Estate and Succession Planning
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New Deduction For Qualified Business Income of S Corporations, Partnerships, LLCs and Sole Proprietorships
Effective January 1, 2018, the Tax Cuts and Job Act, formally entitled “An Act to Provide For Reconciliation Pursuant to Titles II and IV of the Concurrent Resolution on the Budget for Fiscal Year 2018” (the “Tax Act”), enacts new Internal Revenue Code (“Code”) Section 199A which generally provides a deduction of 20% of the “Qualified Business Income” (“QBI”) from a S corporation, partnership, LLC (taxed as a partnership) or a sole proprietorship. Although new Section 199A also provides rules for dividends from qualified real estate investment trusts, dividends from qualified cooperatives and income from publicly traded partnerships, this Article will focus on the deduction applicable for owners of S corporations, partnerships, LLCs and sole proprietorships.
The Deduction in General
For taxable years beginning after December 31, 2017 and before January 1, 2026, taxpayers (including estates and trusts) other than corporations generally may deduct 20% of the QBI of an S corporation, partnership, LLC or a sole proprietorship allocable to such shareholder, partner, member or sole proprietor. In order to obtain the full benefit of the deduction without being subject to the wage and capital limitations discussed below, the taxable income of the shareholder, partner, member or sole proprietor must be less than $157,500 or less than $315,000 in the case of a married taxpayer filing jointly.
Qualified Business Income
The term QBI generally means the net amount of “qualified items of income, gain, deduction and loss” with respect to any “qualified trade or business” of the taxpayer. Qualified items of income, gain, deduction and loss mean items of income, gain, deduction and loss to the extent such items are effectively connected with the conduct of a trade or business within the United States (in other words, QBI only includes domestic income and not foreign income). However, in the case of a taxpayer who otherwise has QBI from sources within the commonwealth of Puerto Rico, provided all of the income is taxable, the taxpayer’s income from Puerto Rico will be included in determining the individual’s QBI.
This section leaves open what constitutes a “trade or business” for purposes of determining the deduction. There are a number of different interpretations of what constitutes a trade or business under the Code, with the highest standard being that of a Section 162 trade or business. In order for an activity to achieve that standard, the business must be regular, continuous and substantial. Hopefully, there will be further guidance on what constitutes a “trade or business” for purposes of the new 199A deduction, or expect lots of litigation over this issue.
Qualified items also do not include specified investment-related income, deductions or loss. Specifically, qualified items do not include short-term capital gain or loss, long-term capital gain or loss, dividend income or interest income. Additionally, QBI does not include any amount paid by an S corporation that is treated as reasonable compensation to the taxpayer, nor does it include any guaranteed payments made by a partnership to a partner for services rendered with respect to the trade or business or any other amounts paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.
As will be discussed in more detail below, a qualified trade or business means a trade or business other than a “specified service trade or business” and other than the trade or business of being an employee.
The deduction reduces a taxpayer’s taxable income but not his or her adjusted gross income (i.e., it is a “below the line” deduction). However, the deduction is available whether you itemize deductions or take the standard deduction.
Limitation Based on W-2 Wages and Capital
For businesses other than a “specified service business” (which will be discussed below) and for which the taxpayer’s taxable income exceeds $207,500, or $415,000 if married filing jointly, the deducible amount for each trade or business carried on by the S corporation, partnership, LLC or sole proprietorship is the lesser of 20% of the taxpayer’s allocable share of QBI with respect to the qualified trade or business; or the greater of (a) the taxpayer’s allocable share of 50% of the W-2 wages with respect to the qualified trade or business, or (b) the taxpayer’s allocable share of 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” (the wage and capital limitations).
W-2 wages are wages paid to an employee, including any elective deferrals into a Section 401(k)-type vehicle or other deferred compensation. W-2 wages do not include, however, things like payments to an independent contractor or management fees.
For purposes of the provision, “qualified property” means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year, which is used in the production of QBI sometime during the taxable year, and for which the depreciable period has not expired before the close of the taxable year. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date ten years after such date; or (b) the last day of the full year in the asset’s normal depreciation period.
