New Internal Revenue Code Section 199A, created by the Tax Cuts and Jobs Act (TCJA) signed by the President in December 2017, allows a deduction to individuals and trusts for a “combined qualified income amount,” which is generally 20% of business income earned directly and from pass-through entities. There are limitations on the types of business income that qualify and several caps and limitations on the amount itself. This alert explains the new law and highlights certain aspects that require further clarification by the Treasury Department.
Commonly referred to as the “pass-through deduction,” new Section 199A, at its most basic level, provides a deduction for the sum of 20% of a non-corporate taxpayer’s:
(i) business income earned either directly (or through a disregarded LLC) or indirectly through partnerships or S corporations;
(ii) certain REIT dividends; and
(iii) certain income from publicly-traded partnerships.
Income from certain types of business activities is not eligible for the deduction. An outer limit of 20% of taxable income (less net capital gains) caps the deduction, and other limitations – including those based on wages and asset basis – may curtail the deduction. Oddly, the deduction does not reduce the business income, nor is it an itemized deduction, and it is allowable to non-itemizers. This special deduction applies only to taxable years 2018-2024.
Calculation of the Section 199A Deduction
Calculation of the Section 199A deduction, the “combined qualified business income amount”, begins with a determination of the taxpayer’s eligible trades or businesses. By definition, “qualified business income” – the primary source of the Section 199A deduction – must be derived from a “qualified trade or business.”
What is a Qualified Trade or Business?
Generally, a qualified trade or business includes any trade or business conducted directly by a taxpayer and indirectly through partnerships and S corporations (e.g., Schedule C or E), but excludes any “specified service trade or business” as well as the performance of services as an employee. Specified service trades or businesses include those involving:
The last category above is exceedingly vague and further guidance from the Treasury Department is clearly needed.
Note that the exclusion from the qualified trade or business qualification for specified service trades or businesses does not apply to the extent a taxpayer’s taxable income is below $157,500 ($315,000 in the case of a joint return). Additionally, there is a partial exclusion for taxable income between $157,500 and $207,500 (between $315,000 and $415,000 in the case of a joint return). These threshold amounts will be indexed for inflation in future years.
What is Qualified Business Income?
Qualified business income is the net amount of those items of income, deduction, gain, and loss from each trade or business conducted in the US (plus certain Puerto Rico activities) by the taxpayer and his or her distributive share of such amounts from each partnership or S corporation interest held by the taxpayer. Thus foreign trade or business income does not qualify.
Qualified business income does not include certain investment income, such as:
Nor does qualified business income include:
What is the Deductible Amount?
The deductible amount, computed separately for each trade or business, is the lesser of:
(a) 20% of the qualified business income, or
(b) the greater of:
The wage and asset basis limitations do not apply to taxpayers below the income thresholds discussed above applicable to determining a specified service trade or business W-2 wages.
With contemporary business practices involving the use of paymaster entities, professional employer organizations, leased employees, etc., further guidance is needed from the Treasury Department to determine a qualified trade or businesses W-2 wages for this purpose. For example, it is common in the real estate industry for wages of personnel nominally employed by the property manager to be allocated among, and reimbursed by, the properties benefitted. Whose wages are these for purposes of Section 199A?
Unadjusted Basis of Qualified Property
Qualified property under Section 199A is generally defined as any depreciable tangible property (real or personal). More specifically, the property must:
A property’s depreciable period is the longer of 10 years or the last day of the applicable Modified Accelerated Cost Recovery System (MACRS) recovery period. If the property is disposed of or has its recovery period expire before the last day of the taxable year, it does not count as qualified property for any part of the year.
The unadjusted basis of all qualified property of the trade or business is added together for purposes of the 2.5% of calculation. This means that any depreciation, including bonus depreciation, deducted with respect to the trade or business does not reduce the basis of the qualified property for this purpose.
As noted above, a taxpayer computes his or her deductible amount for each qualified trade or business separately. The amount for a particular qualifying trade or business may be negative (i.e., a loss was sustained), but the combined amount from all of the taxpayer’s qualifying trades or businesses cannot be negative. Thus, if a taxpayer has an aggregate loss from all qualifying trades or businesses, that net loss is carried forward to the succeeding tax year as a loss from a qualifying trade or business.
What is the Combined Qualified Business Income Amount?
Lastly, the deduction is calculated by taking the lesser of:
(i) The Combined Qualified Business Income Amount of the taxpayer, or
(ii) 20% of the excess (if any) of the taxable income of the taxpayer for the taxable year over net capital gains.
Combined Qualified Business Income Amount is equal to the sum of:
Sheila reports the following qualified trade or business income on her personal return:
(i) She operates several flower shops (through a single member LLC from which she earned taxable income of $500,000 after deducting expenses including wages of $100,000, and depreciable property used in the business is minimal;
(ii) She has a 40% interest in an LLC that operates a catering business from which her distributive share of taxable ordinary income is $600,000, including her share of wage expense of $300,000, and 2.5% of her share of the basis of depreciable property is $25,000.
(iii) She owns no REIT shares nor publicly traded partnership interests.
Her amount from each trade or businesses is:
|Flower Shops||$50,000 (lesser of 20% of taxable income or 50% of wages paid)|
|Catering||$120,000 (lesser of 20% of taxable income or greater of 50% of wages paid or 25% of wages plus 2.5% of depreciable property)|
|Total Potential Deduction||$170,000|
Fred owns a commercial rental property through a single member LLC which generated taxable income of $8 million for the tax year — all of which is qualified business income. The original depreciable basis of the property is $50 million and the W-2 wages paid for the year was $400,000.
His deduction for the year is $1,350,000, the lesser of 20% of the taxable income or the greater of 50% of wages paid, or 25% of wages plus 2.5% of the unadjusted basis depreciable property.
Remaining Interpretive Issues
As alluded to above, there are several areas within this new provision that require additional guidance from the Treasury Department, including:
New Section 199A certainly presents opportunities for tax savings for many taxpayers. Its application, however, is complex and to optimize the potential benefits from it, many taxpayers may need to rearrange their business affairs. In so doing, it is important to be mindful that there are several open issues that could be impacted by expected guidance and the law, in its current form, is set to expire at the end of 2024. Thus, be careful with changes to business structures that are irreversible.
For questions on how Section 199A may apply to you and your business activities, please contact Joseph Most 212.699.8813 | jmost@BERDONLLP.com or reach out to your Berdon advisor.
Berdon LLP New York Accountants