January 31, 2018
The new tax reform legislation contains numerous provisions that have a wide-ranging and significant tax impact on most businesses. One of the more significant provisions is the new Internal Revenue Code Section “199A”, which applies to owners of pass-through entities.
In short, this particular new provision applies to owners of entities taxed as S corporations, partnerships, and sole proprietorships that are generating income from a qualified business in the United States. Simplistically, the owners of these businesses may benefit from a deduction equal to 20% of the income. In other words, if a qualifying business generates $100,000 of income, the owner may only pay tax on $80,000 of this income after taking the 20% pass-through deduction.
Before you leap to conclusions and celebrate the benefits of this provision, you need to understand that this particular provision is very complex, with the new law stretching 23 pages and containing numerous exceptions and nuances to the rules. Some of the key provisions that you should understand are as follows:
1) This deduction is “below the line” and reduces taxable income, but does not reduce adjusted gross income. This nuance impacts some state tax calculations and many federal income phase-out provisions. Taxpayers are eligible to take this deduction whether they itemize or not.
2) Reasonable compensation paid from an S corporation or guaranteed payments from a partnership generally reduce the qualified income. As a result, in some situations a sole proprietorship may capture a larger deduction as a result, as there is no compensation tied to the owner.
3) Income and important attributes from each business is generally tallied separately in calculating the available credit. Qualifying business losses generally carry forward to offset future income when calculating the deduction.
4) Taxpayers with taxable income less than $157,500 (single) or $315,000 (married filing jointly) are subject to few restrictions on their ability to claim this deduction. Taxpayers making over this amount are subject to the following key limitations:
a. The business cannot be a service business where the principal asset of the business is the reputation or skill of 1 or more of its employees (health, law, accounting, actuarial science, performing arts, consulting athletics, financials services, brokerage services, security trading, etc.)
b. The deduction cannot exceed the greater of 1) 50% of the W-2 wages paid by the qualified business, or 2) the sum of 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis of qualified property (generally all depreciable property)
The complexities of this provision give rise to many planning opportunities. For example, owners that are over the taxable income threshold may in some cases be limited based on W-2 wages or business assets. In those cases, an S corporation structure may be attractive, as the owner salary will generate qualifying W-2 wages for the calculation. In the real estate world, there will be significant thought put into whether an activity rises to the level of a “trade or business”, and there are huge planning opportunities available to maximize the deduction when real estate assets are sold for a gain.
Please contact us for assistance in understanding how this deduction may impact your business. This provision is extremely complex, and this article is intended only to give you a broad overview of the general scope of this new deduction.