Section 199A: New 20% Pass-Through Deduction
Glen E. Frost, Managing Partner
When the Tax Cuts and Jobs Act reduced the C corporation tax rate from 35% to 21%, it also created a significant tax break for flow-through entities and structures in an attempt to level the playing field for small businesses.1As such, beginning January 1, 2018, S corporations, partnerships, limited liability companies (LLCs), sole proprietorships, trusts and estates all stand to benefit. Under new Internal Revenue Code (I.R.C.) §199A, taxpayers (excluding C corporations) may be able to deduct up to 20% of the “qualified business income” (QBI) earned in a “qualified trade or business”2subject to limitations. However, those wanting to take advantage of the QBI deduction must first become familiar with new terminology and proficient with complicated calculations.
Understanding QBI
Per I.R.C. §199A(a), taxpayers (excluding corporations) are now allowed a deduction in an amount equal to the lesser of: (1) taxpayer’s combined QBI, or (2) 20% of the excess of taxable income over the sum of net capital gain.
One may succinctly describe QBI as taxpayer’s ordinary income (less ordinary deductions) earned from a passthrough entity or structure. However, the statutory language with regard to this calculation is highly technical, and many items are specifically excluded from the definition. As such, we will parse out the definition of QBI, which is” the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.”3
The “qualified items of income, gain, deduction, and loss” referred to in the first part of the definition must be items whichare:(1) “effectively connected” to aU.S. business,”4and (2) included or allowed in determining taxable income for the taxable year.5
The second part of the definition refers to ” any qualified trade or business,” which includes all trades or businesses, except for ” a specified service trade or business, or the trade or business of performing services as an employee.”6In other words, a qualified trade or business does not include the business of being an employee, nor does it include businesses providing specified services such as investment management, health, law, accounting, performing arts, and consulting services and other services listed in I.R.C. §1202(e)(3)(A).7This may be referred to as the “service business exclusion.”
However, an exception, based on the amount of taxpayer’s taxable income, is provided which allows a deduction with respect to the specified service business’ QBI. In fact, only a taxpayer with taxable income exceeding a particular threshold amount will be entirely precluded from a QBI deduction.8This is further discussed in the next section.
Significantly, §199A also clarifies what QBI does not include. Specifically, QBI does not include wages that taxpayer earns as an employee, nor does it include guaranteed partnership payments allocated to a partner for services to such trade or business. Additionally, I.R.C. §199A(c)(3(B) lists several investment-type items of income, gain, deduction and loss which do not qualify as QBI.
The QBI Calculation
Now that we have a basic understanding of the concept of QBI, we must consider the mechanics of the calculation, involving a number of limitations and thresholds. Again, the QBI deduction is an amount equal to the lesser of: (1) taxpayer’s combined QBI, or (2) 20% of the excess of taxable income over the sum of net capital gain.
The second prong of this definition acts as the first limit-under no circumstance is the QBI deduction allowed to exceed taxpayer’s net taxable income minus net capital gains. This is a relatively straight forward aspect of the formula. As such, the remainder of the article, and the examples herein, will focus on the first prong of the definition involving “combined QBI.”
First, QBI must be determined separately for each of the taxpayer’s qualified businesses. However, to prevent taxpayer abuse, the new law places limitations on QBI.In other words, determining combined QBI is not simply finding the sum of all QBI for each business; rather, it requires calculating the sum of alldeductibleQBI for each business. “Combined QBI” is defined as the sum of the amounts determined under I.R.C. §199A(b)(2)(deductible QBI) for each qualified trade or business, plus 20% of taxpayer’s total qualified real estate investment trust dividends and qualified publicly traded partnership income.9
Generally, deductible QBI equals the lesser of (1) 20% of the taxpayer’s QBI from the trade or business, or (2) the W-2 wage limitation.10The W-2 wage limitation is equal to the greater of:
(1) 50 percent of the W-2 wages with respect to the qualified trade or business,11or
(2) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.12
Significantly, the wage limitation will not apply if taxpayer’s taxable income does not exceed applicable threshold amounts.13Specifically, these threshold amounts for 2018 are $157,500 and $315,000 for joint filers.
