Taxes - Income, Estate and Gift
The Tax Cuts and Jobs Act ("TCJA"), signed into law on December 22, 2017, created a brand new code section to help lower the tax burden on owners of certain pass-through entities. This new code section is Section 199A - Deduction for Qualified Business Income of Pass-Through Entities.
The new provision offers a 20% deduction with respect to "qualified business income," which may lower the top effective marginal rate to 29.6% on such income. Without the new deduction, pass-through income is taxed at the ordinary income tax rate of each shareholder, partner or owner—at a maximum federal tax rate of 37% under the TCJA.
The deduction is calculated at the shareholder or partner level, and it reduces taxable income directly. It is not an itemized deduction.
Entities taxed as C-corps do not qualify. Only "pass-through" entities such as S-corps, partnerships, disregarded entities and sole proprietorships may qualify. Most LLCs are taxed as pass-through entities.
The deduction is temporary. It went into effect on January 1, 2018, and it is set to expire on December 31, 2025, under current law.
The deduction is limited to "qualified business income" (QBI), which includes the net amount of qualified items of income, gain, deduction and loss from a domestic trade or business. Explicit exceptions include: capital gains and losses, dividends, payments in lieu of dividends, interest and annuity income (other than that properly allocable to a trade or business), reasonable compensation paid to a taxpayer by a qualified trade or business, any guaranteed payments paid to partners, REIT dividends, qualified cooperative dividends, or qualified publicly traded partnership income.
Certain "specified service businesses" may see reduced benefits or no benefits at all. For owners of a specified service business, the deduction begins to phase out at taxable income of $315,000 (for married filing jointly) and is eliminated once taxable income exceeds $415,000. A specified service business includes a business that performs services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of the business is reputation or skill of one or more employees.
Non-service business owners with taxable income in excess of $315,000 (for married filing jointly) will also begin to see certain limitations phased in. The limitations are completely phased in once taxable income reaches $415,000. For these non-service businesses, the deduction may be limited on the basis of wages paid and/or capital of the business. Generally, the limitation is the greater of (i) 50% of W-2 wages, or (ii) 25% of W-2 wages plus 2.5% of unadjusted basis of qualified property. Wages refers to the amounts paid to employees during the calendar year that is attributable to QBI which is properly reported to the Social Security Administration. Qualified property is property used in the qualified business which is subject to depreciation that is acquired or depreciated within specific periods.
The new code section is fairly complex and leaves tax professionals with many unanswered questions. The law explicitly requires the Secretary of the Treasury to prescribe regulations relating to the application of the new code section to tiered entities as well as to implement anti-abuse rules. Treasury Regulations and IRS guidance that bring clarity and add certainty will be much-welcomed by tax professionals and their clients alike.
The new law creates many planning opportunities. For example, managing taxable income may take on increased importance as it could mean the difference between eligibility for the deduction and falling short of strict income limits. This may be especially important for taxpayers in specified service businesses where the deduction is eliminated at certain income thresholds. For non-service businesses, increasing wages and/or investment could allow owners to take advantage of a deduction that might otherwise be left unused.
Business owners should consider contacting a trusted CPA, tax attorney or financial professional to explore strategies for capitalizing on the new deduction to the greatest extent their specific circumstances and business permit.
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