On December 22, 2017, President Trump signed a “tax reform”
law usually referred to as the Tax Cuts and Jobs Act (TCJA). Not only did the
TCJA give a large tax cut to C-Corporations, the TCJA potentially gives
individuals with taxable business income from a sole proprietorships or from
pass-through entities (Partnerships, S-Corporations and LLCs), a deduction that
can reduce the federal Taxable Income of that individual business owner. This
Business Deduction is sometimes also referred to as the “Section 199A”
deduction.
Note that there was an original House Bill of the TCJA, then
a Senate Bill and then a final Conference Agreement between the House and Senate
which makes sorting through the complete TCJA difficult and sometimes confusing
- as the bill includes the language from all three bill versions and the IRS (as
of December of 2018) has yet to provide additional final guidance. The IRS
should soon provide a new Publication 535 to address the Business Deduction.
Ultimately, the maximum deduction that can subtracted by a business owner
from their federal Taxable Income is 20% of the “Qualified Business Income”
(QBI) of the business. This is further limited by the TCJA to a maximum of 20%
of the business owner’s Taxable Income (which would be the individual’s Adjusted
Gross Income minus any Standard or Itemized Deduction taken) minus any Long Term
Capital Gains in the case where 20% of the QBI would exceed that amount.
The TCJA also provides for a potential phase-out or limitation of the Business
Deduction based on the individual business owner’s federal Taxable Income
(further discussed later this document). In addition, the way that the Business
Deduction may be phased out or otherwise be limited depends on whether or not
the business is a “Specified Service Trade” as defined by the TCJA.
Here
is the language taken directly from the TCJA:
“For taxable years
beginning after December 31, 2017 and before January 1, 2026, an individual
taxpayer generally may deduct 20 percent of qualified business income from a
partnership, S corporation, or sole proprietorship, as well as 20 percent of
aggregate qualified REIT dividends, qualified cooperative dividends, and
qualified publicly traded partnership income.”
“The taxpayer’s
deduction for qualified business income is equal to the lesser of the combined
qualified business income amount for the taxable year or an amount equal to 20
percent of the taxpayer’s Taxable Income (reduced by any net capital gain) for
the taxable year. The combined qualified business income amount is the sum of
the deductible amounts determined for each qualified trade or business for the
taxable year and 20 percent of the qualified REIT dividends and qualified
cooperative dividends received by the taxpayer for the taxable year.”
You can bet that the IRS and accountants will be arguing for years about
what is “qualified business income” (QBI) for purposes of this Business
Deduction. But here is how the TCJA defines it:
“For any taxable year,
qualified business income means the net amount of qualified items of income,
gain, deduction, and loss with respect to the qualified trade or business of the
taxpayer. The determination of qualified items of income, gain, deduction, and
loss takes into account these items only to the extent included or allowed in
the determination of taxable income for the year.”
And further:
“Qualified business income does not include any amount paid by an S
corporation that is treated as reasonable compensation of the taxpayer.
Similarly, qualified business income does not include any guaranteed payment for
services rendered with respect to the trade or business, and to the extent
provided in regulations, does not include any amount paid or incurred by a
partnership to a partner who is acting other than in his or her capacity as a
partner for services.”
Defining “reasonable compensation” is likely
going to be an ongoing battle between the IRS and tax accountants. For an owner
of an S-Corp, reasonable compensation would be in the form W-2 wages subject to
payroll taxes and not part of that individual’s QBI. Most S-Corp pass-thru
income, though, could likely be characterized as QBI and 20% of that QBI should
be available as a potential Business Deduction to the individual owner or
partner (subject to any phase-out or other limitation discussed below).
But how “reasonable compensation” relates to an individual’s income from a
partnership or sole proprietorship is likely up for some speculation as the TCJA
seems to be silent on the matter. Although the TCJA is clear that the potential
Business Deduction is available to sole proprietors and partners, the business
income from those types of entities is not classified by the IRS as W-2 wages
(but rather self employment income subject to the payment of self employment
taxes). Whether or not all of a sole proprietor’s or partner’s net business
income can be characterized as QBI and available for the Business Deduction or
if some type of “reasonable compensation” needs to be subtracted from that
income is a question that should soon be answered by the IRS.
