The Section 199A deduction constitutes one of the most scrutinized and technically challenging elements of the Tax Cuts and Jobs Act of 2017.
Created as a means for businesses other than C corporations to keep pace with the corporate tax cut from 35 percent to 21 percent, Section 199A provides a 20 percent deduction for “qualified business income” earned in a qualified trade or business. The deduction is effective Jan. 1, 2018 through Dec. 31, 2025.
While there are questions as to the definitions of multiple terms in the law, the IRS has clarified some of the confusion with proposed regulations issued in August. As the public commentary and hearing stage of the regulations continues, it’s important to become more 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 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 of the 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 become 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 also can also create unintended consequences if property is contributed to the C corp or there are significant prior year earnings to distribute.
The 20 percent deduction is based on the net amount of income, gains, deductions and losses 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. Owners calculate their 199A deductions based on their allocable share of qualifying items determined on a per-day pro rata allocation.
If multiple business activities qualify, the calculation and subsequent limitations should be considered for each activity. Treatment of extraordinary items related to operations, such as the income or loss generated from acquisitions and dispositions of qualifying business interests, remains 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 percent calculation that apply if the taxpayer’s income exceeds $315,000.
The tentative 20 percent deduction can’t exceed 50 percent of the W-2 wages allocable to the owner or partner. The wages allocable to the owner or partner isn’t the amount of wages they were paid during the year, but 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 businesses won’t reduce wages to avoid payroll taxes and maximize 199A deductions. The alternative limitation replaces the 50 percent of allocable W-2 wages floor with a new one calculated as 25 percent of allocable W-2 wages in addition to 2.5 percent of the unadjusted basis of qualified property. The taxpayer can use whichever of the two limitations providing the greater 199A deduction. This alternative calculation appears to be designed to allow rental property owners to qualify for the 20 percent deduction generated by the activity without paying themselves wages. However, with rental activities included in the uncertainty of what qualifies as a trade or business for 199A purposes, this conclusion could prove 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 total income to determine if any of the limitations come into play. Once it’s clear the 20 percent deduction is available, specific income and loss items must 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 wage and capital limitations as they relate to maximizing the deduction. In cases involving a more significant potential deduction, it could be worthwhile to adjust the ownership structure of the entity — add an owner, for example — to obtain more favorable threshold calculations.
Looking forward to the 2018 filing season, Congress must address industry concerns and issue final regulations to clarify how 199A will apply. Such fundamental questions as where the deduction will be reported, what falls under the specified service umbrella and what classes of pass-through income are eligible have yet to be answered. Until that guidance becomes available, proceed with caution and avoid interpreting the rules too aggressively.