By Travis McMurray and Andy Clark
Two hundred and twenty-nine days – that’s how long we’ve waited. The Tax Cuts and Jobs Act was signed into law on December 22, 2017 and on August 8, 2018, the IRS finally issued Proposed regulations (184 pages) for the new Section 199A deduction (aka 20% pass-through deduction). I don’t envy the folks at the IRS and the task of taking tax law and creating tax forms that comply with legislation. Looking ahead, we have a few months to figure things out for 2018.
BRIEF RECAP
Effective for tax years beginning after December 31, 2017 and before January 1, 2026, a taxpayer other than a corporation is entitled to a deduction equal to 20% of the taxpayer’s “qualified business income”, QBI, earned in a “qualified trade or business.” The full calculation of the deduction, however, involves a multi-step process that may phase-out the deduction if income exceeds a certain threshold.
A taxpayer other than a corporation would consist of sole proprietorship or partnership, s-corporation, trust, or estate. This deduction can only be taken at the individual level or by some trusts and estates.
BASIC CALCULATION:
In the deductions simplest form, a taxpayer other than a corporation can claim a deduction that is equal to the lesser of (i) 20% of the taxpayer’s qualified business income (QBI) earned within a qualified trade or business plus 20% of the taxpayer’s combined qualified Real Estate Investment Trust (REIT) dividends and qualified Publicly Traded Partnership, PTP, income OR (ii) 20% of the excess (if any) of the taxpayer’s taxable income over their net capital gains.
If a taxpayer has multiple qualified trades or businesses, the taxpayer must do this calculation separately for each trade or business.
WHAT IS QUALIFIED BUSINESS INCOME (QBI)?
QBI consists of the net amount of qualified items of income, gain, deduction, and loss attributable to any qualified trade or business of the taxpayer. QBI does not include certain investment related income, such as interest, capital gains, and etcetera. Investment-related income is excluded because these items are typically taxed at preferential rates.
WHAT IS A QUALIFIED TRADE OR BUSINESS?
The regulations define qualified trade or business as all trades or businesses except for the following: The trade or business of performing services as an employee, and a specified service trade or business.
This means that an employee receiving a W-2 from an employer is not eligible to receive a 20% deduction as it relates to W-2 income. The second exception is to prevent business owners from converting personal service income into QBI and claiming a 20% deduction.
WHAT IS A SPECIFIED SERVICE TRADE OR BUSINESS (SSTB)?
Section 199A defines a specified service trade or business to be 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, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. The law specifically excludes engineering and architecture from being a SSTB.
Luckily, the IRS clarified what types of services are included within the fields mentioned above. Below is how the IRS regulations define each field.
Health: Includes – medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient. Does not include – operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing and manufacture and/or sales of pharmaceuticals or medical devices.
Law: Includes – lawyers, paralegals, legal arbitrators, mediators, and similar professionals. Does not include – services that do not require skills unique to the field of law. For example, the services by printers, delivery services, or stenography services.
Accounting: Includes – accountants, enrolled agents, returns preparers, financial auditors, and similar professionals. This does include tax return and bookkeeping services. Does not include – payment processing and billing analysis.
Actuarial Science: Includes – actuaries and similar professionals. Does not include – analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.
Performing Arts: Includes – individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals. Does not include – maintenance and operation of equipment or facilities for use in the performing arts, persons who broadcast or other disseminate video or audio of performing arts to the public.
Consulting: Includes – providing advice and counsel regarding advocacy with the intention of influencing decisions, including government lobbyists. Does not include – performance or services other than advice and counsel.
Athletics: Includes – individuals who participate in athletic competition such as athletics, coaches, and team managers in sports. Does not include – Maintenance and operation of equipment or facilities for use in athletic events and broadcasters.
Financial Services: Includes – financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals. Does not include – taking deposits or making loans.
Brokerage Services: Includes – stock brokers and similar professionals. Does not include – real estate agents and brokers, or insurance agents and brokers.
Catch-All: Includes – receiving income from endorsing products or services, licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, and receiving appearance fees or income performing as themselves on TV, social media , or other forms, radio, TV, and other media hoses and video game players. Does not include – If you’re not famous, you’re ok.