The TCJA
places a limitation or phase-out on the Business Deduction if the individual’s
Taxable Income exceeds certain income thresholds. Taxable Income is assumed to
be the individual’s federal Adjusted Gross Income (AGI) minus any Standard or
Itemized Deduction taken. Here is the language directly from the TCJA:
“A limitation based on W-2 wages paid is phased in above a threshold amount
of taxable income. A disallowance of the deduction with respect to specified
service trades or businesses is also phased in above the threshold amount of
taxable income.”
“For a taxpayer with taxable income within the phase-in
range, the wage limit applies as follows. With respect to any qualified trade or
business, the taxpayer compares (1) 20 percent of the taxpayer’s qualified
business income with respect to the qualified trade or business with (2) 50
percent of the W-2 wages with respect to the qualified trade or business. If the
amount determined under (2) is less than the amount determined (1), (that is, if
the wage limit is binding), the taxpayer’s deductible amount is the amount
determined under (1) reduced by the same proportion of the difference between
the two amounts as the excess of the taxable income of the taxpayer over the
threshold amount bears to $50,000 ($100,000 in the case of a joint return).”
But under the Conference Agreement of the TCJA, this wage limit was expanded
to include a capital element:
“The conference agreement modifies the
wage limit applicable to taxpayers with taxable income above the threshold
amount to provide a limit based either on wages paid or on wages paid plus a
capital element. Under the conference agreement, the limitation is the greater
of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or
business, or (b) the sum of 25 of percent of the W-2 wages with respect to the
qualified trade or business plus 2.5 percent of the unadjusted basis,
immediately after acquisition, of all qualified property. “
The TCJA
defines “qualified property” as:
“For purposes of the provision,
qualified property means tangible property of a character subject to
depreciation that is held by, and available for use in, the qualified trade or
business at the close of the taxable year, and which is used in the production
of qualified business income, and for which the depreciable period has not ended
before the close of the taxable year“
And the TCJA defines “W-2
Wages” as:
“W-2 wages are the total wages subject to wage
withholding, elective deferrals, and deferred compensation paid by the qualified
trade or business with respect to employment of its employees during the
calendar year ending during the taxable year of the taxpayer. W-2 wages do not
include any amount which is not properly allocable to the qualified business
income as a qualified item of deduction. In addition, W-2 wages do not include
any amount which was not properly included in a return filed with the Social
Security Administration on or before the 60th day after the due date (including
extensions) for such return”
The TCJA also allows an individual to
take a Business Deduction if an individual has income from an agricultural
cooperative (in a similar way as described in the bill for sole proprietors,
partners, and owners of S-Corps):
“For taxable years beginning after
December 31, 2017 but not after December 31, 2025, a deduction is allowed to any
specified agricultural or horticultural cooperative equal to the lesser of (a)
20 percent of the cooperative’s Taxable Income for the taxable year or (b) the
greater of 50 percent of the W-2 wages paid by the cooperative with respect to
its trade or business or the sum of 25 percent of the W-2 wages of the
cooperative with respect to its trade or business plus 2.5 percent of the
unadjusted basis immediately after acquisition of qualified property of the
cooperative.”
The “threshold amounts” for 2018 (which will be
inflation adjusted) were defined in the TCJA as:
“Under the
conference agreement, the threshold amount is $157,500 (twice that amount or
$315,000 in the case of a joint return), indexed. The conferees expect that the
reduced threshold amount will serve to deter high-income taxpayers from
attempting to convert wages or other compensation for personal services to
income eligible for the 20-percent deduction under the provision. The conference
agreement provides that the range over which the phase-in of these limitations
applies is $50,000 ($100,000 in the case of a joint return). “
As
these levels will be indexed by the IRS for inflation, the potential phase-out
of the Business Deduction for the 2021 tax filing year, begins at $163,300 and
ends at $213,300 for an individual (single, head of household, or married filing
separate) and begins at $326,600 and ends at $426,600 if married filing jointly.
