TAX CUTS AND JOBS ACT (TCJA) – PART 2
SECTION 199A DEDUCTION (from Form 1040 #1 in Part 1)
Section 199A Deduction also known as the Qualified Business Income Deduction arises from the Tax Cuts and Jobs Act of 2017. This new provision allows many owners of sole proprietorships, partnerships, trusts and S corporations to deduct up to 20 percent of their qualified business income (QBI) plus 20% of qualified real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income.
The resulting calculation will go on Page 2, Line 9 of the IRS Form 1040. The amount calculated will be deducted from your adjusted gross income (AGI) to further reduce your taxable income.
The IRS is still working out the kinks in the proposed regulations as well as the methods for calculating the 20 percent deduction of the QBI. The most recent document of the proposed amendments to the Income Tax Regulations under sections 199A and 643 of the code was published in the Federal Register (The Daily Journal of the United States Government) on Aug. 16, 2018. The closing comments for this amendment will be held at a public hearing on Oct. 16, 2018. (All this means to you and me is that the amendment is still under discussion. With that said, some of the information provided in this article may change at the end of this year.)
We’ll begin with the steps needed to help determine whether your business entity is eligible for the up to 20 percent deduction:
Step #1: Determine Taxpayer’s Eligible Taxable Income for Income Limits
- If Single and your Adjusted Gross Income (AGI) is less than $157,500 your QBI Deduction will be up to 20 percent (minus your net capital gains).
- If Single and your AGI is more than $157,500 your QBI Deduction will be phased out incrementally until completely phased out by $207,500.
- If Married (filing jointly) and your Adjusted Gross Income (AGI) is less than $315,000 your QBI Deduction will be up to 20 percent (minus your net capital gains).
- If Married (filing jointly) and your AGI is more than $315,000 your QBI Deduction will be phased out incrementally until completely phased out by $415,000.
Step #2: Determine Your Qualified Trades or Business
Listed below are the types of businesses that qualify:
- Sole Proprietorships
- Real Estate Investors
- Single Member or Multi-member LLCs
- S Corporations
- Trusts or Estates
Step #3: Determine Specified Service Trade or Business (SSTB)
If you are Single and your AGI is less than $157,500 or Married filing jointly and your AGI is less than $315,000 your business qualifies regardless of the Specified Service Trades or Businesses listed below.
For all other taxpayers above the Income Threshold your deduction will be subject to the SSTB limitation. Limitations such as the type of trade or business, the taxpayer’s taxable income, the amount of W-2 wages paid by the qualified trade or business and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business. (Yada, yada, yada) (For those of you above the eligible taxable income limit, you are definitely going to need the help of a professional tax preparer!)
According to IRS Provision 11011 Section 199A an SSTB includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.
The definition in the paragraph above is strikingly familiar with the definition of Personal Service Corporations in IRS Publication 542 on Page 3 (2017 version) except they left out the fields of engineering and architecture. Interesting.
Step #4: Determine Your Qualified Business Income
Whether you own one or more businesses they may all qualify for the business income deduction. Once you have determined which of your businesses qualify you will aggregate the total net income allocated to you as a taxpayer for the qualified businesses.
Your qualified business income includes items of income, gain, deduction, and loss (a.k.a. net profit or loss) from your trades or businesses, including income from partnerships, S corporations, sole proprietorships, and certain trusts. (Please see the Draft Instructions for 2018 Form 1040 below for what the qualified business income does not include. Please read instructions for Line 9 starting on Page 34.)