Example 1:T’s qualified business produces $30,000 of QBI during tax year 2018. T pays himself $10,000 of W-2 wages that year. T files a joint return and reports taxable income of $250,000. T’s QBI deduction is $6,000 ($30,000 X .2). T’s taxable income is less than $315,000, so the W-2 limitation does not apply.
If taxpayer’s taxable income exceeds the threshold amount plus $50,000 ($100,000 for joint filers), the W-2 limitation is fully applicable.
Example 2:Use the same facts as Example 1, except that T reports $450,000 of taxable income. T’s taxable income now exceeds $415,000 (the applicable threshold amount of $315,000 plus $100,000). As such, the full W-2 limitation is applicable resulting in a limitation of $5,000 ($10,000 wages X .5). Since the $5,000 W-2 limitation is less than 20% of QBI ($6,000), T’s QBI deduction is limited to $5,000.
Finally, if taxpayer’s taxable income falls between the threshold and the threshold plus $50,000 ($100,000 for joint filers), the W-2 limitation is phased in. The phased-in W-2 wage limitation is determined by subtracting a “reduction amount” from 20% of the QBI. The reduction amount is “the amount which bears the same ratio to the excess amount as the amount by which the taxpayer’s taxable income for the taxable year exceeds the threshold amount, bears to$50,000 ($100,000 in the case of a joint return).”14In other words, the taxpayer must:
(1) Determine the excess amount by finding the excess of 20% QBI over the amount of a full W-2 limitation.
(2) Determine the reduction ratio. The numerator of this ratio is the amount of taxable income exceeding the threshold amount, and the denominator is $50,000 (or $100,000 for joint filers). Convert the ratio to a percentage.
(3) Multiply the excess amountin step 1 by the percentage in step 2 to arrive at the reduction amount.
(4) Subtract the reduction amount in step 3 from the amount equal to 20% of QBI. Example 3: Assume the same facts as Example 1, except that T reports $350,000 in taxable income. The W-2 limitation must be phased in, because taxable income falls between the applicable threshold of $315,000 and $415,000 ($315,000 plus $100,000). The excess amount is $1,000 [20% of QBI ($6,000) less full W-2 limitation ($5,000)]. The reduction ratio is ($350,000-$315,000)/$100,000, resulting in 35%. The excess amount of $1,000 is multiplied by 35%, resulting in a reduction amount of $350. Subtracting the reduction amount, $350, from the amount equal to 20% of QBI, $6,000, provides the amount that taxpayer’s QBI deduction is limited to–$5, 650.
Note that if the net amount of QBI is a loss for the year, the amount is carried forward to the next year as a loss from a qualified trade or business.15Any allowed deduction in a later year must be reduced (but not below zero) by 20% of the carried over qualified business loss.16
QBI in the Context of Specified Service Businesses
Similarly, while the service business exclusion would preclude specified service businesses from a QBI deduction, an exception using the same W-2 limitation threshold amounts is available to either wholly, or partially, preserve a deduction.17If the taxpayer’s taxable income exceeds the threshold amount, then the service business exclusion continues to phase in until fully phasing in (i.e. entirely eliminating the QBI deduction) once the income exceeds the threshold amount plus $50,000 ($100,000 for joint filers).18Under this exception, the service business uses the “applicable percentage” to determine QBI.19In this context, only the:
applicable percentage of qualified items of income, gain, deduction, or loss, and the W-2 wages and the unadjusted basis immediately after acquisition of qualified property, of the taxpayer allocable to such specified service trade or business shall be taken into account in computing the qualified business income, W-2 wages, and the unadjusted basis immediately after acquisition of qualified property of the taxpayer for the taxable year for purposes of applying this section.20
The “applicable percentage” is then defined as “100 percent reduced (not below zero) by the percentage equal to the ratio of the taxable income of the taxpayer for the taxable year in excess of the threshold amount, bears to$50,000 ($100,000 in the case of a joint return).”21In other words, taxpayer must:
1. Determine the ratio having as its numerator the amount of taxable income exceeding the threshold amount, and the denominator as $50,000 (or $100,000 for joint filers).