Note though, that the phase-out is applied differently if the
pass-through entity is characterized as a “Specified Service Trade” business in
comparison to how the phase-out is applied to a business that is not a specified
service trade (discussed later in this document). In particular, for a Specified
Service Trade (as defined in the TCJA) the Business Deduction will always
phase-out to zero if the individuals Taxable Income fully exceeds the upper end
of the phase-out bracket. That is not the case for a business that is not a
specified service trade, as the Business Deduction will not phase-out if there
are significant W-2 wages or depreciable capital assets that can be claimed by
the owner for that business.
In the final version of the TCJA, a
“specified service trade” means:
“any trade or business involving
the performance of services in the fields of health, law, 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, or which involves the performance of services
that consist of investing and investment management trading, or dealing in
securities, partnership interests, or commodities. For this purpose a security
and a commodity have the meanings provided in the rules for the mark-to-market
accounting method for dealers in securities.”
“The conference agreement
modifies the definition of a specified service trade or business in several
respects. The definition is modified to exclude engineering and architecture
services, and to take into account the reputation or skill of owners.”
In particular given that for just about any business “the principal asset of
such trade or business is the reputation or skill of one or more of its
employees or owners”, one could argue that most any business could be classified
as a “Specified Service Trade” (using the definitions in the TCJA) unless the
owner’s and/or employee’s are totally incompetent. Again, we will leave that to
the IRS and accountants to feud about.
One of the more confusing elements
of the TCJA, is how the Business Deduction phase-out works once an individual’s
federal Taxable Income reaches or exceeds the income thresholds defined in the
bill. Again, the phase-out is applied somewhat differently whether the business
can be classified as a “Specified Service Trade” or not - although the
thresholds of the Taxable Income limits are the same.
If the business
owner’s federal Taxable Income does not exceed the threshold, then there is no
limitation or phase-out of the Business Deduction outside of haggling over what
actually is the business owner’s Qualified Business Income (QBI). But otherwise,
just take the lesser of 1) 20% of the QBI or 2) 20% of the business owner’s
Taxable Income minus Long Term Capital Gains and deduct that amount from the
individual’s federal Taxable Income. There is no difference in the Business
Deduction whether the business is a Specified Service Trade or not, as long the
individual’s Taxable Income does not exceed the income phase-out thresholds.
Once an individual’s federal Taxable Income exceeds the income threshold,
then the Business Deduction may be limited or phased-out completely to zero. In
which case, three initial calculations need to be made and the individual
amounts compared to each other to determine the potential limits of the
phase-out of the Business Deduction. At this point in the initial calculation,
it does not matter whether or not the business is characterized as a Specified
Service Trade or not.
The three amounts that need to be calculated are as
follows:
1) 20% of the Qualified Business Income (QBI): The issue here is
obviously what exactly is the QBI, what constitutes reasonable compensation to
the owner that is not to be included in the QBI, what types of other income is
not to be included in the QBI, and what is the QBI for a sole proprietor or a
partner where the owner does not have W-2 wages? Go talk to the IRS or your
accountant. This is of course also important even if the individual’s Taxable
Income does not exceed the income thresholds and there is no potential phase-out
of the Business Deduction.
