The Tax Cuts and Jobs Act of 2017 introduced a new write-off for owners of pass-through entities that runs from 2018 through 2025. This deduction doesn’t require any cash outlay or special action to be eligible for it, but reduces the effective tax rate on business income. There is much confusion about this new deduction and some clarification is needed. Here is what is clear so far, how it impacts taxpayers, and what the IRS and/or Congress needs to explain further.
Q: What is the new deduction?
A: Under new Code Section 199A there is a 20% deduction for qualified business income from a pass-through entity.
Q: Where is the deduction taken?
A: It is a deduction from taxable income (meaning it is taken after adjusted gross income has been reduced by itemized deductions).
The deduction is not a business deduction used to reduce profits subject to tax; and 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.
Q: What is a pass-through entity for purposes of Code Sec. 199A?
Schedule C filers: Sole proprietors, independent contractors, and single-member limited liability companies (LLCs)
Q: What is qualified business income?
A: It is the net amount of domestic source (including Puerto Rico, but only if the income is also taxable in the U.S.) income, gain, deduction, and loss from a qualified trade or business. It does not include investment income, such as short-term and long-term capital gains and losses, dividends, and interest income (other than what’s allocable to the business). And it doesn’t include reasonable compensation to S-Corporation shareholders or guaranteed payments to partners. It does include most REIT dividends and income from publicly traded partnerships. Generally speaking, a specified service, trade or business is not a qualified trade or business.
Q: What is a specified service trade or business?
A: This 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 the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities. It also includes a “catch-all” category that 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 and/or owners. As previously stated, a specified service trade or business generally does not qualify for the deduction. There are exceptions to this rule if any owner of a specified service business has taxable income below certain amounts.
Q: What is the deduction amount?
A: Essentially, the deduction is 20% of qualified business income. But due to the technical definition of the deduction, it means that the 20% deduction is based on taxable income (less net capital gains) if it is less than qualified business income. However, there are additional limitations that can apply in certain situations.
Q: Who can claim the full 20%-of-qualified business-income deduction?
A: An individual who has taxable income below certain thresholds can apply the 20% deduction against all types of qualified business income, irrespective of whether or not the taxpayer is in a specified service 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, a taxpayer with taxable income below the applicable threshold amount for his or her filing status would be able to claim the deduction with respect to income from a specified service business. As the owner’s taxable income increases, the ability to claim the 20% deduction is phased out for specified service businesses. The benefit is phased out for taxable income from $157,500 to $207,500 for single filers and from $315,000 to $415,000 for taxpayers filing joint returns. As the taxpayer’s income increases over the threshold amounts, the W-2 limitation must also be taken into account.
Q: What is the W-2 limitation?
A: If the owner’s taxable income is above the threshold discussed above, then a further limitation comes into play. The deduction is the lesser of:
If the amount of qualified business income is greater than the taxpayer’s taxable income, then the 20% applies only to the extent of taxable income as explained earlier.
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 qualified business income, and likely will have to be reported on Schedule K-1. While it is currently unclear how wages paid by a PEO are treated or how wages paid by one company on behalf of related companies are treated, many commentators believe that such wages should be eligible as long as the taxpayer is deemed to be the common law employer.
Q: What is the W-2 limitation for a qualified service business?
A: For single filers with taxable income less than $157,500 and for joint return filers with taxable income less than $315,000, the W-2 wage limitation does not apply to any type of business. The benefit of not being subject to the W-2 wage limitation also phases out from $157,500 to $207,500 of taxable income for single filers and from $315,500 to $415,000 for joint return filers for all businesses.
For taxpayers in specified service businesses, the benefits of (1) being able to claim the 20% deduction and (2) not being subject to the W-2 wage limitation, both phase out over these income levels.
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 from a qualified trade or business 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. And it’s not clear 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 qualified businesses.
As you can see from the questions and answers above, there is much that is not clear. Additional guidance from the Treasury and IRS is certainly needed. opeHHopefully the guidance will be forthcoming sooner rather than later so taxpayers can assess their situation with a certain amount of clarity.
A version of this article originally appeared in the New York Law Journal.
If you would like more details about any aspect of how the new law may affect you, please do not hesitate to contact the Citrin Cooperman Federal Tax Policy Team.
Sidney Kess is of counsel to Kostelanetz & Fink and a senior consultant to Citrin Cooperman & Co., LLP. He is a member of the NYSSCPA Hall of Fame and was awarded the Society’s Outstanding CPA in Education Award in May 2015. He is also a member of The CPA Journal Editorial Advisory Board.