The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a new write-off for owners of pass-through entities that runs from 2018 through 2025. This deduction does not require any cash outlay or special action to be eligible for it, but using it reduces the effective tax rate on business income. There is much confusion about this new deduction, and some clarification will await IRS guidance. This article covers what is clear so far, how it impacts professionals, and what the IRS or Congress needs to explain further.
Q: What is the new deduction?
A: Under new Internal Revenue Code (IRC) section 199A, there is a 20% deduction for qualified business income (QBI) from a sole proprietorship or a pass-through entity.
Q: Where is the deduction taken?
A: The deduction is not a business deduction used to reduce profits subject to tax; it does not reduce net earnings for self-employment tax purposes. It is not a reduction to gross income taken in the Adjusted Gross Income section of Form 1040. It is a deduction from adjusted gross income, much like the standard deduction or itemized deductions used to reduce taxable income.
Q: What is a pass-through entity for purposes of IRC section 199A?
A: Many business owners may be eligible to take the deduction on their personal returns, including:
- Schedule C filers—sole proprietors, independent contractors, and single-member limited liability companies (LLC);
- Schedule E filers—S corporation shareholders, partners, members in multimember LLCs, real estate investors, beneficiaries of trusts and estates, owners of real estate investment trusts (REIT), and those with interests in qualified cooperatives; and
- Schedule F filers—farmers and ranchers.
Q: What is qualified business income?
A: QBI is not merely the owner’s share of net income from the business; it is the net amount of income, gain, deduction, and loss from a qualified U.S. trade or service business (including Puerto Rico). It does not include investment items, such as short-term and long-term capital gains and losses, dividends, and interest other than what’s allocable to the business. It also does not include reasonable compensation or guaranteed payments to owners. It does, however, include most REIT dividends and income from publicly traded partnerships.
Q: What is a specified service trade or business?
A: This is a business where the owner must reduce the amount of QBI on which the deduction is taken (explained below). It includes any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, as well as the performance of services that consist of investing and investment management or trading or dealing in securities, partnership interests, or commodities. It also includes 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 TCJA removed engineering and architecture from the list of trades or businesses, but the IRS could still view such businesses as a specified service based on this “reputation or skill” clause.
Q: What is the deduction amount?
A: Technically, the deduction is the sum of—
- the lesser of 1) the individual’s combined QBI or 2) 20% of the excess of taxable income over net capital gain plus qualified cooperative dividends; and
- the lesser of 1) 20% of cooperative dividends or 2) taxable income reduced by net capital gains.
Essentially, the deduction is 20% of QBI; due to the technical definition of the deduction, however, the deduction is based on taxable income if such income is less than QBI.
Q: Who can claim the full deduction?
A: An individual who has taxable income below set levels can apply the 20% deduction against QBI, regardless of whether or not the taxpayer is in a specified service trade or business. For 2018, the taxable income limit is $315,000 for a married couple filing a joint return and $157,500 for any other filer. These taxable income thresholds are where the 24% tax brackets end and the 32% tax brackets begin for 2018. The taxable income limit will be adjusted for inflation after 2018. Thus, an attorney or accountant with taxable income below the applicable threshold amount for his filing status would be able to claim the deduction with respect to income from a practice.
Q: What is the W-2 limitation?
A: If the owner’s taxable income is above the threshold, then a limitation comes into play. The deduction is the lesser of:
- 20% of QBI, or
- The greater of 1) 50% of W-2 wages for the qualified business, or 2) 25% of W-2 wages with respect to the business plus 2.5% of the unadjusted basis (immediately before acquisition) of qualified property.
If the amount of QBI is greater than the taxpayer’s taxable income, then the 20% applies only to the extent of taxable income, as explained above.
W-2 wages are amounts reported as such to the Social Security Administration for owners and other employees. Payments to independent contractors do not factor in. For partners, LLC members, and S corporation owners, the allocations of W-2 wages and the unadjusted basis of property are made in the same way as the allocation of QBI, and likely will have to be reported on Schedule K-1.
Q: What is the limitation for a specified service business?
A: For purposes of figuring the W-2 limitation, the owner of a specified service business with taxable income above the threshold reduces the amount of QBI to which the deduction applies. The reduction is a percentage derived from the ratio of taxable income for the year in excess of the threshold ($100,000 on a joint return, $50,000 for all other filers). In effect, if taxable income for the owner of a service business who files jointly is $415,000 or over in 2018 (or $207,500 for other filers), then no deduction can be claimed because there is no QBI on which to apply the deduction. Thus, attorneys with taxable income over $415,000 (or $207,500, depending on filing status) cannot claim any deduction.
If an individual above the taxable income threshold owns a specified trade or service business and a nonspecified trade or service business, it is not yet clear whether the deduction can be taken with respect to the nonspecified service business.
Q: What is a section 199A loss and how does it impact the deduction?
A: If the net amount of income, gain, deduction, and loss is less than zero, the net amount is treated as a loss in the succeeding year. It is not clear whether the loss is carried forward only to the following year or continues to be carried forward indefinitely until used up. It is also unclear whether the loss is used to offset only income in the subsequent year from the business that generated it or must be used to offset income from all of a taxpayer’s businesses.
Waiting for Guidance
As is evident from the questions and answers above, much about the QBI deduction is not clear. Additional guidance from the IRS may not be immediately forthcoming in this tax filing season. Once said guidance does arrive, then business owners can decide on what to do, including changing their form of entity, deciding whether to add independent contractors to the payroll, or taking other actions.
Adapted with permission from the February 20, 2018, edition of the New York Law Journal, copyright 2018 ALM Media Properties LLC. All rights reserved. Further duplication without permission is prohibited.