By Scott A. Dondershine, CPA, Esq.
December 2017
The tax legislation that President Trump signed into law on Friday, December 22, 2017 contains a novel deduction that has broad implications for S corporations, partnerships and sole proprietorships (referred to in this Alert as “Pass-Through Entities“).1 Although the legislation covers a wide variety of topics affecting individuals, businesses and estates/trusts, this Client Alert focuses on the new deduction against the income of Pass-Through Entities.
I initially planned on providing a simple summary of the new provision. After reading the 23 pages of the new act dedicated to describing the new Section 199A, however, I realized it would not be possible to explain the deduction without meandering through the provision’s various nuances. I apologize in advance to those compelled to proceed further!
I. Combined Qualified Business Income. Generally, non-corporate taxpayers (including trusts and estates) receive a deduction based upon the amount of combined qualified business income (called, “QBI“) which generally is the sum of (A) 20% of a taxpayer’s qualified business income with respect to a qualified trade or business, but then limited by a W-2 wage and capital limitation plus (B) 20% of the aggregate amount of qualified Real Estate Investment Trust (“REIT“) dividends and qualified publicly traded partnership income of the applicable taxpayer. Each component is discussed below.
A. Trade or Business Income. A taxpayer first computes 20% of the net amount of income “effectively connected” with a trade or business conducted in the United States.2 The result is then compared to a wage and capital limitation (the “Wage and Capital Limitation“). If the Wage and Capital Limitation is less than 20% of the net amount of income from the applicable trade or business, then the amount of the Wage and Capital Limitation is used instead.
The Wage and Capital Limitation is the greater of:
(1) 50% of the W-2 (employment) wages paid by the applicable business; or
(2) the sum of (a) 25% of W-2 wages plus (b) 2.5% of the unadjusted acquisition basis of any “qualified property” held and available for use by the applicable business at the close of the applicable tax year. The property must have been used during the applicable tax year and must still be subject to depreciation, e.g., must not have been fully depreciated. (NOTE: The ability to increase the deduction based upon 2.5% of the basis of qualified property was added to allow Pass-Through Entities in capital intensive industries that don’t have significant wage expenses, such as real estate, to also receive the benefit of this deduction).
Fortunately, the full amount of the Wage and Capital Limitation only applies to taxpayers having “taxable income” exceeding $415,000 for married individuals filing jointly and $207,500 for all other individuals. The limitation is phased out for taxpayers having between $315,000 and $415,000 of taxable income filing on a married joint basis (between $157,500 and $207,500 for all other individuals). The threshold amounts are indexed for inflation.
For example, assume the net amount of income from a trade or business solely owned by John Bloom is $100,000. The trade or business component of QBI, without the limitation, would be $20,000. The $20,000 applies in full, i.e., is not limited or reduced, if John Bloom has taxable income of less than the $315,000/$157,500 threshold. If John Bloom has taxable income of over $415,000/$207,500 and the Wage and Capital Limitation is less than $20,000, the $20,000 would be reduced to the amount of the applicable Wage and Capital Limitation. If John Bloom has taxable income of between $315,000 and $415,000 the impact of there being a Wage and Capital Limitation of less than $20,000 would be commensurately reduced.
B. REIT Dividends and Publicly Traded Partnership Income. Next, one adds to QBI 20% of the amount, if any, of any dividends from a REIT or income from a publicly-traded partnership. This second component is not subject to any Wage and Capital Limitation. Thus, 20% of such dividends and income are deductible in full, providing a significant advantage to taxpayers investing in REITs or publicly traded partnerships.
C. Final Calculation of the Deduction. The combined QBI determined through the application of Sections I.A and B above, i.e., $20,000 in the above example assuming the taxpayer’s taxable income is below the $315,000/$157,500 threshold and there are no REIT dividends or publicly traded partnership income, is adjusted one last time. The actual deduction is the lesser of:
(1) The combined QBI, i.e. $20,000; or
(2) An amount equal to 20% of the excess (if any) of:
(a) the taxpayer’s taxable income, less
(b) the sum of (i) any net capital gains of the taxpayer, (ii) the aggregate amount of any qualified cooperative dividends, and (iii) the lesser of (A) 20% of any qualified cooperative dividends or (B) taxable income of the taxpayer reduced by any net capital gains.
II. Specified Service Trade or Business. An addition limitation applies to any specified service trade or business (“SSTB“).
A. What is a SSTB? An SSTB is any trade or business involving the performance of services in one of the following fields: health, law, accounting, actuarial science, arts, consulting, athletics, financial, brokerage, investing or investment management, trading or dealing in securities. A SSTB 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.
B. Calculation for a SSTB. The trade or business portion of combined QBI, i.e., the first component of QBI discussed above in Section I.A, cannot be considered (meaning no deduction is available) for an individual owner of a service business having taxable income in excess of $415,000 for married owners filing jointly and $207,500 for all other individuals. The use of QBI is phased out between $315,000 and $415,000 for married individuals filing jointly and between $157,500 and $207,500 for all other individuals. NOTE: The second component of combined QBI, i.e., 20% of the amount of any dividends from a REIT or income from a publicly traded partnership, would still be allowed as a deduction.
III. Summary. We suspect that taxpayers will seek opportunities to reduce taxable income through the use of Pass-Through Entities. However, as you can see from the above, the deduction is very complicated and has significant limitations. Many of the concepts are new and subject to change, by regulation or corrective legislation, as interpretational issues arise.
One area where clarification is needed is the ability of taxpayers to quit their jobs in favor of billing their former employers as a contractor through a newly-established Pass-Through Entity. While it may be a valid strategy for some, Section 199A(d)(1)(B) provides that QBI generated from a trade or business (the first component in the QBI calculation discussed above in Section I.A) cannot be generated from “the trade or business of performing services as an employee.” The restriction on the use of SSTBs presents a further obstacle, as does the exclusion of certain types of compensation paid to a taxpayer from the computation of QBI (see footnote 2). We suggest clients proceed with caution, at least until the IRS provides further guidance.
This Client Alert is intended as an introduction only to the topics addressed – it is not a full discussion of the issues. For instance, not explored are (a) the method of allocating W-2 wages to partners in a partnership or shareholders of an S corporation or (b) application of the deduction to specified agricultural or horticultural cooperatives. Let us know if you want to discuss the issues in this Client Alert in greater detail or have other questions regarding other areas of the new tax law.
DISCLAIMER. This Client Alert does not provide legal advice. We are providing it for general informational purposes only.
[1] The deduction applies for tax years beginning after December 31, 2017 and before January 1, 2026, when many of the provisions affecting individuals sunset.
[2] Certain types of trade or business income are excluded from the computation such as (1) the income included as part of the second component discussed below in Section I.B, (2) qualified cooperative dividends, (3) certain investment income, (4) amounts paid to a taxpayer as reasonable compensation and (5) guaranteed or service payments paid by a partnership to the taxpayer.