Understanding Section 199A
The passing of the Tax Cuts and Jobs Act marked a new era in taxation. A new deduction — Internal Revenue Code Section 199A — was created that permits owners of sole proprietorships, S corporations and partnerships to potentially deduct up to 20 percent of their business income.
While the addition of a state and local tax (SALT) deduction limitation hurt many taxpayers, this new deduction may create a more favorable tax outcome for some.
Effective for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, a taxpayer other than a corporation may be entitled to a deduction equal to 20 percent of qualified business income (QBI) earned in a qualified trade or business. The deduction is the sum of:
- The lesser of a) the “combined QBI amount” or b) 20 percent of the excess of taxable income over the sum of any net capital gain and the aggregate qualified cooperative dividends; plus
- The lesser of a) 20 percent of the aggregate qualified cooperative dividends or b) taxable income minus capital gains.
Combined QBI is the sum of deductible amounts determined for each qualified trade or business plus 20 percent of the taxpayer’s aggregate qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income. Generally, the qualified business deductible amount can be summarized as the lesser of:
- 20 percent of the taxpayer’s QBI from the trade or business or
- Greater of a) 50 percent of allocable share of W-2 wages paid by business or b) 25 percent of allocable share of W-2 wages paid by the business plus 2.5 percent of allocable share of unadjusted basis (original cost) of qualified property
QBI does not include wages, guaranteed payments, capital gains (losses) or investment income. There is a deduction phase-out that starts for single taxpayers at taxable income of $157,500 ($315,000 married filing jointly (MFJ)) with no deduction allowed if they reach $207,500 ($415,000 MFJ). Any taxpayer who has a taxable income below the phase-out limitations does not have any limitations on the deduction in terms of wages, property or industry specifics. As the deduction is phased out, the limitations partially apply. If the taxpayer’s income goes above the threshold, the limitations and industry exclusions fully apply.
Qualified Trade or Business
In order to claim the Section 199A deduction, the trade or business must be a qualified trade or business. Employees that perform services as a trade or business would not qualify for the deduction. Specified service trades or businesses (SSTB) that would not qualify include the performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investments, trading, or working where the principal asset is the reputation or skill of one or more employees. It is important to note that engineering and architecture are specifically removed from the list of excluded services and are considered a qualified trade or business.
- Example 1: Company A is an S corporation owned 100 percent by Dave. The S corporation had $200,000 of net income for the year, which includes interest of $25,000. Dave’s wages were $75,000. QBI is calculated as $175,000 ($200,000 net income minus $25,000 interest). The QBI deduction is $35,000 ($175,000 x 20 percent).
- Example 2: Company B is a single-member LLC owned by Dave. The business had $500,000 of net income for the year, which includes interest of $100,000, and Dave is not paid any wages. QBI is calculated as $400,000 ($500,000 net income minus $100,000 interest). The potential QBI deduction is $80,000 ($400,000 x 20 percent). Dave’s income is over the threshold, and the deduction is subject to the wage and property tests. Since there are no wages or property, the QBI deduction is $0.
- Example 3: Company C is an engineering firm. Total W-2 wages paid are $9 million, unadjusted basis in fixed assets are $3 million and QBI is $17 million. The partner’s profit-and-loss percentage is multiplied by these three amounts. The partner is a 10-percent shareholder. His share of W-2 wages paid is $900,000, unadjusted basis in fixed assets is $300,000 and QBI is $1.7 million. The partner’s maximum possible deduction is $340,000 (20 percent x $1.7 million). Next, the wage and property limitations must be tested. Fifty percent of the partner’s allocable share of the wages are taken and compared to the sum of 25 percent of the wages plus 2.5 percent of the basis in the assets. The $450,000 in wages is greater than the $232,500 sum, so the $450,000 is used. Finally, the lesser of ($340,000) or $450,000 must be chosen. In this case, the wages paid by the partnership are great enough to get the full 20-percent QBI deduction.
The IRS has issued FAQs and proposed regulations (REG-107892-18) that provide some clarification for most aspects of the QBI deduction that needed guidance. Below is a summary.
- Reputation or skill of one person. The IRS set to clarify the type of business that would be disallowed under the “reputation or skill of one person” criteria. Businesses with income from endorsing products, appearance fees, licensing or receiving income for an individual’s image or likeness would not qualify for the QBI deduction. The majority of taxpayers that fall in this category would be professional athletes, celebrities, media personalities, social media stars and even professional video game players.
- De minimis tax rule. If a business is involved in multiple activities, the business would not be disqualified from taking the QBI deduction if less than 10 percent of the gross receipts (5 percent if gross receipts are greater than $25 million) are attributable to a SSTB activity.
- Aggregation rule. The proposed regulations allow taxpayers to aggregate commonly controlled businesses rather than calculating the QBI deduction separately for each entity. To aggregate two or more businesses, the following criteria must be met: each business must meet the definition of a “trade or business” and not be an SSTB; the same person or group must directly or indirectly own a majority interest in each of the businesses for the majority of the year; and they all must have the same taxable year. Lastly, the taxpayers must meet two of the following three factors, which demonstrate the businesses are part of a larger conglomerate:
- Businesses provide products and services that are the same or customarily provided together
- Businesses share facilities or significant centralized business elements (common personnel, accounting, legal, manufactures, HR, IT)
- Businesses are operated in coordination with, or reliance on, other businesses in the group
Thankfully, the proposed regulations have made Section 199A a little easier to understand.
This article appeared in the January/February 2019 issue of New Jersey CPA magazine. Read the full issue.