Why Is Everyone Talking About the 20% Qualified Business Income Deduction?
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We really need to talk about the biggest change that came out with the Tax Cuts and Jobs Act of 2017: Section 199A. This section allows owners of flow through entities such as Sole Proprietorships,S Corporations or Partnerships a deduction of 20% of the income earned by the flow-through. Ever since December 2017, the entire tax community has been abuzz with this new section and has been eagerly awaiting the Internal Revenue Service's guidelines on interpretation.
The Internal Revenue Service dropped the proposed regs on Section 199A on August 8th, 2018, all of its 184 pages can be accessed here. Since December, a lot of different interpretations were being tossed around, everyone was hoping that the guidance would clear up the ambiguity. There is a lot still that needs to be addressed but unlike the story of the four blind men and the elephant, a solid shape is emerging out of the mist!
Caveat: Today's post is a small introduction to this new section. There is a LOT more information to be culled from the 184 pages, my dear readers. I am hoping that you will take today's post to glean some knowledge about the new section and will talk to experts about the mechanics of qualifying for the deduction.
Let us get some basics out of the way first:
Caveat: Today's post is a small introduction to this new section. There is a LOT more information to be culled from the 184 pages, my dear readers. I am hoping that you will take today's post to glean some knowledge about the new section and will talk to experts about the mechanics of qualifying for the deduction.
Let us get some basics out of the way first:
I. What is a pass through business?: A pass through is a business where taxes are not levied at the entity level but rather at the owner level where the income and expenses have been passed through. The owners' tax rates apply to this pass through income. Pass through entities are typically sole proprietorships, partnerships, LLC's, trusts and S corporations. Only pass through entities are eligible for the Section 199A deduction.
II. Do all pass-through businesses qualify for the deduction?: YES any trade or business qualifies UNLESS
One: The pass-through is a "Specified service trade or business" or SSTB.
An SSTB is one that involves performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading and 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. In short, if the business would not run if it were not for your skill or expertise, the business is an SSTB.
Two: The proposed regulations that came out on August 8th, 2018 made it clear that an employee or an employee who organized herself/ himself as a pass-through to be an independent contractor and did essentially the same work as before to take advantage of Section 199A would NOT qualify for the deduction.
AND YES there are EXCEPTIONS TO THE EXCEPTION!!
1. A pass-through that provides engineering or architecture services is not an SSTB.
2. If the taxpayer's taxable income DOES NOT exceed $315,000 if married filing jointly or $157,500 for everyone else, the SSTB exception DOES NOT apply and one can claim the 20% deduction.
III. What is qualified business income or QBI?: QBI is the "net income of qualified items of income, gain, deduction and loss from any qualified trade or business".
1. Only items included in taxable income are counted.
2. Items must be effectively connected with U.S. trade or business.
3. Items such as capital gains and losses, dividends, interest income are excluded.
Note #1: For the sake of simplicity, we are not going to tackle the income and deduction items in this blog. And oh boy does that get even more complicated? Fun, fun!
IV. How do S Corps/ Partnerships handle the deduction? OR What if I have an S Corp or a partnership that is a share-holder or partner in another pass-through entity?: Well, if you are organized in such a manner, you know the entities themselves do not report income/ losses hence cannot take the deduction. The S Corporation/ Partnerships then report the shareholder's/ partner's share of QBI, W-2 wages, UBIA of qualified property among other items on the shareholders'/partners' Schedule K-1. The shareholders/ partners then take the 20% deduction on their personal returns.
V. What Is Section 199A Deduction?:
A. If the taxpayer's taxable income is below $315,000 for married filing jointly or $157,500 for all others, we do not worry if the trade or business is an SSTB and the deduction is the LESSOR of:
II. Do all pass-through businesses qualify for the deduction?: YES any trade or business qualifies UNLESS
One: The pass-through is a "Specified service trade or business" or SSTB.
An SSTB is one that involves performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading and 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. In short, if the business would not run if it were not for your skill or expertise, the business is an SSTB.
