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Daniel Cullinane CPA p 848-250-9587
BUSINESS INCOME DEDUCTION
Income earned by a C corporation is subject to double taxation: first at the entity level, and then a second time at the shareholder level when the corporation distributes its income as a dividend. Part of the Act reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%. While the Act retained the top rate on dividend income of 20%,2 the dramatic decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.3
In contrast to C corporations, income earned by a sole proprietorship, S corporation, or partnership is subject to only a single level of tax. There is generally no tax at the entity level; instead, owners of these businesses report their share of the business's income directly on their tax return and pay the corresponding tax at ordinary rates. The Act reduced the top rate on ordinary income of individuals from 39.6% to 37%, and Sec. 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.4
Thus, after the passage of the Act, owners of sole proprietorships, S corporations, and partnerships retained a similarly sizable federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.5
While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear. The provision is rife with limitations, exceptions to limitations, phase-ins and phaseouts, and critical but poorly defined terms of art. As a result, Sec. 199A has created ample controversy since its enactment, with many tax advisers anticipating that until further guidance is issued, the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS. Adding concern is that, despite the ambiguity inherent in Sec. 199A, Congress saw fit to lower the threshold at which any taxpayer claiming the deduction can be subject to a substantial-understatement penalty.
This article examines the various computational and definitional elements of claiming the Sec. 199A deduction. It then discusses the primary areas of concern and confusion among tax advisers, highlighting areas where additional guidance is most desperately needed, as well as planning opportunities in the absence of such guidance.
Sec. 199A in general
Effective for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026,6 a taxpayer other than a corporation is entitled to a deduction equal to 20% of the taxpayer's "qualified business income" earned in a "qualified trade or business."7The deduction is limited, however, to the greater of:
50% of the W-2 wages with respect to the qualified trade or business;8 or
The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.9
The deductible amount of qualified business income for each of the taxpayer's qualified trades or businesses is determined separately and added together. The sum of these amounts is then subject to a second limitation equal to the excess of:
The taxable income for the year, over
The sum of net capital gain (as defined in Sec. 1(h)) plus the aggregate amount of the qualified cooperative dividends for the tax year.10
The purpose of this overall limitation is to ensure that the 20% deduction is not taken against income that is taxed at preferential rates.
Example 1: In 2018, A, a married taxpayer, has $100,000 of qualified business income, $100,000 of long-term capital gain, and $30,000 of deductions, resulting in taxable income of $170,000. A's Sec. 199A deduction is limited to the lesser of $20,000 (20% of $100,000) or $14,000 (20% of $70,000, the excess of taxable income of $170,000 over net capital gain of $100,000).
Taxpayers entitled to claim the deduction
The Sec. 199A deduction is available to any taxpayer "other than a corporation."11 This includes:
Individual owners of sole proprietorships, rental properties, S corporations, or partnerships; and
An S corporation, partnership, or trust that owns an interest in a passthrough entity.
With regard to the latter group, future regulations will provide guidance on how to determine the deduction in the case of tiered entities.12
The statute is unclear regarding the determination of the deduction in 2018 for a fiscal-year qualified business. A version of the Act passed by the House of Representatives, which would have generally imposed a top rate of 25% on qualified business income, made clear that taxpayers would be entitled to only a proportional benefit of the reduced rate related to fiscal-year businesses with a tax year that included Dec. 31, 2017.13
The conference committee report to the Act, however, states only that the final version of Sec. 199A is effective "for tax years beginning after Dec. 31, 2017," without differentiating between the tax year of the taxpayer claiming the deduction and the tax year of the business generating the qualified business income.14 Because Sec. 199A is written from the perspective of the taxpayer claiming the deduction — and because the final Act does not contain the specific language governing fiscal-year businesses found in the House bill — it is reasonable to conclude that a calendar-year owner of a fiscal-year business is entitled to claim the full deduction on his or her 2018 tax return, despite the fact that a portion of the income earned by the fiscal-year business was earned prior to 2018.
Example 2: A, an individual, is a shareholder in an S corporation with a fiscal year end of June 30. On A's 2018 Form 1040, U.S. Individual Income Tax Return, A may claim the Sec. 199A deduction for the qualified business income earned by the S corporation for its tax year beginning July 1, 2017, and ended June 30, 2018.