2. Convert the ratio to a percentage.
3. Subtract the percentage from 100%, resulting in the applicable percentage.
4. Multiply the applicable percentage by the specified service business income.
Example 4:On a joint return, T reports taxable income in the amount of $350,000, of which $200,000 is from a specified service business. The exclusion must be phased in, because taxable income falls between the applicable threshold of $315,000 and $415,000 ($315,000 plus $100,000).The numerator in the applicable ratio is $35,000 ($350,000-$315,000) and the denominator is $100,000. The ratio is converted into 65%, which is subtracted from 100%, resulting in an applicable percentage of 35%. Thus, taxpayer may only include$70,000 of the specified service business income as QBI ($200,000 X 35%)).
Planning Considerations
A full discussion of planning opportunities is beyond the scope of this introductory article. As such, only a sample will be discussed below. Follow our newsletter for upcoming articles more specific to QBI deduction planning strategies.
1. Filing Status
In light of the higher thresholds for joint filers, there may be situations where couples who have been filing jointly will benefit from filing separately. For instance, one spouse’s income could qualify for the QBI deduction, but once the other spouse’s income is included the total exceeds the $315,000 threshold.
Example 5:H is a w-2 employee and makes $375,000. W is a sole-proprietorship in a specified service business, which has a net business profit of $180,000. Together their taxable income far exceeds the $415,000 threshold for the QBI deduction for joint filers. If H and W file jointly, W is unable to take advantage of the QBI deduction for her business income. However, if H and W file separately, W benefits from the QBI deduction, significantly reducing her taxes.
2.Convert to S Corporation
Next, business owners of non-specified service businesses, structured as sole proprietorships and partnerships and LLCs that are taxed as partnerships, may want to consider restructuring as S corporations so that owners may receive salaries. For this to be beneficial, the business owner should not have taxable income exceeding the applicable threshold amount.
Example 6:T owns a non-specified service sole proprietorship. T uses independent contractors, rather than hiring W-2 employees. T has no depreciable property. T’s business has a net business profit of $500,000. T’s income is too high for any QBI deduction. However, if T converts her business to an S corporation, T may pay himself a salary. If T pays himself a salary of $100,000, now taxable income is below the applicable threshold amount and the QBI deduction is available.
There are many other planning opportunities that warrant further consideration, including, but not limited to: (1) a business owner transferring business real estate and/or depreciable business property into a new entity which leases the property back to the original business; (2) reducing partnership or guaranteed payments to partners; and (3) establishing retirement plans for business owners so that income of specified service businesses is strategically reduced below the thresholds.
Conclusion
The new I.R.C. §199A, while it is available, offers pass-through entities attractive tax planning opportunities. However, it is quite complicated and tax professionals and taxpayers are still waiting for some regulation clarifications and further guidance on certain issues. A tax professional is best situated to help taxpayers maximize the benefit of the QBI deduction.
If you have questions about the QBI deduction and how it could benefit you, call Frost & Associates, LLC today at 410-497-5947.
1Pub. L. No. 115-97, §11011(a),enacted on December 22, 2017. The deduction remains available for tax years before January 1, 2026.
2I.R.C. §199A(b)(1)(B).
3I.R.C.§199A(c)(1). Note that QBI does not include any qualified REIT dividends or qualified publicly traded partnership income.
4I.R.C. §199A(c)(3)(A)(i).
5I.R.C. §199A(c)(3)(A)(ii).
6I.R.C. §199A(d).
7I.R.C. §199A(d)(1), (2).Note that architecture and engineering are considered qualified trades or business for I.R.C. §199A purposes, pursuant to a specific carveout in the statute for these occupations.
8I.R.C. §199A(d)(3).
9I.R.C. §199A(b).
10I.R.C. §199A(b)(2).
11This limitation is intended to prevent abuse by taxpayers who would opt for flow-through income over wages under the new rules.
12I.R.C. §199A(b)(2)(B).
13I.R.C. §199A(b)(3)(A).
14I.R.C. §199A(b)(3)(B)(ii), (iii).
15I.R.C.§199A(c)(2).
16H. Conf. Rep. No. 466, 115th Cong., 1st Sess. 214 (2017). Note the Conference Report example uses a 23% deduction (the amount originally proposed in the Senate amendment).
17I.R.C.§199A(d)(3).
18I.R.C.§199A(d)(3)(A).
19I.R.C.§199A(d)(3)(A).
20I.R.C.§199A(d)(3)(A)(ii).
21I.R.C. §199A(d)(3)(B).
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