DETERMINING THE TENTATIVE DEDUCTION
Thresholds:
For some taxpayers with taxable income below the stated thresholds, it will be as simple as looking at QBI and multiplying by 20% to arrive at the deduction that can be taken. However, for those taxpayers with taxable income over the imposed thresholds, the calculation will not be as simple, as it will involve a multi-step process. With most tax deductions, adjusted gross income is used as the base for evaluating where a taxpayer falls in regards to threshold limitations. However, the 20% deduction thresholds are based on taxable income before any 20% deduction is applied.
| Married Filing Joint | Phase-in: $315,000; Phase-out: $415,000 |
| Every other filing status including trusts and estates. | Phase-in: $157,500; Phase-out: $207,500 |
*These thresholds will also be indexed for cost-of-living adjustments each year.
Limitations:
Once taxable income exceeds the threshold limits listed above, the deduction for QBI from a qualified trade or business is limited to the following:
Take the greater of:
50% of the W-2 wages with respect to the qualified trade or business, or
The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (UBIA of qualified property).
Wages include wages paid to the owner of an S-Corporation, but guaranteed payments are not considered wages for this limitation.
UBIA of qualified property is tangible property that is held by, and available for use in, a trade or business at the close of the taxable year, and which is used in the production of QBI, and for which the depreciable period has not ended before the close of the taxable year. The unadjusted basis of qualified property is determined before depreciation, bonus depreciation and section 179 deduction. A taxpayer would include any depreciable property placed in service by the taxpayer and ending on the later of (i) the date 10 years after the date placed in service, or (ii) the last day of the last full year in the applicable recovery period. Basically, if the depreciable life is greater than 10 years, the taxpayer will continue to include the unadjusted basis for that length of time it is depreciated above the 10 years. If the depreciable life is less than 10 years the taxpayer will include the unadjusted basis for 10 years.
Once the limitation amount is determined, it will be compared back to the basic calculation and the lesser of the two will be the deduction. (An example section will be included at the end of the article.)
DIFFERENCE BETWEEN CALCULATING DEDUCTION FOR A QUALIFIED TRADE OR BUSINESS VS. A SSTB:
SSTB:
If taxable income is below $315,000, the taxpayer would receive a 20% deduction for each specified service trade or business. If taxable income exceeds the $315,000 threshold, the taxpayer must calculate an applicable percentage that limits the QBI, W-2 wages, and UBIA of qualified property from an SSTB that are used to calculate the deduction. If taxable income exceeds $415,000 (married filing joint) or $207,500 (all other filing status), no deduction can be taken for any activity that comes from a SSTB.
Qualified Trade or Business:
If taxable income is below $315,000, the qualified trade or business would be treated the same as a SSTB. The main difference is that once taxable income exceeds $415,000 (married filing joint) or $207,500 (all other filing status), a qualified trade or business can still receive a deduction. The deduction is limited to the full limitation of either 50% of W-2 wages or 25% of W-2 wages plus 2.5% of qualified property.
ADDITIONAL KNOWLEDGE POINTS FROM THE REGS AND PITFALLS:
De Minimis Rule
The regulations did provide a De Minimis Rule for businesses that sell products and provide a service. This rule would allow them to not be treated as a SSTB. The thresholds to be below the De Minimis Rule are as follows:
If gross receipts are $25 million or less for a taxable year, the activity will not be a SSTB if less than 10% of the gross receipts are attributable to the performance of services which would qualify as a SSTB, or
If gross receipts are in excess of $25 million, than less than 5% of gross receipts can be from a service considered a SSTB.
Forced Grouping of Activities
One pitfall from the regulations issued by the IRS is that they took a hard stance on businesses that would be a qualified trade or business but provide property to a SSTB for business use. Example would be a doctor who purchases a building in a separate entity and rents 100% of the building back to the doctor’s practice for fee. The IRS concluded that the entity holding the building would also be considered a SSTB and disallow any deduction if taxable income exceeds the thresholds.
The IRS concluded that any business that provides 80% or more of its property or services to a commonly-controlled SSTB would be treated as an SSTB. If a qualified trade or business provides less than 80% of property or services to a commonly-controlled SSTB, than the entire business is not treated as an SSTB. The only amounts treated as a SSTB would be the portion of the rent or payments for services received from the SSTB.