Qualified trade or business
A taxpayer must be engaged in a "qualified trade or business" to claim the Sec. 199A deduction. Sec. 199A defines a qualified trade or business by exclusion; every trade or business is qualified, other than:
The trade or business of performing services as an employee;15 and
A specified service trade or business.16
The first prohibition prevents an employee from claiming a 20% deduction against his or her wage income.
Example 3: A is an employee, but not an owner, of a qualified business. A receives a salary of $100,000 in 2018. A is not permitted a Sec. 199A deduction against the wage income because A is not engaged in a qualified business.
Specified service business
This second category of disqualified businesses serves the same purpose as the first — to prevent the conversion of personal service income into qualified business income. This latter category, however, takes aim at business owners, rather than employees, prohibiting the owner of a "specified service trade or business" from claiming a Sec. 199A deduction related to the business.
Sec. 199A(d)(2) defines a specified service trade or business by reference to Sec. 1202(e)(3)(A), which includes among the businesses ineligible for the benefits of that section:
any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, 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 1 or more of its employees.
Sec. 199A modifies this definition in two ways: first, by removing engineering and architecture from the list of prohibited specified services businesses17 before then amending the final sentence to reference the reputation or skill of one or more of its "employees or owners" rather than merely its "employees."18 Sec. 199A(d)(2)(B) then adds to the list of specified service businesses any business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.19 However, see the discussion below of the taxpayer income threshold exception to the denial of the deduction for a specified service trade or business.
Qualified business income
Once a taxpayer has established that he or she is engaged in a qualified trade or business, the taxpayer must determine the "qualified business income" for each separate qualified trade or business.
Qualified business income is defined as the net amount of qualified items of income, gain, deduction, and loss with respect to a qualifiedtrade or business20 that are effectively connected with the conduct of a business within the United States.21Qualified business income does not include, however, certain investment-related income, including:22
Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss;
Dividend income, income equivalent to a dividend, or payment in lieu of a dividend described in Sec. 954(c)(1)(G);
Any interest income other than interest income properly allocable to a trade or business;
Net gain from foreign currency transactions and commodities transactions;
Income from notional principal contracts, other than items attributable to notional principal contracts entered into as hedging transactions;
Any amount received from an annuity that is not received in connection with the trade or business; and
Any deduction or loss properly allocable to any of these bulleted items described above.
Sec. 1231 gain
The statute is silent on the treatment of Sec. 1231 gain in determining qualified business income. In general, a Sec. 1231 asset is any depreciable asset or real property used in a trade or business for more than one year.23 A Sec. 1231 asset is specifically excluded from the definition of a capital asset.24
When an S corporation or partnership sells a Sec. 1231 asset, the transaction is not characterized as long-term capital gain or loss at the business level; rather, the item simply retains its character as Sec. 1231 gain or loss as it passes through to the owners. At the individual owner level, the taxpayer must net all Sec. 1231 gains and losses. A net gain is treated as long-term capital gain,25 while a net loss is deducted as an ordinary loss.26
Both the House and Senate versions of what would become Sec. 199A stated that qualified business income does not include any item taken into account in determining net long-term capital gain or net long-term capital loss, without specifying whether it needs to be "taken into account" at the business or owner level.27 If it is the former, because Sec. 1231 gain is separately stated at the S corporation or partnership level, with its ultimate character determined only after netting at the shareholder or partner level, one could reasonably conclude that the Sec. 1231 gain is not "taken into account" in determining the long-term capital gain of the business and thus should not be excluded from qualified business income.
There is an additional, and perhaps more straightforward, reason that qualified business income should include Sec. 1231 gain. The bulleted items listed above are meant to codify the intent of the legislative history of Sec. 199A that certain "investment-related income" not be included in qualified business income.28 Because a Sec. 1231 asset is, by definition, not a capital asset but rather an asset used in a trade or business, gain from the sale of such an asset should not be treated as investment-related income. As a result, until guidance from the IRS provides otherwise, it is reasonable to include Sec. 1231 gains and losses in qualified business income.
