As part of the 2017 Tax Cuts and Jobs Act, the Internal Revenue Service has proposed the introduction of a deduction for qualified pass-through business owners under the 199A Deduction. This deduction will allow for qualified taxpayers to take a deduction of up to 20% on qualified business income. This deduction became effective January 1, 2018, and will apply to S-Corporations, Partnerships, and Limited Liability Companies only; as they are taxed as pass-through entities. As such, this deduction will not be taken by the entity itself, but rather by the shareholders/partners.
So what does this mean for small business owners?
From a high-level perspective, it’s clear that the proposed regulations are meant to give a significant tax break to small businesses. This tax break is great for pass-through entities, considering that the corporate tax rate (corporations pay tax at an entity level) was cut from 35% to 21%.
While the intention of the Section 199A deduction is clear, the proposed regulations are... not so clear. The rules are riddled with limitations, exceptions, phase-outs, and new definitions for “qualified businesses.”
Making sense of all 184 pages of the regulations is enough to leave even a seasoned CPA scratching their head.
No need to worry though, we’re here to give you a rundown of the terminology and basics of this new deduction.
Terminology
Before digging too far in, we need to define some of the tax “jargon” that you'll see in the regulations.
Pass-Thru Entities - Include these business & entity structures:
- S-Corporations
- Partnerships
- LLCs
- Trusts
- Estates
Specified Service Trades and Businesses (otherwise known as SSTB) include professions in the fields of:
- Health
- Law
- Accounting
- Actuarial Science
- Performance Arts
- Consulting
- Athletics
- Financial Services
- Brokerage Services
Trades or businesses where the principal asset of such is the reputation or skill of 1 or more employee or owner.
Within these businesses, the IRS also included several exceptions that fall within these fields. These include banks, real estate brokers, insurance brokers, engineers, and architects.
Qualified Business Income
Per the regulations, this is defined as “the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business as determined under the rules of 199A-3(b)”
What income limitations apply?
As the proposed regulations explain, the deduction will allow qualified businesses a 20% deduction on qualified business income. The deduction is limited depending upon the filing status and income of the business owner. For joint filers, the income limit is $315,000, for all other filing statuses, the limit is $157,500.
Plain English Please?
For most small business owners, full 20% deduction will be taken. When business owners’ income goes above these thresholds, the deduction begins to get phased in. These “phase in” ranges are between $315,000 - $415,000 for joint filers, and $157,500 - $207,000 for all other filers. If a business owners income goes over the phase in income ranges, they will not be allowed to take the deduction if they are a SSTB. If they are not, they will be allowed a partial deduction.
Here’s a simplified table to visualize the income/limitations for SSTB
Here’s a simplified table to visualize the income/limitations for Non-SSTB
How is the deduction calculated?
Hold onto your seats; this is where things start to get tricky.
The deduction is calculated for qualified taxpayers as the lesser of
- 20% of the taxpayer’s qualified business income, plus 20% of qualified REIT dividends and qualified PTP income…
OR
- 20% of the taxpayer’s taxable income less net capital gains
These will be true for any qualified taxpayer who is under the $315,000/$157,500 income limits.
When incomes fall between $315,000 - $415,000 / $157,500 - $207,500 deductions are phased out.
Specified service trades or businesses will not qualify for a deduction if they are over the phase out ranges.
For non-SSTB taxpayers whose incomes are over the defined limits, it gets a little trickier.
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We calculate their deduction as the greater of
- 50% of the W-2 wages concerning the qualified trade or business…
OR
- The sum of 25 percent of the W-2 wages concerning the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property
Examples
- Steve, an accountant who runs his own firm files as single and has a taxable income of $100,000 - all of which is income from his business. Because he is under the $157,500 limit for single filers, he will be allowed the full 20% deduction. (This would also be true if Steve’s business was not a Specified Service Trade or Business.)
Here’s how he would figure his taxable income:
Example 2:
John operates an online bookstore which earns $1 Million in net qualified business income. His business pays $85,000 in W-2 wages. Since John is above the income limits but operates as a non SSTB, his deduction is limited by comparing the 20% deduction to 50% of W-2 wages. The deduction will be the lesser of:
$1,000,000 x 20% = $200,000,
OR
$85,000 x 50% = $42,500
In this scenario, John would be allowed to deduct $42,500, since that is the lower of the two calculations.
His taxable income would be calculated as follows:
Example 3
Jody operates a law firm which earns $1 Million in net qualified business income. She files her taxes as married filed joint. Her business pays $100,000 in W-2 wages. Since Jody’s business is a specified service trade or business, and she is above the $415,000 threshold, she is not entitled to any deduction.
Her taxable income would be computed as follows:
How will the deduction be taken?
As of this writing, the 2018 Individual Income Tax Return has not been released yet, so it is hard to say where the deduction will be taken on the 1040. The IRS has released a draft of the 2018 1040. This form is still under draft, but as of August 2018, it looks like this.
From this draft, we see that the deduction is taken on line 9 - “Qualified Business Income Deduction” of the second page.
We can also look at a draft of the 1040 instructions to see the worksheet taxpayers will use to figure the amount to claim.
As a reminder, these are just drafts and are not finalized versions of the 1040 and instructions.
Still have questions? Our tax team at Halon deal with these laws every day and know how to leverage them to benefit your business.
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