Again, as long as taxable income is under the thresholds stated above based on the filing status of the taxpayer, then this forced grouping would not affect the deduction. This only affects the deduction when the taxpayer’s taxable income exceeds the thresholds.
Employee vs. Independent Contractor
Another area the IRS focused in on was the sudden transition from employee to independent contractor. Basically, in an effort to prevent abuse, if a person was an employee, but suddenly becomes an independent contractor while providing essentially the same services to the former employer, then it is presumed that they are still an employee for purposes of Section 199A.
Aggregating Multiple Common Controlled Entities
One of the big questions concerning the 199A deduction was how we would apply the threshold limitations with multiple businesses. The IRS does allow for aggregation when certain requirements are met. The same person or groups of persons must, directly or indirectly, own 50% or more of each business to be aggregated. This control test must be met for the majority of the tax year and the businesses must share the same tax year. This aggregation does not apply to SSTBs. Additionally, the IRS goes further and states that businesses must also satisfy two of these three conditions in order to be aggregated.
They must provide products or services that are the same or customarily offered together;
They must share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; or
The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.
Aggregation is done at the owner level; thus, one owner of a business may elect to aggregate that business with another business while a second owner may not choose to do so. This aggregation is purely elective, and generally cannot be revoked once an election is made. When determining whether or not to aggregate, the taxpayer will have to evaluate the effects of QBI losses. See the next section for more about QBI losses.
Losses and Carryover
If an individual has QBI of less than $0 from one trade or business, but has overall QBI greater than $0 when all the trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the limitations based on W-2 wages and UBIA of qualified property. The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. The net gain or income with respect to each trade or business (after being offset by the loss) is the QBI to the trade or business. The W-2 wages and UBIS of qualified property from the trades or businesses with negative QBI are not taken into account and are not carried over into the subsequent year. If negative QBI occurs after all netting, the taxpayer will have a negative QBI carryover that would be applied to the subsequent year’s 199A deduction.
Section 199A contemplates that qualified REIT dividends and qualified PTP income are computed and taken into account separately from QBI and should not affect QBI. If overall losses attributable to qualified REIT dividends and qualified PTP income were netted against QBI, these losses would affect QBI. Therefore, a separate loss carryforward rule is needed to segregate an overall loss attributable to qualified REIT dividends and qualified PTP income from QBI.
Net Operating Loss
The regulations state that a net operating loss carried into the current year will not affect QBI. However, loss generated in 2018 or afterwards could affect QBI.
1231 Gains
Another pitfall from the regulations is that 1231 gains considered capital will not be QBI because they would be taxed at preferential rates. On the flip side, a 1231 loss that is considered ordinary would be QBI and reduce the QBI a taxpayer would report thus decreasing the deduction.
Fiscal Year Entities
For taxpayers with fiscal year ends that straddle the January 1, 2018 effective date, the IRS regulations provide good news. Those taxpayers will be able to take 100% of the QBI, W-2 wages and UBIA of qualified property even though a portion of the income and wages would have been earned in the previous period.
Application to trusts, estates and beneficiaries
For Grantor Trust, including QSSTs, the owner will compute its QBI with respect to the owned portion of the trust as if that QBI had been received directly by the owner.
Non-Grantor trust or estate, the QBI and expenses properly allocable to the business, including W-2 wages relevant to the computation of the wage limitation, and relevant UBIA of depreciable property must be allocated among the trust or estate and its various beneficiaries. Additionally, each beneficiary’s share of the trust or estate’s W-2 wages is determined based on the proportion of the trust or estate’s Distributable Net Income (DNI) which is going to be distributed to that beneficiary for that taxable year. Similarly, the proportion of the entity’s DNI that is not deemed distributed by the trust or estate will determine the entity’s share of the QBI and W-2 wages. In addition, if the trust or estate has no DNI in a particular taxable year, any QBI and W-2 wages are allocated to the trust or estate, and not to any beneficiary.
To the extent UBIA of qualified property is relevant to the trust or estate and any beneficiary, the property amount will be allocated in the same proportion as DNI of the trust or estate is allocated.
