When Congress tackled tax reform last year, the tax treatment of businesses was front and center. The new tax law permanently lowered the tax rate for corporations to 21% while rates typically remained higher for individual taxpayers (you can see the new individual tax rates here). That scheme would have been problematic for sole proprietors and owners of pass-through businesses, so Congress provided a workaround: A deduction of up to 20% to bring the rate lower. That deduction, called the Section 199A deduction, raised a number of questions. The Internal Revenue Service (IRS) has finally issued proposed regulations for Section 199A (downloads as a pdf) intended to address some of those issues.
Before you get too excited, the bad news: There are 184 pages of proposed regulations.
The good news: I’ve got you covered. Here’s what you need to know.
When does the new deduction take effect? The new deduction is available for tax years beginning after December 31, 2017. In other words, eligible taxpayers can claim the deduction on their 2018 federal income tax return (the one you’ll file in 2019).
Who is eligible for the deduction? The deduction is generally available to sole proprietors and business owners with pass-through businesses. The deduction also applies to certain trusts and estates.
What is a pass-through business? Pass-through businesses are those that do not pay corporate income tax at the entity level but instead pass income and expenses through to the owners. The owners then report their share of income and expenses on their own tax returns and pay any resulting tax at their individual income tax rates. Examples include sole proprietorships, partnerships, limited liability companies (LLCs), trusts and S corporations.
Are there exceptions? Yes. For purposes of the deduction, a taxpayer’s qualified trade or business is any trade or business with two exceptions:
- Specified service trade or business (SSTB). An SSTB is any 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.” I like to think of it this way: if the success of your business depends on you and not on something that you sell, you’re pretty much included (except for engineering and architecture services, which were specifically excluded). The definition also includes a business where the performance of services consists of investing and investment management trading or dealing in securities, partnership interests, or commodities. This exception only applies if a taxpayer’s taxable income exceeds $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers.
- Performing services as an employee.
(Quick add: There are literally pages in the proposed regulations about what constitutes SSTB. Expect more guidance on this issue.)
Are there any income limits? The deduction is available to taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers (you’ll see these limits referred to as threshold amounts). If you are above the threshold amounts, you are subject to limitations and exceptions which are determined by your occupation (SSTBs, as noted above) and a wage and capital limit.
What does the deduction actually do? In other words, what am I deducting in the first place? The deduction is intended to reduce the amount of taxable income attributable to your business.
Where will I report the deduction? There’s a space for the deduction on new 1040 draft at line 9. You can see the entire draft 1040 with links to the new schedules here.
What is QBI and why does it matter? You’ll see the term qualified business income (QBI) quite a lot throughout the regs. It’s the net amount of income, gain, deduction and loss from your qualified trade or business. Only items included in taxable income are counted, while items such as capital gains and losses, certain dividends and interest income are excluded. QBI is determined on a per business, not a per taxpayer, basis. You’ll use it to figure your deduction.
How do I figure QBI if I have multiple businesses? If you have multiple businesses, you calculate QBI for each and net the amounts. If you have a negative QBI after you net the amounts, you can carry that amount forward to the next tax year.
Okay, I think I got it. Now, how do I figure the deduction? The deduction is generally equal to the lesser of:
- 20% of your qualified business income (QBI), plus 20% of your qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income; OR
- 20% of taxable income minus net capital gains.
You can see the deduction broken down in chart form here.
That sounds complicated. If I just own a business and I’m below the threshold amount, is there an easier way to figure my deduction? Yes. If your taxable income is below the threshold amount, the deductible amount for each of your businesses is simply 20% of your QBI with respect to each business. For example, if your income is $50,000 and your QBI is $40,000, then your deduction is $8,000, or 20% of your QBI. You’re under the threshold amount so no need to do any more math.
If I’m over the threshold amount, what do I need to know? If you’re over the threshold amount, your deduction may be limited based on :
- Whether your business is an SSTB;
- W-2 wages paid by the business; and
- Unadjusted basis (UBIA) 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 (and will be adjusted for inflation in subsequent years). A phase-in range means that the benefit decreases as income increases.
If I’m over the threshold amount, AND my business is an SSTB, what do I need to know? Again, the phase-in applies which means that your benefit decreases over the threshold amount. However, if your business is an SSTB and you exceed the threshold amount plus the phase-in range ($415,000 for joint filers and $207,500 for all other taxpayers), then you lose the deduction completely. In that case, the old pass-through rules apply meaning that you pay tax using your individual tax rate.
If I’m over the threshold amount, but my business is not an SSTB, what do I need to know? Your deduction isn’t subject to a cut-off, but may still be limited by the amount of W-2 wages paid by your business and UBIA.