Phase-In of Wage and Capital Limitations
For taxpayers having taxable income between $157,500 and $207,500 ($157,500 plus $50,000), or with respect to married individuals filing jointly having taxable income between $315,000 and $415,000 ($315,000 plus $100,000), the wage and capital limitations are phased in. Specifically, if the wage and capital limit is less than 20% of the taxpayer’s QBI with respect to the qualified trade or business, the taxpayer’s deductible amount is determined by reducing 20% of QBI by the same proportion of the difference between 20% of the QBI and the wage and capital limit as the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return). Again, once the taxpayer has $207,500 of taxable income, or $415,000 of taxable income in the case of a married individual filing a joint return, the wage and capital limitations apply fully to the taxpayer.
Specified Service Trade or Business
The Tax Act defines a specified service trade or business as any trade or 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 who are owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. It should be noted that engineering and architecture services are specifically excluded from the definition of a specified service trade or business. Because a specified service trade or business includes “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 who are owners,” there will be a great deal of uncertainty as to whether certain businesses are a specified service trade or business, and thus expect a great deal of litigation to ensue on this issue.
Even though a specified service trade or business is not a qualified trade or business, such business will nevertheless be eligible for the 20% of QBI deduction provided that the taxpayer’s taxable income is less than the threshold amounts of $315,000 in the case of married individuals filing joint returns and $157,500 for all other taxpayers. The ability to take the deduction for 20% of QBI for a specified service trade or business is phased out for a taxpayer having taxable income between $315,000 and $415,000 in the case of married individuals filing joint returns, and code between $157,500 and $207,500 for all other taxpayers. Specifically, for a taxpayer with taxable income within the phase-out range, the taxpayer takes into account only the “applicable percentage” of qualified items of income, gain, deduction or loss, and of allowable W-2 wages. The applicable percentage with respect to any taxable year is 100% reduced by the percentage equal to the ratio of the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 (or $100,000 in the case of a joint return).
Consequently, the deduction for 20% of QBI is not available at all for shareholders, partners, members or sole proprietors of a specified service trade or business whose taxable income is $207,500 or above, or in the case of married individuals filing a joint return, $415,000 or above.
Overall Limitation
In addition to the other limitations described above, the maximum amount of deduction available under new Section 199A cannot exceed 20% of the excess of the taxpayer’s taxable income less any capital gain for the taxable year.
Summary
In the case of a qualified trade or business other than a specified service trade or business, if the shareholder’s, partner’s, member’s or sole proprietor’s taxable income is less than the threshold amount ($157,500 or $315,000), such owner will generally be entitled to deduct 20% of his allocable share of the QBI from an S corporation, partnership, LLC or sole proprietorship. In the event that the taxable income of such shareholder, partner, member or sole proprietor is over the full phased-in amount ($207,500 or $415,000), the deduction is equal to the lesser of (1) 20% of the taxpayer’s allocable share of QBI from the S corporation, partnership, LLC or sole proprietorship; or (2) the greater of (a) the taxpayer’s allocable share of 50% of the W-2 wages of the qualified trade or business; or (b) the taxpayer’s allocable share of 25% of the W-2 wages of the qualified trade or business plus 2.5% of the qualified property used in such trade or business.
In the case of a specified service trade or business, provided the taxable income of the shareholder, partner, member or sole proprietor is less than the threshold amounts ($157,500 or $315,000), his or her deduction should be equal to 20% of such taxpayer’s allocable share of the QBI of the S corporation, partnership, LLC or sole proprietorship. However, in the event that the taxable income of the shareholder, partner, member or sole proprietor is over $415,000 for married individuals filing joint returns, or $207,500 for all other taxpayers, no deduction will be allowed for such taxpayer.
Conclusion
Clearly, the rules for the new deduction available to owners of S corporations, partnerships, LLCs and sole proprietorships are extremely complex (and certainly did not simplify the Code), especially where the taxpayer’s taxable income exceeds the threshold amounts ($157,500 or $315,000) discussed above. If you would like to work through the mechanics of the deduction with us, with particular attention to the impact it can have on your specific business, please feel free to call any of the tax attorneys at Dean Mead at your convenience.
Mr. Looney is the chair of the Tax & Corporate department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at slooney@www.deanmead.com.
