Reviewing the Finer Points of the Section 199A Tax Deduction
It’s been over a year since the IRS issued final regulations regarding Internal Revenue Code Section 199A. This Code Section created a tax deduction enabling owners of sole proprietorships, partnerships, limited liability companies and S corporations to write off up to 20% of their qualified business income (QBI).
If your construction company is organized under one of these entity types, now’s a good time to review the finer points of the Sec. 199A deduction to determine whether it might benefit your tax situation.
Know the Limits
The deduction is subject to two significant limitations for owners whose taxable income exceeds certain thresholds. First, it’s unavailable for specified service trades or businesses (SSTBs) after a certain earning level, including consultants. Second, the deduction is limited to 50% of the owner’s allocable share of the entity’s W-2 wages or, if greater, 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified depreciable property.
Both limitations are phased in gradually, beginning at taxable income of $160,700 ($321,400 for joint filers). They’re fully applicable when taxable income reaches $210,700 ($421,400 for joint filers). The final regs generally apply to tax years ending after February 8, 2019. For the most part, they conform to proposed regulations that were issued in August 2018, with a few important modifications.
Investigate the Details
Several issues of importance to construction companies may come into play when seeking to claim the deduction. First, Sec. 199A specifically excludes “performing services as an employee” from the trades and businesses eligible for the QBI deduction. So, there may be an incentive for construction workers to convert from employee to independent contractor status to qualify for the deduction.
The proposed regulations put a damper on this strategy by providing that an employee who’s subsequently treated as a nonemployee while performing substantially the same services is presumed to be an employee for Sec. 199A purposes. The final regulations take this a step further, providing that the presumption will continue for three years after the conversion. The presumption can be rebutted with evidence that the worker is performing services as an independent contractor.
Another important issue is consulting services. Construction businesses may provide certain consulting services connected with the performance of construction services without being considered SSTBs (provided they’re not paid for separately). But certain standalone consulting services may jeopardize the deduction for high-income owners. Fortunately, the regulations contain a “de minimis” rule: A business isn’t an SSTB if less than 10% of its gross receipts (5% if gross receipts exceed $25 million) is attributable to consulting or other specified services.
What if a construction company’s standalone consulting services exceed the de minimis threshold? Under the proposed regulations, that would have tainted all the business’s income, making its high-income owners ineligible for the pass-through deduction. The final regulations, however, allow owners to claim the deduction for QBI attributable to non-SSTB services if the firm’s SSTB and non-SSTB trades or businesses are “separate and distinct.”
What defines “separate and distinct” is a factual question. At minimum, the company must keep a “complete and separable set of books and records” for each trade or business. An example in the final regulations suggests that it’s helpful if each trade or business has separate employees, though it’s unclear whether that’s a requirement.
Finally, there’s the matter of aggregation. To maximize the deduction, the proposed regulations allow owners to aggregate separate businesses for Sec. 199A purposes, provided they’re part of a larger, integrated trade or business and meet certain other requirements. The final regs contain several provisions that make aggregation easier, including an option to make an aggregation election at the entity level.
Ask for Help
The Sec. 199A deduction remains a potentially valuable tax break to consider if your construction company operates under one of the applicable entity types. Feel free to contact any of our tax professionals for help determining whether to pursue the deduction and, as always, for assistance in completing and filing your tax return.