New Internal Revenue Code Section 199A of the Tax Cut and Jobs Act
The recently passed Tax Cuts and Jobs Act, signed by President Trump on December 22, 2017 contains a multitude of new tax provisions that will reduce the Federal tax liability of most taxpayers. One of the more beneficial provisions for individuals is the addition of new Internal Revenue Code Section 199A – Qualified Business Income.
Section 199A, sometimes referred to as the “pass-thru entity” tax cut, can provide the owners of pass-thru businesses like sole proprietors, partnerships, S corporations and real estate investors a deduction of up to 20% of qualified business income.
The Sec. 199A deduction will work like the standard deduction does. It does not reduce your total income or adjusted gross income (AGI), but it is subtracted from your AGI in determining your taxable income. In its simplest application, the Sec. 199A deduction will provide a deduction equal to the lesser of:
- 20% of the taxpayers qualified business income from the taxpayer’s unincorporated businesses, or
- 20% of the taxpayer’s taxable income adjusted for any net capital gains.
Joseph earns $130,000 in a law firm he operates as a sole proprietorship. His taxable income equals $100,000 (includes net capital gains of $20,000). His Sec. 199A deduction of $16,000 is calculated as the lesser of:
- $26,000 (20% of the $130,000 in qualified business income), or
- $16,000 (20% of $80,000. His taxable income of $100,000 net of the included capital gains of $20,000).
As with many provisions in the Tax Code, there are limitations and phase-out provisions which apply to various taxpayers. The two main limiting provisions for the Sec. 199A deduction include the Specified Service Trade or Business Disqualification, and Income Phase-in Limitation.
The Specified Service Trade or Business Disqualification
Under this provision a taxpayer potentially loses the ability to take or fully take the Sec. 199A deduction if taxable income rises too high and the pass-thru entity earns its income in a specified service business. If a single taxpayer’s income exceeds $157,500 or if a married taxpayer’s income exceeds $315,000, and if the taxpayer or taxpayers earn their qualified business income in a traditional “white-collar” service business or as a performer or an athlete, the taxpayer or taxpayers lose some or all of the deduction. Full phase-out occurs at $207,500 for single taxpayers and $415,000 for joint taxpayers.
Specified service businesses include trades or businesses that provide services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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 or owners.
Martha earns $500,000 as a surgeon (specified service business) working as a partner in a surgical center and her family’s taxable income equals $500,000. As her taxable income exceeds the $415,000 (full phase-out threshold) and her income was derived from a specified service business, Martha’s Sec. 199A deduction is $0. Had the income been derived from a business that was not a specified service business, the Sec. 199A deduction could have been as high as $100,000 (if not subject to the Income Phase-in Limitation – discussed below).
Note: If a taxpayer falls into the gray area between the threshold amount ($157,500 for a single taxpayer and $315,000 for a married taxpayer) and that upper boundary ($207,500 for a single taxpayer and $415,000 for a married taxpayer), the tax law doesn’t disqualify the taxpayer from using the Sec. 199A deduction. Rather, the amount of the qualified business income that the taxpayer plugs into the deduction formula phases out.
If in example #2 Martha earned $365,000 as surgeon and her family’s taxable income equaled $365,000, she would be subject to a partial phase-out as her taxable income would fall halfway (50%) between the $315,000 bottom phase-out limit and the $415,000 full phase-out limit. Martha’s Sec. 199A deduction would be $36,500 ($365,000 times 20% times 50%).
Income Phase-in Limitation
Unlike the Specified Service Business Trade or Business Disqualification provision, the Income Phase-in Limitation can apply to any taxpayer, regardless of the source of the qualified business income, whose taxable income exceeds certain limits. The Income Phase-in Limitation does not automatically disqualify a taxpayer from obtaining the Sec. 199A deduction, but imposes additional requirements in calculating the qualified business income.
If a single taxpayer’s taxable income exceeds $157,500 or a married taxpayer’s income on a jointly filed return exceeds $315,000, the Sec. 199A deduction formula is subjected to additional limitations based the W-2 wages paid to employees of, as well as to the depreciable property held by, the pass-thru entity from which the qualified business income was derived. The additional limitations are calculated based on a percentage of the W-2 wages paid by the entity from which the qualified business income was derived, and 2.5% of the cost basis of the depreciable property held by the entity from which the qualified business income was derived.
1. Above the top of the phase-out range ($207,500 or $415,000), the Sec. 199A limits the taxpayer’s deduction to the lesser of:
- 20% of the taxpayer’s qualified business income with respect to the qualified trade or business,
- or the greater of:
- 50% of the W-2 wages paid (directly or indirectly) by the taxpayer, or
- 25% of the W-2 wages paid plus 2.5% times the cost of depreciable property (ignoring accumulated depreciation);
2. If taxable income falls within the phase-out ranges a formula calculates how much of the Sec. 199A deduction a taxpayer can utilize.
Ken has $1,000,000 in taxable income and operates a manufacturing company which earns $100,000 of qualified business income. Ken should tentatively get a $20,000 Sec. 199A deduction ($100,000 times 20%), but the manufacturing company only pays $30,000 in W-2 wages. On its own, without considering depreciable property, that $30,000 of W-2 wages only supports $15,000 of Sec. 199A deduction because 50% of $30,000 equals $15,000.
However, the manufacturing company owns the equipment used in the business with an original cost of $400,000. The $400,000 of equipment supports $10,000 of Sec. 199A deduction because $400,000 times 2.5 percent equals $10,000.
The Sec. 199A deduction formula therefore limits the Sec. 199A deduction to $17,500, or 25% of the $30,000 ($7,500) of W-2 wages plus 2.5% times the depreciable property ($10,000).
Note: Special rules apply to the calculation of the W-2 wages utilized in the calculation as well as the cost basis of qualified property used in the calculation.
Application to Multiple Entities Owned by the Taxpayer
If a taxpayer owns several pass-thru entities or interests in pass-thru entities, the taxpayer first calculates the qualified business income for each of the individual entities, as well as the Sec. 199A deduction for each entity, so the W-2 wages limitation and depreciable property limitation can be applied at an entity level. The taxpayer then combines the individual Sec. 199A deduction amounts.
Although the law is effective for tax years beginning after December 31, 2017, now is the time to review your personal situation with regards to your potential sources of “qualified business income” and determine if there are steps you can take now to maximize your Sec. 199A deduction for 2018. We can assist you in analyzing your projected Sec. 199A deduction based on the type of entities generating qualified business income and other factors that may limit your Sec. 199A deduction at the entity level (i.e. wage or property factor). We also expect that there will be additional guidance on the application of Sec. 199A in the near future.
To learn more about this, contact Karl Jacob, CPA/PFS, CFP®, CDA
of Dannible & McKee, LLP at (315) 472-9127 or via E-mail at firstname.lastname@example.org.