Aren’t W-2 wages just what is reported on a normal W-2? Yes and no. Only W-2 wages which are properly allocable to QBI can be used to figure the deduction. The IRS has announced three ways to figure those wages:
- Unmodified box method. This method is the lesser of the total entries in box 1 of all forms W-2 filed with the Social Security Administration (SSA) by you with respect to your employees OR the total entries in box 5 of all forms W-2 filed with SSA by you with respect to your employees.
- Modified box 1 method. To use this method, total the amounts in of all forms W-2 filed with the SSA by you with respect to your employees. Next, subtract any amounts included in box 1 of forms W-2 that are not wages for federal income tax withholding purposes. Now, add to that the total amounts reported in box 12 of forms W-2 with respect to your employees that are properly coded D, E, F, G, and S.
- Tracking wages method. To use this method, total the amounts of wages subject to federal income tax withholding that are paid to your employees and that are reported on forms W-2 that you filed with SSA for the calendar year, and add the amounts reported in box 12 of forms W-2 with respect to your employees that are properly coded D, E, F, G, and S.
(For more on reading and understanding your form W-2, including the codes, click here.)
If you’re still scratching your head, you can check out Notice 2018-64 for more guidance.
Do I figure W-2 wages for all businesses at the same time? No. The W-2 wage limitation in section 199A applies separately to each trade or business. If W-2 wages are allocable to more than one trade or business, you have to figure the applicable share for each business (see proposed reg §1.199A-2).
So once I have the W-2 numbers, what happens next? If you’re over the threshold amount, the wage and capital limit applies. That limit is the greater of 50% of W-2 wages or the sum of 25% of W-2 wages + 2.5% of the unadjusted basis (UBIA), immediately after acquisition, of all qualified property. Click here for more on the formulas, including some examples.
Okay, but pass-through entities don’t always issue a form W-2. What about net earnings from self-employment and net investment income (dividends, for example)? The proposed regulations provide that the section 199A deduction does not reduce net earnings from self-employment under section 1402 or net investment income under section 1411. Calculate those as though there is no section 199A deduction.
What about UBIA? Basis, at its most simple, is the cost paid for an asset plus adjustments. Figuring UBIA, or the unadjusted basis immediately after acquisition (UBIA) of qualified property used in your sole proprietorship shouldn’t be all that complicated. However, figuring basis for property in a partnership, like an LLC, can be complicated at the best of times. Section 199A doesn’t make any of this more simple, but here are the general rules:
- For purchased or produced qualified property, UBIA generally will be its cost under section 1012 as of the date the property is placed in service.
- For property contributed to a partnership in a section 721 transaction and immediately placed in service, UBIA generally will be its basis under section 723.
- For property contributed to an S corporation in a section 351transaction and immediately placed in service, UBIA generally will be its basis under section 362.
- For inherited property immediately placed in service by the heir, the UBIA generally will be its fair market value at the time of the decedent’s death under section 1014.
Some special rules apply, including a reduction in basis for the non-business use of property, and a restriction on property acquired and disposed of near the end of the taxable year without having been used in a trade or business for at least 45 days. You’ll want to see proposed reg §1.199A-2(c) for more. But don’t panic: Remember that the UBIA rules only apply to taxpayers over the threshold amount.
This feels like it’s a loophole after loophole waiting to happen. What does the IRS think? Loophole has such ugly connotations. It’s true that there will be attempts to take advantage of the rules – some legitimately so (that’s why we pay tax professionals) and some not so legitimate. The proposed regulations do establish anti-abuse rules and hint that more might be on the way. Keep watching this space.
Wait, you didn’t even get into like-kind exchanges, 1231 losses, and aggregation rules. Is that all? No. There’s more to come. Keep in mind that the proposed regulations are 184 pages and the guidance on W-2 wages constitutes an additional 14 pages – plus FAQs, to boot. This article is meant to provide you with an overview. If you have special circumstances, including ownership in a REIT or if you are a member of a co-op, that can complicate things. Those topics are a little beyond the scope of this article: I fully expect that my Forbes colleagues will write related pieces and I’ll be sure to link once those are published.
Finally, remember that these are proposed regulations. If you have any comments, you have 45 days to let the IRS know what you think. You can send your submissions via the post to CC:PA:LPD:PR (REG-107892-18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044. You can hand-deliver them, Monday through Friday between the hours of 8 a.m. and 4 p.m., to CC:PA:LPD:PR (REG-107892-18), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C., 20224. You can also email your thoughts via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-107892- 18).