Many people believe one of the cornerstones of the Tax Cuts and Jobs Act of 2017 (TCJA) is the Section 199A deduction. This is an important deduction against income tax of up to 20 percent of qualified business income (QBI) from a domestic business operated as a sole proprietorship, partnership, S-corporation, trust or estate. Given the many complexities surrounding the deduction, the IRS has issued proposed regulations intended to clarify the new tax provision.
Under the TCJA, QBI eligible for the deduction is all ordinary income earned in a trade or business, but it does not include shareholder wages, guaranteed payments or capital gains, even if they are earned from a pass-through entity. The 199A deduction is available to eligible taxpayers for the first time on the 2018 federal income tax return they will file in 2019. Taxpayers may rely on the rules in the proposed regulations until final regulations are published in the Federal Register.
In determining how the deduction will apply, there are two brackets of individuals that taxpayers must be aware of—taxpayers who have taxable income below $315,000 married filing jointly (MFJ) or $157,500 all other filers (AOF) and those who have taxable income above $415,000 (MFJ) or $207,500 (AOF). For taxpayers with taxable income between these two amounts, the 199A deduction applies, but is subject to certain phaseouts. For taxpayers with taxable income below the initial threshold, the 199A deduction applies regardless of profession or business activities performed. Simply said, these taxpayers get the 199A deduction without limitation.
However, for taxpayers with taxable income above the second threshold, the profession or business activity performed by the taxpayer must be considered. The IRS has indicated that taxpayers involved in health, law, accounting, actuarial sciences and certain other professions do not get any 199A deduction once their income exceeds the second threshold. Taxpayers with income falling between the first and second thresholds received a reduced deduction. All other taxpayers who do not work in the lines of service specifically disallowed by the IRS continue to get the deduction, without any phaseout, even after their income exceeds the second threshold.
Taxpayers who have taxable income above the $315,000 MFJ/$157,500 AOF threshold amounts and are not in a disallowed service line still aren’t completely in the clear. The 199A deduction will be limited to the greater of 50 percent of their W-2 wages, or the sum of 25 percent of their W-2 wages, plus 2.5 percent of the unadjusted basis of qualified property.
There are three ways to calculate wages to determine what the starting point of the W-2 wage limitation will be. The simplest way to calculate total wages for the purpose of this limitation is to take the lesser of all the wages reported in box 1 of the employee’s W-2s or the total wages reported in box 5 of the W-2s. Other methods for calculating wages include making adjustments to box 1 of the W-2 for employee contributions to qualified plans or determining wages subject to federal income tax withholding. Once the taxpayer has properly calculated wages, they must then compare the amount of their 199A deduction to 50 percent of the wages they calculate. The 199A deduction cannot be higher than 50 percent of the wages and is thus limited to that amount.
Taxpayers who don’t have a substantial amount of W-2 wages but do have an adequate amount of property can use the 25 percent of wages (as calculated above) plus 2.5 percent of the unadjusted basis of qualified property. To help calculate the unadjusted basis of qualified property, taxpayers will need to look at their fixed asset records at year end and take 2.5 percent of the cost basis (predepreciation) for assets other than land and assets purchased within the last 60 days of year end.
For taxpayers who have multiple pass-through entities that may be limited by either 50 percent of wages or 25 percent of wages and 2.5 percent of qualified property, there may be some benefit in looking to aggregate their ownership in these entities for the purposes of the 199A deduction.
The new 20 percent deduction of your QBI is a significant outcome of the tax reform act, as long as you understand how it can be applied. There are several complexities surrounding the deduction, particularly if your income exceeds the threshold.