full effect of the Act has not been felt yet and probably won’t be until taxpayers start calculating the 2018 tax returns next year, but there are few obvious opportunities to consider:
- Reducing Income.
- Reducing income or spreading it out among several taxpayers, so that the taxpayer’s taxable income is below the threshold amount.
- Minimizing guaranteed payments and compensation for services rendered to the business.
- Pass Through Entities need to monitor their QBI to make sure QBI does not exceed the payroll limitations, so the deduction is not lost or reduced.
- Transmuting Income. Converting income from specified service businesses to income from non-specified service businesses.
- Changing Structures.
- Sole proprietorships not in a specialized service business should consider incorporating and making an S-election to distinguish between income for services and QBI if their taxable income is in excess of the income threshold.
- Employees could consider incorporating themselves and become independent contractors in certain situations.
Each situation is unique and DeAngelis Legal is available to work with you and your team to find the right legal structure for your business under the Act. Just give us a call.