2) 50% of the W-2 Wages Paid: This can be W-2
wages paid to the owner of an S-Corp, or W-2 wages paid to an employee of the
business (for any type of business entity). It does not appear to include the
business income taken by a sole proprietor or partner which instead would be
characterized as income subject to self-employment tax and not by the IRS as W-2
wages. For a partnership, it would include the allocable share of W-2 wages paid
to employees. In other words, for a 50/50 partnership, each partner would be
able to allocate 50% of the employee W-2 wage paid for purposes of the Business
Deduction. It all depends on the partnership agreement. Same goes for an S-Corp
as it would likely depend on the ownership agreement. But for an S-Corp, the
business owner would certainly add his own W-2 wages received along with any
allocable share of W-2 wages paid to employees. For an S-Corp, the owner’s
individual W-2 wages would not be included in the QBI that is passed thru to the
owner. For a sole proprietorship, this would include all of the W-2 wages paid
to employees but not to independent contractors performing services for which no
W-2 wages were reported to the IRS by the business
3) 25% of W-2 Wages
Paid plus 2.5% of percent of the unadjusted basis, immediately after
acquisition, of all qualified property: OK, perhaps time to talk to your tax
accountant. But again for an S-Corp or Partnership, this would be the partner’s
or owner’s allocable share of the cost of all accumulated depreciable capital
assets. For a sole proprietorship, it would simply be the sole business owner’s
original cost of all acquired capital assets for that business that have not yet
been fully depreciated.
Once these three items listed above are
determined, then take the greater of 2) or 3) above, and then compare to 1),
taking the lesser amount. This lesser amount will be the Lower Limit of the
Business Deduction and 1) from above will be the Upper Limit of the Business
Deduction.
So, for the mathematically inclined, the phase-out calculation
for a business that is not a specified service trade would look like this:
Business Deduction = UpperLimit – (UpperLimit – LowerLimit) X %Factor
Where for the 2021 Tax Filing Year: UpperLimit = Always 20% of QBI
LowerLimit = Either 1), 2) or 3) from above %Factor = (TaxableIncome –
163,300)/50,000 for a Single filer; or (TaxableIncome – 326,600/100,000) for
married filing jointly;
Note that the %Factor will range from 0 to 1
depending on how much the individual’s taxable income exceeds the income
threshold.
Therefore for a business that is not specified service trade,
once a business owner’s Taxable Income fully exceeds the end of the phase-out
bracket, the Business Deduction will be the Lower Limit of the Business
Deduction as described above.
For a business that is not specified
service trade, when a business owner’s Taxable Income falls between the
phase-out threshold and the end of the phase-out bracket, the Business Deduction
will proportionally fall between these upper and lower Business Deduction limits
based on the where the individual’s Taxable Income proportionally falls within
the phase-out bracket.
Note that for a business that not a specified
service trade, if 20% of QBI is less than either 2) or 3) above), then the Lower
and Upper Limits of the Business Deduction will be the same and there will be no
phase-out or reduction of the Business Deduction. On the other hand, if that
business has no W-2 employee wages to declare or no depreciable assets, then the
Lower Limit of the Business Deduction will be zero resulting in a complete
phase-out of the Business Deduction once the individual’s Taxable Income exceeds
the end of the phase-out bracket ($213,300 for single and $426,600 for married
jointly).
Now for a Specified Service Trade business, the Upper and
Lower Limits of the Business Deduction are determined as above, but the formula
is different. Again for the mathematically inclined, the phase-out calculation
would look like this:
BusinessDeduction = UpperLimit X %RFactor -
((UpperLimit X %RFactor) - (LowerLimit X %RFactor)) X (1 - %RFactor)
Where for the 2021 Tax Filing Year: UpperLimit = Always 20% of QBI
LowerLimit = Either 1), 2) or 3) above %RFactor = 1 - (TaxableIncome –
163,300)/50,000 for a Single filer; or 1 - (TaxableIncome – 326,600/100,000)
for MFJ;
Note that the %RFactor will now range from 1 to 0 depending on
how much the individual’s taxable income exceeds the threshold. This is just the
reverse as how the %Factor worked above for a business that is not specified
service trade.
Therefore for Specified Service Trade Business, the
Business Deduction will always be reduced to zero once the individual’s Taxable
Income fully exceeds the end of the phase-out bracket. If 20% of QBI is less
than either 2) or 3) above), then the Lower Limit and Upper Limit of the
Business Deduction will be the same and the Business Deduction will be phased
out in the same proportion as the individual’s Taxable Income that exceeds the
range of phase out threshold.
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