The legislation formerly known as the Tax Cuts and Jobs Act (the “Act”) adds section 199A to the Internal Revenue Code (the “Code”). The provision provides a new deduction that reduces the effective tax rate on qualified business income (“QBI”) for owners of businesses taxed as sole proprietorships, partnership, limited partnership, limited liability company, S corporation and similar pass-through entities (herein after “pass-through entity”).
Qualified Business. Most businesses owned and operated by a pass-through entity within the United States, including real estate rental and investment activities, will satisfy the qualified business requirement. However, certain “specified service businesses” including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services and any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, are subject to more significant limitations. Firms providing engineering or architectural services are not treated as specified service businesses even though they would seem to meet the foregoing definition.
Qualified Business Income. QBI is defined as the net amount of items of income, gain, deduction and loss attributable to each qualified business conducted by a sole proprietor or pass-through entity. QBI excludes wages and reasonable compensation by an owner received from an S corporation, and guaranteed payments received by a partner for services provided to a partnership’s business. Also excluded are specified investment-related items including capital gains or losses, dividends, interest income, qualified REIT dividends, qualified cooperative dividends or qualified publicly traded partnership income. The amount of QBI allowed as a deduction is subject to the limitations discussed below.
Allowable QBI Deduction. An owner or investor in a qualified business may deduct up to 20% of QBI, subject to the following limitations:
W-2 Wage Limitation. The QBI deduction may not exceed the greater of: (i) 50% of W-2 wages paid to employees of the qualified business during the taxable year, or (ii) the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis (usually, the original acquisition cost) of qualified property. “Qualified property” means tangible, depreciable property, including tangible property and real property improvements, used in the qualified business for the production of income, and for which the depreciable period has not ended before the close of the tax year. Under an exception to this limitation, the W-2 wage limitation does not apply to reduce the amount of the full QBI deduction until an owner’s taxable income exceeds $157,500 or $315,000 for joint filers (the “Threshold Amount”). In other words, the full 20% QBI deduction is allowed for owners with taxable incomes under the Threshold Amount. The W-2 wage limitation is phased in for taxable income over the Threshold Amount and is fully applicable for taxable incomes which exceed the Threshold Amount by $50,000 for individuals and $100,000 couples (i.e., $207,500 for individuals, and $415,000 for joint returns).
Specified Service Businesses. Owners of specified service businesses (as described above) with taxable income below the Threshold Amount are eligible for the full 20% QBI deduction. Unfortunately, the QBI deduction is phased out and eliminated for owners with taxable incomes in excess of $207,500 for individuals, and $415,000 for joint returns.
Trusts and Estates. Trusts and estates are eligible for the 20% deduction under Code section 199A. Rules similar to the rules under present-law Code section 199 (as in effect on December 1, 2017) apply for apportioning W-2 wages and unadjusted basis of qualified property between fiduciaries and beneficiaries.
Example: Taxpayer owns an office building that has an unadjusted basis when purchased of $10,000,000, of which $8,000,000 is allocated to a depreciable building. Taxpayer has four employees with a total W-2 wages paid of $300,000. Taxpayer’s net income from the building is $1,000,000.
Information Needed to Calculate the QBI Deduction:
20% of qualified business income: $200,000
50% of W-2 wages: $150,000
25% of W-2 wages: $75,000
2.5% of the unadjusted basis of depreciable property: $200,000
The lesser of: (i) $200,000 (QBI) or (ii) the greater of: (a) $150,000 (50% of W-2 wages) or (b) $275,000 (25% of W-2 wages plus 2.5% of unadjusted basis of depreciable property).
Answer: The maximum QBI deduction is allowed since $200,000 is less than $275,000 which results from the combined wage and depreciable basis calculation. The result would remain the same if the taxpayer in the above example had no employees since 2.5% of $8,000,000 is $200,000, an amount equal to $200,000. If the value of the unadjusted basis of the building is reduced to $7,000,000 and there are no employees, the QBI deduction would be limited to $175,000 (which is 2.5% of $7,000,000).
Sunset: The Section 199A provisions discussed above expire on December 31, 2025, unless Congress extends or eliminates the sunset date.
Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.