Two: The proposed regulations that came out on August 8th, 2018 made it clear that an employee or an employee who organized herself/ himself as a pass-through to be an independent contractor and did essentially the same work as before to take advantage of Section 199A would NOT qualify for the deduction.
AND YES there are EXCEPTIONS TO THE EXCEPTION!!
1. A pass-through that provides engineering or architecture services is not an SSTB.
2. If the taxpayer's taxable income DOES NOT exceed $315,000 if married filing jointly or $157,500 for everyone else, the SSTB exception DOES NOT apply and one can claim the 20% deduction.
III. What is qualified business income or QBI?: QBI is the "net income of qualified items of income, gain, deduction and loss from any qualified trade or business".
1. Only items included in taxable income are counted.
2. Items must be effectively connected with U.S. trade or business.
3. Items such as capital gains and losses, dividends, interest income are excluded.
Note #1: For the sake of simplicity, we are not going to tackle the income and deduction items in this blog. And oh boy does that get even more complicated? Fun, fun!
IV. How do S Corps/ Partnerships handle the deduction? OR What if I have an S Corp or a partnership that is a share-holder or partner in another pass-through entity?: Well, if you are organized in such a manner, you know the entities themselves do not report income/ losses hence cannot take the deduction. The S Corporation/ Partnerships then report the shareholder's/ partner's share of QBI, W-2 wages, UBIA of qualified property among other items on the shareholders'/partners' Schedule K-1. The shareholders/ partners then take the 20% deduction on their personal returns.
V. What Is Section 199A Deduction?:
A. If the taxpayer's taxable income is below $315,000 for married filing jointly or $157,500 for all others, we do not worry if the trade or business is an SSTB and the deduction is the LESSOR of:
- 20% of the taxpayer's QBI PLUS 20% of the his/ her's qualified real estate investment trust and qualified publicly traded partnership income
- 20% of the taxpayer's income MINUS net capital gains
B. If the taxpayer's taxable income is between $315,000 and $415,000 for married filing jointly or between $157,500 and $207,500 for all others, the deduction is LIMITED based on:
- Whether the business is an SSTB
- Whether W-2 wages are paid by the business
- Unadjusted Basis immediately after acquisition (UBIA) of certain property used by the business
C. If the taxpayer's taxable income is above $415,000 for married filing jointly or above $207,500 for all others, the deduction is NOT AVAILABLE if the trade or business is an SSTB.
D. If the taxpayer's taxable income is above $415,000 for married filing jointly or above $207,500 for all others, and if the trade or business IS NOT an SSTB, the deduction is limited by:
- The amount of W-2 wages paid by the trade or business
- Unadjusted Basis immediately after acquisition (UBIA) of certain property used by the business
Note #2: The numbers $157,500, $315,000, $207,500 and $415,000 are for 2018 alone. The subsequent years' numbers will be adjusted for inflation.
VI. What if taxpayer owns multiple pass-through entities?:
- The QBI is calculated on each pass-through entity.
- The taxpayer's taxable income is calculated.
- Non-SSTB QBI can still be deducted as per above explanation in Question #V, Part D without regard to taxpayer's income.
- Experts seem to interpret this as all non-SSTB QBI can be aggregated.
- I am not sure if taxpayer's income is below the limits, can SSTB QBI be aggregated as well.
Well, if your eyes have not glazed over yet- you are either a hard working tax geek like me or really interested to know if you can bag a 20% deduction on your pass-through income. This journey definitely is not for the faint-hearted! There are many, many planning opportunities that you, my dear reader may be eligible for. Grab that phone and call your favorite tax professional to get more information.
Glossary: SSTB-Specified Service Trade or Business; QBI- Qualified Business Income; UBIA-Unadjusted Basis Immediately After Acquisition; REIT-Real Estate Investment Trust; PTP-Publicly Traded Partnership
Bibliography: Section 199A; REG-107892-18; irs.gov Section 199A FAQs
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Consult with a Circular 230 tax professional for your unique needs and make sure your questions are answered. Please read my disclaimer here. If you have any questions regarding this issue or other tax matters, all of my contact information is on my website www.mntaxbiz.com.
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