Reasonable compensation and guaranteed payments
In addition, qualified business income does not include:29
Reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business;
Any guaranteed payments described in Sec. 707(c) paid to a partner for services rendered with respect to the trade or business; and
To the extent provided in regulations, any payment described in Sec. 707(a) to a partner for services rendered with respect to the trade or business.
As discussed later in this article, Congress's decision to exclude from qualified business income wages paid to a shareholder or guaranteed payments to a partner will place those taxpayers at a disadvantage relative to sole proprietors at certain income levels.
Shareholder or partner's allocable share
A shareholder in an S corporation and a partner in a partnership must take into account only his or her allocable share of each qualified item of income, gain, deduction, and loss. A shareholder determines his or her allocable share of S corporation income on a per-share, per-day, pro rata basis, as provided by Sec. 1377. A partner determines his or her allocable share of partnership income by taking into consideration any special allocations permitted by Sec. 704.
Example 4: A is a 30% shareholder in an S corporation for all of 2018. The S corporation generates $100,000 of qualified business income in 2018. Under the pro rata, per-share, per-day allocation rules of Sec. 1377, A's share of the qualified business income is $30,000.
Determining the deductible amount
A taxpayer determines his or her deductible amount separately for each qualified trade or business. The taxpayer begins by computing a tentative deduction equal to 20% of qualified business income.
Example 5: A owns 20% of X, an S corporation, and 30% of Y, a partnership. Both X and Y are qualified businesses. Xallocates to A $40,000 of qualified business income. Y allocates to A $20,000 of qualified business income. A's tentative deduction related to X is $8,000, and his tentative deduction related to Y is $4,000.
50% of W-2 wages limitation
For taxpayers with taxable income in excess of a threshold, the tentative deduction attributable to each separate qualified trade or business is limited to the greater of:
50% of the W-2 wages with respect to the qualified trade or business;30 or
The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.31
"W-2 wages" are the total wages (as defined in Sec. 3401(a)) subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to its employees during the calendar year ending during the tax year of the taxpayer.32 The wages must be properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for the return.33
A shareholder in an S corporation and a partner in a partnership take into account only their allocable share of the W-2wages paid by the business before applying the 50% limitation.34 The shareholder determines his or her allocable share on a strict per-share, per-day, pro rata basis.35 A partner's allocable share is determined in the same manner as the partner's share of the partnership's wage expense.36
Example 6: A owns a 30% interest in Partnership ABC, which conducts a qualified business. Pursuant to the terms of the operating agreement, A is specially allocated 40% of all of the ordinary income or loss of the partnership and 70% of all depreciation expense. Partnership ABC pays $100,000 of W-2 wages in 2018.
Because the partnership's deduction for W-2 wages is part of its ordinary income or loss, A must be allocated 40% of the partnership's W-2 wages.
25% of W-2 wages plus 2.5% of unadjusted basis limitation
The version of Sec. 199A that initially passed the Senate contained only the "50% of W-2 wages" limitation. During the subsequent conference committee meetings, however, an alternate limitation was added: 25% of W-2 wages, plus 2.5% of the unadjusted basis of "qualified property."
The unstated motivation behind this late addition to the statute was to permit owners of rental property to qualify for the benefits of Sec. 199A. Often, an entity that owns rental property — typically, a partnership — does not pay W-2 wages; rather, it pays a management fee to a management company. Because a management fee is not considered W-2 wages for the purposes of Sec. 199A, without this last-minute change, many large landlords would have been shut out from claiming the deduction.
Example 7: A owns a commercial rental property through a limited liability company (LLC). His share of the rental income earned by the LLC is $800,000. The LLC pays no W-2 wages, but A's share of the unadjusted basis of the building is $10million.
In the absence of the alternate limitation, A would be entitled to no deduction because the "50% of W-2 wages" limitation would be zero. Under the final version of Sec. 199A, however, A is entitled to a deduction of $160,000, the lesser of 20% of qualified business income or the greater of:
50% of W-2 wages = $0; or
25% of W-2 wages plus 2.5% of $10 million = $250,000.
