The Tax Cuts and Jobs Act enacted on December 22, 2017, introduced Internal Revenue Code Section 199A. This new code section grants a deduction of up to 20% of qualified business income (“QBI”). It replaces Section 199 which was the Domestic Production Activities Deduction, beginning in 2018. The Section 199A deduction is scheduled to expire after 2025.
The Qualified Business Income Deduction (“QBID”) has an extremely complex set of rules. In August of 2018, the IRS issued six proposed regulations. This article will highlight who qualifies, what limitations are applicable, and how the deduction is calculated. It will also discuss planning opportunities.
The Section 199A deduction is available to individual taxpayers, non-grantor trusts and estates. Partnerships and S corporations flow through the relevant information to their partners or shareholders. Similarly, trusts and estates that distribute income will flow that information to their beneficiaries.
A new concept that is a key element is that of a Specialized Service Trade or Business (“SSTB”). Businesses that are SSTBs are subject to limitations based on taxable income. Taxpayers with income that exceed the phase-out levels will not be entitled to a QBID for SSTBs.
The QBID is based on the lesser of 20% of the QBI or the greater of 50% of wages, or a combined 25 % of wages plus 2.5% of eligible depreciable fixed assets. For taxpayers with taxable income below the threshold amounts, the wage and asset limitations do not apply.
For 2018, married taxpayers filing joint tax returns will begin to phase-out the Section 199A deduction for SSTBs when their income exceeds the threshold amount of $315,000 and will no longer be entitled to the deduction if income exceeds $415,000. For all other taxpayers, the threshold amount is $157,500 and is subject to phase-out until income exceeds $207,500. These income levels will be adjusted for cost of living increases beginning in 2019. For all businesses with income exceeding the threshold amounts above, the wages and fixed asset limitations will be part of the calculation.
The income that qualifies as QBI is basically the net income derived from the conduct of a trade or business within the United States. It does not include nonbusiness income such as portfolio interest, dividends or capital gains. Special rules also exist for income from publicly traded partnerships, dividends from real estate investment trusts, and income from agricultural or horticultural cooperatives. The QBI for multiple businesses is calculated separately and later combined at the taxpayer level to determine the QBID. Losses from qualified activities offset QBI to determine the QBID. A net loss will result in a carryover to succeeding years.
A qualified trade or business does not include any services provided as an employee. It also does not include any income earned from a partnership as guaranteed payments. Once again, SSTBs are not considered qualified trades or businesses if the taxable income before the Section 199A deduction is in excess of the income limitation.
SSTBs are trades or businesses that are engaged in certain industries that are identified in Section 199A as clarified by the proposed regulations. In general, they include the following categories:
- Actuarial Science
- Performing Arts
- Financial Services
- Brokerage Services
- Investing, trading or dealing in securities, partnership interests or commodities
- Any business where the principal asset is the reputation or skill of one or more of its owners or employees.
Wages that qualify for the limitation calculation for the QBID are those wages plus elective deferrals that are attributable to QBI and are included on Forms W-2 that are filed no later than 60 days after the due date including extensions for filing Form W-2.
Qualified property means, with respect to any qualified trade or business for a taxable year, tangible property of a character subject to the allowance for depreciation under section 167—
- which is held by, and available for use in, the qualified trade or business at the close of the taxable year,
- which is used at any point during the taxable year in the production of qualified business income, and
- the depreciable period for which has not ended before the close of the taxable year. The depreciable period is defined as the later of 10 years after the property was placed in service or the last full year of the applicable recovery period under IRC Section 168
Special rules exist for businesses that have short taxable years or are acquired or sold during the year.
Section 199A is a relevant issue with respect to many tax returns. The intricacies of the law were clarified greatly by the proposed regulations issued, however some gray areas still exist. Please speak with your Prager Metis advisor to determine how the new law affects you and to determine what year-end tax planning should be considered.