As posted by Thomson Reuters on 1/23/18

Enacted on 12/22/17, the Tax Cuts and Jobs Act (TCJA) added §199A, which applies to tax years 2018-2025. Under this new provision, individuals, estates, and trusts may deduct up to 20% of their Qualified Business Income (QBI) from sole proprietorships (including farms) and pass-through entities. This means that the QBI of taxpayers in the new 37% tax bracket may be taxed at an effective top marginal rate of 29.6%.

Although §199A can greatly benefit many noncorporate taxpayers, it’s one of the more convoluted provisions of the TCJA. It contains various rules and limits that can substantially reduce or eliminate the deduction. Given this, a step-by-step guide to claiming the deduction would be helpful. This Tax Planning Letter examines in detail the following steps:

1. Identifying QBI.
2. Computing the deductible amount for each trade or business, including application of the “wage/investment limit”.
3. Determining the combined QBI amount, which includes 20% of any qualified Real Estate Investment Trust (REIT) dividends and qualified Publicly Traded Partnership (PTP) income.
4. Calculating the final deduction. 20% of qualified cooperative dividends are added and the taxable income limits applied.

STEP 1: IDENTIFYING QBI

The first step in computing the §199A deduction is identifying QBI from each of the taxpayer’s trades or businesses. In general, QBI is the net amount of items of income, gain, deduction, and loss from a qualified trade or business conducted within the U.S. (including Puerto Rico). QBI doesn’t include investment income such as capital gains and losses, dividends, interest income (unless properly allocable to a trade or business), and commodity and foreign currency gains.

Also, the following items are specifically excluded from QBI:

• Reasonable compensation paid by the qualified business to the taxpayer.
• Guaranteed payments to partners under §707(c) for services rendered with respect to the business.
• To the extent provided in regulations, payments under §707(a) to partners acting outside their capacity as a partner.

A qualified trade or business is generally defined as any trade or business other than:

• the business of performing services as an employee, and
• a “specified service business”.

A “specified service business” is one that involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. The term also includes any business that participates in investing and investment management, trading, or dealing in securities, partnership interests, or commodities. A business whose principal asset is the reputation or skill of one of its owners or employees is also considered a specified service business.

Note:  Excluding “specified service businesses” from the definition of a qualified trade or business means that many professionals won’t be able to take advantage of this deduction. Interestingly, engineering and architecture firms are specifically excluded from the definition of a “specified service business”, to the extent the services provided are in those fields.

Special Rule for Small Taxpayers in a Specified Service Business

The specified service business exclusion doesn’t apply to taxpayers with 2018 taxable income of $315,000 or less if married filing jointly ($157,500 for all others). In other words, these taxpayers can treat a specified service business as a non-service business for §199A purposes. However, this exception is fully phased out when 2018 taxable income is $415,000 or more if married filing jointly ($207,500 for all others). In other words, joint filers with 2018 taxable income of $415,000 or more can’t treat any income from a specified service business as QBI.

Note:  If the taxpayer’s QBI is a loss, that loss is carried forward and treated as a loss from a qualified business in the next year. Currently, there is no guidance on whether pre-2018 losses must be carried forward.

STEP 2: COMPUTING THE DEDUCTIBLE AMOUNT

After QBI has been identified, the next step is computing the deductible amount for each trade or business. The deductible amount is generally 20% of the QBI for each qualified business. However, that amount is limited to the greater of:

• 50% of the W-2 wages paid by the business, or
• 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of the business’s “qualified property”.

This limit is commonly referred to as the “wage/investment limit”.

W-2 Wages

These are total wages subject to withholding, elective deferrals, and deferred compensation paid by the qualified business during its year ending in the taxpayer’s taxable year, provided such compensation is properly allocable to QBI. The business must file Form W-2 reporting such wages. The IRS has been directed to issue regulations on how wages are determined in cases of a short tax year.

Qualified Property

This is depreciable tangible property held by the “qualified business” and available for use at the end of the tax year that is used to produce QBI and for which the depreciable period hasn’t ended before the close of the year. The depreciable period is the later of:

• 10 years from the placed-in-service date, or
• the last day of the last full year in the MACRS recovery period, determined without considering the alternative depreciation system.

The IRS has been instructed to issue rules similar to those in §179(d)(2) (relating to purchases from related parties) to prevent taxpayers from manipulating the depreciable period.

Example 1: Applying the “wage/investment limit”

In 2018, Art, Ben and Charlie form ABC, LLC, a retail business. ABC is classified as a partnership for tax purposes, and each member owns one third of the company’s capital and profits interests. In April 2018, ABC acquires a building for $1 million, $400,000 of which is allocated to land and $600,000 to a building with a 39-year recovery period. The company’s operations are mostly performed by the LLC members; however, ABC employs a bookkeeper who is paid $40,000 in 2018.

Assume that Art, Ben and Charlie each have taxable income over $500,000 for 2018. In computing the deductible amount under §199A, the “wage/investment limit” for each member applies as follows:

• W-2 Wage Limit – This limit equals $6,667, which is ($40,000 x 50%) / 3.
• W-2 Wage/Qualified Property Limit – This limit equals $8,333, which is [($40,000 x 25%) + ($600,000 x 2.5%)] / 3.