A shareholder or partner may only take into consideration 2.5% of his or her allocable share of the unadjusted basis of qualified property. A shareholder is allocated basis on a strict per-share, per-day basis. A partner, however, must be allocated basis in the same manner in which he or she is allocated the partnership's depreciation expense.37
Example 8: A owns a 30% interest in Partnership ABC, which conducts a qualified business. Pursuant to the terms of the operating agreement, A is specially allocated 40% of all of the ordinary income of the partnership and 70% of all depreciation expense. Partnership ABC pays no W-2 wages but owns a commercial building with an unadjusted basis of $20 million in 2018.
In computing A's share of that unadjusted basis, A must be allocated 70% of the basis, the same percentage A is allocated of the partnership's depreciation expense. Thus, A's alternate limitation is $350,000 ($20,000,000 × 70% × 2.5%).
Only the unadjusted basis of qualified property is counted toward the limitation. Qualified property is tangible property subject to depreciation under Sec. 167; as a result, the basis of raw land and inventory, for example, would not be taken into account.38 The basis of property used to determine the limitation is unadjusted basis determined "immediately after acquisition."39 Thus, the basis is not reduced for any subsequent depreciation. It is not clear whether capitalized leasehold improvements, which are generally treated as an adjustment to basis of the underlying building, are considered qualifiedproperty.
It is also unclear whether a partnership that elects to step up the basis in its underlying property pursuant to Sec. 754 may include the step-up in its qualified property. At first blush, because the increase in basis is treated for tax purposes as a new asset placed in service by the partnership, to the extent the step-up is allocated to depreciable assets, it would appear to create qualified property.40 If the policy reason behind allowing the "2.5% of unadjusted basis" limitation was to reward business owners who invest in tangible assets, however, it is unlikely that a Sec. 754 step-up, which reflects an increase in the underlying value of partnership property, rather than a new investment, should be included in qualified property. As with many aspects of Sec. 199A, advisers must await further guidance.
Qualified property must have been used at any point during the tax year in the production of qualified business income and be held by, and available for use in, the qualified business at the close of the tax year.41
A taxpayer may take into consideration the unadjusted basis of property only for a year for which the "depreciable period" of the property has not ended before the close of the tax year.42 The depreciable period begins on the date the property is placed in service and ends on the later of:
10 years after the date placed in service;43 or
The last day of the last full year in the applicable recovery period that would apply to the property under Sec. 168 (ignoring the alternative depreciation system).44
Example 9: On April 12, 2010, Partnership AB, a calendar-year partnership, places in service a piece of machinery purchased for $50,000 that has a five-year modified accelerated cost recovery system (MACRS) life.
The partners may take into account their allocable share of the $50,000 unadjusted basis of the property in 2018, despite the fact that the asset was fully depreciated before the year began. This is because the depreciable period runs for the longer of:
10 full years from April 12, 2010 (to April 12, 2020); or
The last day of the last full year in the recovery period, which for a five-year MACRS asset placed in service during 2010 would have been 2014.
The partners will also take into account the $50,000 unadjusted basis of the property in 2019. The basis will not be taken into account in 2020, however, because the depreciable period ends on April 12, 2020, before the end of the 2020 tax year.
Alternatively, assume the machinery was placed in service on June 1, 2008. The partners of Partnership AB would not take the $50,000 unadjusted basis into account in 2018 because the depreciable period ended on June 1, 2018, before the close of the 2018 tax year.
Regulations will provide rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions.45
Exception to W-2 and qualified property—based limitations based on taxable income
The W-2 and qualified property-based limitations do not apply when the taxpayer claiming the deduction has taxable income for the year of less than $315,000 (if married filing jointly; $157,500 for all other taxpayers).46 Taxable income for these purposes is determined without regard to any Sec. 199A deduction.47
Example 10: A is a sole proprietor. The business generates $100,000 of qualified business income during 2018 but pays no W-2 wages and has no qualified property. A files jointly with his wife for 2018, and their combined taxable income for the year, including the qualified business income, is $250,000.
Absent this exception, A's tentative deduction of $20,000 would be limited to zero, the greater of:
50% of W-2 wages = $0; or
25% of W-2 wages plus 2.5% of unadjusted basis of qualified property = $0.
Because A's taxable income for 2018 is less than $315,000, however, the W-2 limitations do not apply, and A is entitled to claim the full $20,000 deduction.
The W-2 limitations are phased in over the next $100,000 of taxable income (if married filing jointly; $50,000 for all other taxpayers).48 Thus, once taxable income reaches $415,000 for a married taxpayer filing jointly ($207,500 for all other taxpayers), the W-2 limitations apply in full.