Draft Form 1040 Instructions: https://www.irs.gov/pub/irs-dft/i1040gi–dft.pdf
Step #5: Determine Your Qualified Business Income Deduction
If your taxable income falls below the thresholds stated in Step #3 above, then your Qualified Business Income Deductions will be the lesser of:
- 20 percent of your QBI, plus 20 percent of your qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income
- 20 percent of your taxable income minus net capital gains
If your taxable income is above the thresholds, the deduction may be limited based on whether the business is an SSTB, the W-2 wages paid by the business and the unadjusted basis of certain property used by the business. These limitations are phased in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500. (Yep…complicated stuff)
Here are some examples to help you navigate the rough QBI deduction trail:
- Andrea (Single Taxpayer) has a net income from her business as an accountant, operating as an S Corporation, of $100,000 and her taxable income is $80,000 on her tax return due to other deductions such as her itemized deductions. Her Section 199A deduction would be $16,000 since it is limited by the lesser of 20% of $100,000 or $80,000.
[Even though she operates a specified service trade business, her income falls below the threshold of $157,500 making her fully eligible for the deduction.]
- Dave and Mary (Married filing jointly) have earned gross wages of $275,000. Dave earned $200,000 in wages as an employee of an unrelated company in 2018. Mary owns 100% of the shares of Mary’s Art Consulting Service, an S Corporation. Mary’s Art Consulting Service generated $50,000 in net income from operations in 2018. The company paid Mary $75,000 in wages in 2018. Dave and Mary had no capital gains or losses in 2018. Dave and Mary’s taxable income for 2018 was $225,000 after adjustments and itemized deductions.
In this example, Mary’s Art Consulting Service’s QBI is the $50,000 in net income from the operations. Because Mary is the sole owner of the company, all of its QBI is attributed to her.
Taking 20% of the $50,000 gives us $10,000. We then compare that amount to 20% of taxable income less any net capital gains. [Yes, the IRS puts her husband’s income in the mix of the calculations, although not stated specifically in the instructions, but implied that a “taxpayer” is considered one taxpayer when married.] Here taxable income is $225,000 and the couple had no net capital gains. 20% of $225,000 is $45,000. We compare $45,000 to the $10,000 figure and because $10,000 is less, that amount is Mary’s Section 199A deduction for 2018.
(If Mary’s business was a sole proprietorship, she would have no taxable wages and the entire net profit of $125,000 would put her over the threshold amount of $315,000 for Married filing jointly. Their Section199A deduction would be limited to the lesser of 20% QBI or the greater of (1) 50% of the W-2 wages paid with respect to that business [$0] or (2) 25% of the W-2 wages paid with respect to that business plus 2.5% of the unadjusted basis of qualified property for that business, aka Assets. Mary had no assets [$0]. In this case 20% of QBI is equal to $25,000. Since the business paid no W-2 wages, the Section 199A deduction is limited to $0! She would not qualify for the Section 199A deduction.) Luckily, Mary created an S corporation and paid out W-2 wages to maximize her Section 199A deduction.
- George (Single Taxpayer, Sole Proprietor) owns four rental properties with net incomes of $25,000, $20,000, $15,000, with one losing $5,000 annually. These property incomes would be aggregated to be $55,000. He would deduct 20% of $55,000.
- Kathy (Single Taxpayer, Partner) has 50% ownership in a health nutrition business operated as a partnership with another unrelated individual. Let’s say that the K-1 Kathy received from the partnership tax return indicated that her share of the QBI is $25,000. She also received guaranteed payments of $75,000 for the year. Her total taxable income after the standard deduction would be $88,000. 20% of the $88,000 gives her $17,600. We then compare that to the 20% of the QBI ($25,000), which is $5,000. Her Section 199A deduction would be $5,000.
Section 199A deduction cannot be taken in loss years. If your QBI is less than zero in a year, the amount will be treated as a loss from a qualified business in the next year (Sec.199A(c)(2)).
As you can see by the examples, tax reform does not mean tax simplification!
It took countless hours of reading IRS Publications, draft instructions, draft forms, and interpretation of the IRS Code 26 USC 199A to come up with the above scenarios. I’m mentally exhausted!
William A. Bailey, CPA, J.D., LL.M. stated, “Much of the Sec. 199A deduction’s complexity comes from congressional concerns of potential abuse.” (Mechanics of the new Sec. 199A deduction for qualified business income, Journal of Accountancy, May 1, 2018)