One of the most scrutinized and technically challenging elements of the new Tax Cuts and Jobs Act of 2017 (TCJA) is the Section 199A deduction, effective from January 1, 2018 through December 31, 2025. Created as a means for businesses other than C Corporations to keep pace with the corporate tax cut from 35% to 21%, Section 199A provides a 20% deduction for “qualified business income” earned in a qualified trade or business. While there are questions as to the specific definition of multiple terms in the law, the IRS has clarified some of that confusion with proposed regulations issued August 8, 2018. As the public commentary and hearing stage of the regulations continues, it is important to be familiar with this critical benefit.
In general, owners of sole proprietorships, rental properties, S Corporations, and partnerships should be considered for the deduction. Qualified trades and businesses include all trades and businesses except those based on the performance of services or those that the law defines as “specified service” trades or businesses. These include some specifically excluded professions, such as law and accounting, and more broadly include businesses whose principal asset is the reputation or skill of one or more owners or employees. This focuses the deduction to producers of tangible goods or products, and opens the phrase “specified service” to a number of interpretations as small businesses make arguments to remain eligible. Some taxpayers have already acted against the uncertainty of their specified service classification by preemptively converting to C Corporations. While this can provide some immediate tax rate relief if the 199A deduction is not available, it can also generate unintended consequences if property is contributed to the C Corp or there are significant prior year earnings that need to be distributed.
The 20% deduction itself is calculated based on the net amount of income, gains, deductions, and losses that are effectively connected with the conduct of the qualifying trade or business. This includes all items related to core business operations, not investment income from portfolio gains or investment expenses. Each owner calculates their own 199A deduction based on their allocable share of qualifying items determined on a per-day pro rata allocation.
If multiple business activities qualify, then the calculation and subsequent limitations (see below) should be considered for each individual activity. Treatment of extraordinary items related to operations, such as the income or loss generated from acquisitions and dispositions of qualifying business interests, is still uncertain and subject to further regulation.
While any individual earning trade or business income may take this deduction if their taxable income is below $315,000 on a married filing jointly return, there are two key limitations to the basic 20% calculation that apply if the taxpayer’s income exceeds $315,000. First, the tentative 20% deduction cannot exceed 50% of the W-2 wages allocable to the owner or partner. The wages allocable to the owner or partner is not the amount of wages they were paid during the year, but rather their share of the entity’s wage expense allocated in the same per-day pro rata method used in the original calculation. This limitation ensures that businesses will not reduce their wage expense to avoid payroll taxes and maximize their 199A deduction. The alternative limitation replaces the 50% of allocable W-2 wages floor with a new one calculated as 25% of allocable W-2 wages + 2.5% of the unadjusted basis of qualified property. The taxpayer can use whichever of the 2 limitations provides the greater 199A deduction. This alternative calculation appears to be designed to allow rental property owners to qualify for the 20% deduction generated by the activity without needing to pay themselves wages. However, with rental activities included in the uncertainty of what qualifies as a trade or business for 199A purposes, this conclusion could turn out to be incorrect.
The most practical approach to Section 199A starts with an analysis of the taxpayer’s trade or business for eligibility, followed by consideration of their total income to determine if any of the limitations will come into play. Once it is clear that the 20% deduction is available, specific income and loss items need to be evaluated at the business level to determine what qualifies and how much should be allocated to the owner or partner in question. Proper planning will likely involve consideration of the wage and capital limitations as they relate to maximizing the deduction. In cases involving a more significant potential deduction, it may be worthwhile to adjust the ownership structure of the entity (i.e. add an owner) to obtain more favorable threshold calculations.
Looking forward to the 2018 filing season, Congress will need to address industry concerns and issue final regulations to clarify how the standards of 199A will be applied. Fundamental questions like where the deduction will be reported, what exactly falls under the specified service umbrella, and which classes of pass-through income are eligible have yet to be fully resolved. Until that guidance becomes available, proceed with caution and avoid interpreting the rules too aggressively.
Greg Ward, CPA, joined Dalby, Wendland & Co.’s Glenwood Springs office in August of 2013. He attended the University of Illinois at Urbana-Champaign and attained a bachelor’s degree in accounting, with highest honors. Greg works in the areas of individual taxation, estates and trusts, small business taxation, tax-exempt organization reporting, and foreign reporting. He is a member of the American Institute of CPAs, Colorado Society of CPAs, National Eagle Scout Association, and volunteers his time as the treasurer for the Colorado Society of Certified Public Accountants Roaring Fork Chapter.