On August 8, 2018, the Internal Revenue Service issued proposed regulations for section 199A, the new provision of federal tax law under the Tax Cuts and Jobs Act of 2017 that allows for a tax deduction of up to 20% of business income from a sole proprietorship, S corporation, or partnership, and some estates and trusts.
The regulations state that until final regulations are published, taxpayers may rely on the proposed regulations. Spanning 184 pages, they provide much needed guidance on the operation of the new section 199A deduction and include definitions, computations, examples, rationale, and enforcement guidelines.
While all of the guidance is helpful, I’ll focus here on the essentials that can help you estimate your deduction and plan your year.
Computation Formula
The proposed regulations clarify computation of the section 199A deduction and provide several useful examples.
They first describe the calculation in terms of whether a taxpayer’s taxable income exceeds a particular threshold. For 2018, the threshold amount is taxable income (before the section 199A deduction) of $315,000 for married couples filing joint tax returns and $157,500 for all other tax filing statuses (e.g., single, head of household, married filing separately).
These threshold amounts will be adjusted each year for cost of living. (To keep things as simple as possible, the proposed regulations use the term “individual” to refer to all filing statuses.)
1. Formula for individuals with taxable income at or below the threshold amount (before the section 199A deduction)
An individual with “qualified business income” (other than from a C corporation or as an employee) and with taxable income before section 199A deduction below the threshold amount may take a section 199A deduction equal to the lessor of:
(i) 20% × (qualified business income) + 20% × (qualified REIT dividends +
publicly traded partnership income); or
(ii) 20% × ( taxable income - net capital gain)
As a simplified version of an example in the proposed regulations, assume Adam is an unmarried individual who owns and operates a small business as a sole proprietorship. The business generates $100,000 in taxable income in 2018, which is qualified business income. Adam has no REIT (real estate investment trust) dividends, publicly traded partnership income, or capital gains or losses. Adam’s total taxable income for 2018 is $81,000. Based on this information, his section 199A deduction for 2018 is the lesser of the following:
(i) 20% × ($100,000) + 20% × (0) = $20,000; or
(ii) 20% × ($81,000 - 0) = $16,200
With a section 199A deduction of $16,200, Adam’s total taxable income after the deduction is $64,800.
Notice that, as shown in Adam’s case, not all individuals will receive the full deduction of 20% of their pass-through business income. These deductions are subject to a number of restrictions, and the full deduction represents the maximum you can receive.
The proposed regulations confirm that the new section 199A deduction is a deduction from taxable income on a personal tax return (i.e., Form 1040) and not a deduction on a business tax return (i.e., Form 1120S or Form 1065). It is taken on the personal tax return after the standard deduction or itemized deductions are taken, and after taxable income is calculated.
2. Formula for individuals with taxable income above the threshold amount (before the section 199A deduction)
When an individual’s taxable income is above the threshold amount, the same general rule for calculating the section 199A deduction applies. However, further restrictions apply to the qualified business income term in the equation:
(i) 20% × (qualified business income) + 20% × (qualified REIT dividends +
publicly traded partnership income); or
(ii) 20% × ( taxable income - net capital gain)
For those subject to further restrictions around this one term, a taxpayer’s qualified business income (and therefore section 199A deduction) may be limited based on the (1) type of business, (2) the amount of W-2 wages paid by the business, and/or (3) the unadjusted cost basis immediately after acquisition of property used in the business.
Unadjusted cost basis can be thought of as the cost of property (such as equipment and furniture) used in the business at the time it was purchased and before any depreciation. Again, these limitations apply to only the qualified business income component and not to the REIT or publicly traded partnership components of the formula in (i) above.
The factors noted in items (1), (2), and (3) are also subject to “phase-in” rules based on the amount the taxpayer’s taxable income (as reported on Form 1040, before the section 199A deduction and including capital gains) exceeds the threshold amount.
The phase-in range is a range of taxable income that has a lower limit equal to the threshold amount ($315,000 for married couples filing joint tax returns and $157,500 for all other tax filing statuses) and an upper limit equal to the threshold amount plus $100,000 for joint tax returns and $50,000 for all other filing statuses. That is, the phase-in range for married couples filing joint tax returns is currently $315,000 to $415,000. The phase-in range for all other filing statuses is currently $157,500 to $207,500.