The wage/investment limit is the greater of those two numbers, or $8,333. Therefore, each member’s deductible amount is potentially limited to $8,333.

Exception for Certain Taxpayers

The wage/investment limit doesn’t apply if the taxpayer’s taxable income (before the §199A deduction) is less than or equal to a threshold amount (for 2018, $315,000 for joint filers and $157,500 for all other filers). The limits are phased in for joint filers with taxable income from $315,001 – $415,000 ($157,501 – $207,500 for all other filers). The phase-in is computed by determining the amount by which 20% of QBI exceeds the wage/investment limit (the excess amount). The taxpayer’s phased-in wage/investment limit equals the “excess amount” multiplied by the percentage obtained when dividing the amount of taxable income that exceeds the threshold amount by $100,000 ($50,000 for non-joint filers).

Example 2: Phasing in the wage/investment limit

David files a joint return that reflects the activities of his Schedule C manufacturing business. His 2018 taxable income (before any §199A deduction) is $375,000. David’s taxable income over the threshold amount is 60% [($375,000 – $315,000) / $100,000] into the $100,000 phase-in range.

Assume that David has QBI from his manufacturing business of $500,000, which would result in a deductible amount of $100,000 ($500,000 x 20%) before the wage/investment limit. The manufacturing business pays total wages of $150,000 and owns qualified property with an unadjusted basis of $1 million. Under the general rule, David’s wage/investment limit would be the greater of $75,000 ($150,000 x 50%) or $62,500 [($150,000 x 25%) + ($1,000,000 x 2.5%)]. Thus, his excess amount is $25,000 ($100,000 – $75,000). Under the phase-in rules, David’s wage/investment limit is $15,000 ($25,000 x 60%). So, David’s deductible amount from the manufacturing business is $85,000 ($100,000 – $15,000). (In this example, David’s QBI is higher than his taxable income. As such, he may be subject to the taxable income limit. See Step 4, discussed later in this Tax Planning Letter.)

As stated earlier, these rules are highly complex and depend on several variables. The following table briefly summarizes how to compute the deductible amount for each of the taxpayer’s qualified trades or businesses.

STEP 3: DETERMINING THE COMBINED QBI AMOUNT

Once the deductible amounts for all qualified trades or businesses are calculated, those amounts are combined with 20% of qualified REIT dividends and qualified PTP income. The result is known as the combined QBI amount.

Qualified REIT Dividend – Any dividend from a REIT received during the tax year that isn’t a §857(b)(3) capital gain dividend or qualified dividend income under §1(h)(11).

Qualified PTP Income – The sum of:

• the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss from a §7704 PTP that isn’t treated as a corporation for tax purposes, and

• any gain recognized by the taxpayer upon the disposition of a PTP interest to the extent it’s treated as an amount realized from the sale or exchange of property other than a capital asset.

STEP 4: CALCULATING THE FINAL DEDUCTION

The final §199A deduction is the lesser of:

• the combined QBI amount calculated in Step 3, or
• 20% of the excess of taxable income over net capital gain and qualified cooperative dividends.

This last restriction is generally referred to as the taxable income limit. That amount is then combined with 20% of any qualified cooperative dividends (or, if less, the taxpayer’s taxable income before any §199A deduction less net capital gains) to arrive at the final deduction.

OTHER CONSIDERATIONS

As you calculate the §199A deduction, keep the following in mind:

• The deduction applies only for income tax purposes . . . it doesn’t reduce self-employment tax.

• The deduction isn’t taken into account in determining adjusted gross income. However, the deduction:

• can be taken by taxpayers who don’t itemize their deductions,
• isn’t subject to the limits on itemized deductions, and
• may be taken into account in determining withholding allowances.

• For AMT purposes, QBI is determined without regard to any adjustments under §56 – 59.

• The deduction is applied to partnerships and S corporations at the partner or shareholder level. For partnerships, partners take into account their allocable share of the entity’s qualified income, deduction, gain, and loss. Also, when computing the wage/investment limit, partners take into account their allocable share of the entity’s W-2 wages (determined in the same manner as their share of wage expenses) and qualified property (determined in the same manner as their share of depreciation expenses). For S corporations, a shareholder’s allocable share is their pro-rata share of an item.

• Generally, for the accuracy-related penalty, a tax understatement that is over $5,000 is considered substantial if it’s more than 10% of the tax required to be shown. For taxpayers claiming the §199A deduction, such an understatement is substantial if it’s more than 5% of the tax required to be shown. This change to the penalty indicates that Congress is aware of the potential for gamesmanship and is attempting to discourage aggressive positions with respect to the deduction.

CONCLUSION

As you can see, while the new §199A deduction adds more complexity to the Code, it also brings more planning opportunities to taxpayers with pass-through income. Although the deduction isn’t applicable to 2017 returns, now is the time to get familiar with this valuable incentive.