The threshold amount is determined at the trust level before taking into account any distribution deduction.
EXAMPLES:
Example 1:
Situation: Taxpayer A receives a W-2 for $100,000. Taxpayer A’s spouse receives a W-2 for $120,000. They also have interest totaling $3,000 and dividends totaling $3,000. Taxable income is less than $315,000.
Solution: The taxpayer and spouse would receive no deduction. They are an employee which received W-2’s and had no income from pass-through entities. Additionally, the interest and dividends were not from REIT’s.
Example 2:
Situation: Taxpayer A receives a W-2 for $50,000. Taxpayer A’s Spouse has QBI from a qualified trade or business in the amount of $150,000. Taxable income is below $315,000.
Solution: The spouse would receive a 199A deduction of $30,000. Since taxable income is less than $315,000, the taxpayer and spouse would multiple any QBI by 20% to arrive at their tentative deduction.
Example 3:
Situation: Taxpayer A is single and had taxable income of $140,000. Taxpayer A receives QBI from one entity in the amount of $50,000 and another $45,000 from a second entity. Taxpayer A also has REIT dividends totaling $3,000 and a PTP loss of $4,000.
Solution: Taxpayer A’s taxable income is less than the threshold of $157,500; therefore, they will receive a deduction in the amount of $10,000 from the first entity and $9,000 from the second entity for a total deduction in the amount of $19,000. The taxpayer will also have a 199A loss carryforward in the amount of $200 as it pertains to REIT dividends and PTP income. The REIT dividends would have received a deduction in the amount of $600 which is netted with the negative PTP loss deduction of $800.
Example 4:
Situation: Taxpayer A has QBI from a qualified trade or business in the amount of $275,000. The portion of W-2 wages allocated to taxpayer A is $100,000 and the portion of qualified property is $25,000. Taxpayer A’s spouse has a W-2 in the amount of $200,000. Taxable income exceeds $415,000.
Solution: The 199A deduction would be $50,000. 20% of QBI would be $55,000 which is than compared to the greater of 50% of wages or 25% of wages plus 2.5% of qualified property. 50% of wages would be greater in the amount of $50,000. Since $50,000 is less than $55,000, the taxpayer’s deduction would be $50,000.
Example 5:
Situation: Taxpayer A has income from a SSTB in the amount of $600,000. Taxpayer A’s portion of W-2 wages and qualified property is $200,000 and $50,000. Taxpayer A’s spouse has no income.
Solution: The taxpayers’ deduction would be $0 since the income was from an SSTB and exceeded the $415,000 phase-out threshold.
Example 6:
Situation: Taxpayer A has income from a SSTB in the amount of $80,000. Taxpayer A’s portion of W-2 wages and qualified property is $25,000 and $10,000. Taxpayer A’s spouse has QBI in the amount of $200,000. The spouse’s portion of W-2 wages and qualified property is $80,000 and $35,000. The taxpayer and spouses taxable income exceeds $415,000.
Solution: The deduction from SSTB income is $0 because taxable income was in excess of $415,000. However, a deduction would be available on the QBI. The deduction would be $40,000. 20% if QBI is $40,000 and the greater of 50% of wages or 25% of wages plus 2.5% of qualified property is $40,000 (50% of W-2 wages).
Example 7:
Situation: Taxpayer A is a doctor with SSTB income of $200,000. The doctor’s portion of wages is $75,000 and qualified property is $50,000. The doctor also owes the building which is rented back to the medical practice. The QBI from the rental is $60,000. Taxpayer A’s spouse has W-2 income in the amount of $150,000. Taxable income for the taxpayer and spouse is in excess of $415,000.
Solution: The 199A deduction would be $0. The W-2 income is not eligible for the deduction. Additionally, the SSTB income would not receive a deduction due to taxable being in excess of $415,000. The QBI from the rental is going to be considered a SSTB since the qualified property is solely rented to an SSTB.
CONCLUSION AND PLANNING OPPORTUNITIES:
This is definitely one of the more complicated parts of the tax law. This article is meant to be a good overview of the basics but doesn’t address more complex situations. If you think you are eligible for this deduction, would like tax planning done in order to maximize your deduction or just have additional questions, please feel free to contact us.