Example 11: A is a sole proprietor. During 2018, the business generates $400,000 of qualified business income, pays $120,000 of W-2 wages, and has $100,000 of qualified property. A files jointly with his spouse for 2018, and their combined taxable income for the year, including the qualified business income, is $600,000.
A's tentative deduction is $80,000 ($400,000 × 20%). Because A's taxable income for 2018 is greater than $415,000, however, the W-2 limitations apply in full. As a result, A's deduction is limited to the greater of:
50% of W-2 wages = $60,000; or
25% of W-2 wages ($30,000) plus 2.5% of unadjusted basis of qualified property ($2,500) = $32,500.
Thus, A is entitled to a $60,000 deduction in 2018.
Exception to the denial of deductions for specified service businesses based on taxable income
Similarly, the prohibition on claiming the Sec. 199A deduction based on income earned in a specified service business does not apply if the taxpayer claiming the deduction has taxable income of less than $315,000 (if married filing jointly; $157,500 for all other taxpayers).49 Because the two W-2-based limitations also do not apply when taxable income is below those same thresholds, a taxpayer in a specified service business with taxable income below the thresholds simply deducts 20% of any qualified business income (subject to the overall limitation).
Example 12: A, a single taxpayer, is an attorney who operates his business as a partnership. The partnership pays no W-2 wages during the year. During 2018, A earns $100,000 from his law business and has total taxable income of $150,000. While A would otherwise be barred from claiming a deduction under Sec. 199A by virtue of being engaged in a specified service business, because A's taxable income is less than $157,500, the prohibition on specified service businesses does not apply. In addition, because taxable income is less than $157,500, the W-2 limitations do not apply. As a result, A's final deduction is $20,000 (20% of $100,000).
The ability for owners of a specified service business to claim the deduction is phased out over the next $100,000 of taxable income (if married filing jointly; $50,000 for all other taxpayers), so that once taxable income exceeds $415,000 (if married filing jointly; $207,500 for all other taxpayers), the deduction is lost completely.50 The W-2-based and property-basedlimitations are phased in over the same span of taxable income.
Example 13: Assume the same facts as in the previous example, except A has taxable income of $230,000. Because taxable income exceeds $207,500, A is not entitled to any deduction under Sec. 199A.
Reporting the deduction
The Sec. 199A deduction does not reduce a taxpayer's adjusted gross income.51 The deduction is taken after adjusted gross income is determined, but it is not an itemized deduction;52 rather, the deduction is available to both taxpayers who itemize deductions and those who claim the standard deduction.53 For purposes of determining a taxpayer's alternative minimum taxable income, qualified business income is computed without any adjustments or preference items under Secs. 56 through 59.54 As a result, a taxpayer's Sec. 199A deduction for alternative minimum tax purposes will be identical to the deduction against regular tax.
The Sec. 199A deduction is allowed only for purposes of Chapter 1 of the Code (income taxes).55 Thus, the deduction does not reduce a taxpayer's self-employment income (as this tax is levied under Chapter 2) or net investment income (Chapter 2A). The Sec. 199A deduction is also not allowed in determining a net operating loss deduction.56
Increased exposure to underpayment penalty
Sec. 6662 imposes a 20% accuracy-related penalty on an underpayment of tax due to a substantial understatement of tax. Generally, for taxpayers other than C corporations, the understatement is substantial if its amount for the tax year exceeds the greater of:
10% of the tax required to be shown on the return for the tax year; or
Part of the Act amended Sec. 6662 to provide that any taxpayer who claims a Sec. 199A deduction is subject to a lower threshold before a substantial-understatement penalty is applied, equal to the greater of:
5% of the tax required to be shown on the return for the tax year; or
This lower threshold is particularly harsh, given the lack of guidance surrounding key aspects of Sec. 199A and the resulting challenges taxpayers and their advisers face in implementing the provision. Importantly, the changes to Sec. 6662 do notrequire the substantial understatement to be attributable to the Sec. 199A deduction. Thus, any taxpayer who claims the deduction will be subject to the lower threshold, even if the understatement on the return is unrelated to Sec. 199A.