The way in which qualified business income may be limited by the phase-in range depends first on what type of business is involved. Certain types of service businesses are treated differently than other types of businesses.
If a business is considered a specified service trade or business (SSTB), it may be subject to additional limitations. Section 199A defines an SSTB as a business in the fields of health, law, accounting, actuarial science, performing arts, 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 of more of its employees or owners.” Engineering and architecture were specially omitted from this list, and therefore service businesses in those two fields are not considered SSTBs.
Importantly, the proposed regulations clarify that the “reputation or skill” requirement applies to income related to an individual’s image, name, voice, endorsements, and appearances (as income would, for example, in the case of celebrities, athletes, and entertainers), alleviating a big concern that nearly all small business would fall under this definition.
For businesses that are SSTBs, if the taxpayer’s taxable income (before section 199A deduction and including capital gains) is above the top of the phase-in range, then no qualified business income (or W-2 wages or unadjusted cost basis as described below) is allowed to be used in the section 199A deduction calculation.
That means taxpayers with SSTBs and taxable income above the top of the phase-in range will not receive any of the potential 20% deduction for qualified business income—they lose it completely—unless they have qualified REIT dividends or publicly traded partnership income. Taxpayers with SSTBs and taxable income within the phase-in range will lose a part of the deduction in proportion with how far their taxable income is into the phase-in range. The actual calculations for deduction limitation within the phase-in range are detailed, complex, and lengthy, and are not covered in this article.
For taxpayers with taxable income above the threshold amount, the qualified business income value to be used in the formula in (i) above is further limited according to the following formula.
The qualified business income amount to be used is determined using the lessor of:
(i) 20% × (qualified business income); or
(ii) The greater of:
a. 50% of W-2 wages paid in that trade or business (including to owners), or
b. 25% of W-2 wages paid in that trade or business + 2.5% of unadjusted
cost basis of property used in the business.
The following simplified example from the proposed regulations illustrates the above calculation. Assume that Ed, an unmarried individual, owns an LLC. In 2018, the LLC, which is not considered an SSTB, had qualified business income of $900,000. The LLC paid total W-2 wages of $300,000, and its unadjusted cost basis of property used in the business was $30,000.
After allowable deductions not related to the LLC, Ed’s taxable income is $880,000. Because Ed’s taxable income is above the top of the phase-in range ($207,500), his qualified business income that is allowed to be used in the section 199A deduction equation, and thus his deduction itself, will be limited by the formula directly above.
For (i), 20% of qualified business income ($900,000) is $180,000. For (ii, a), 50% of the W-2 wages ($300,000) is $150,000. For (ii, b), 25% of W-2 wages ($300,000) is $75,000, and 2.5% of the unadjusted cost basis ($30,000) is $750. Together they total $75,750. For (ii), the greater of (a) ($150,000) and (b) ($75,750) is $150,000. The qualified business income component of Ed’s section 199A deduction is thus limited to $150,000, the lessor of (i) ($180,000) and (ii) ($150,000).
Now let’s place this amount in the general 199A deduction formula. Ed’s section 199A deduction is equal to the lessor of (i) 20% of the qualified business income limited as shown here ($150,000) or (ii) 20% of Ed’s taxable income ($880,000 × 20% = $176,000). Therefore, Ed’s section 199A deduction is $150,000 for 2018.
This example demonstrates the calculation when taxable income exceeds the top of the phase-in range. For taxable income greater than the threshold amount but still within the phase-in range, the limitation applies proportionally to the amount the taxable income extends into the phase-in range. Again, the specific calculations within the phase-in range are (even more) detailed, complex, and lengthy, and are not covered in this article.
A Further Note on Qualified Business Income
Whether an individual’s taxable income falls at, below, or above the threshold amount, qualified business income is defined as the “net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business …”
Importantly, the proposed regulations provide clarification on the definition of “trade or business.” The proposed regulations define trade or business as “a section 162 trade or business other than the trade or business of performing services as an employee.” Section 162 is an important portion of federal tax law that defines allowable expenses for a trade or business and that has been thoroughly litigated in court, providing substantial case law that can be used to help determine whether income meets the definition of coming from a trade or business.
This is particularly relevant to owners of rental income property. The proposed regulations do not provide specific guidance on whether rental income is qualified business income, and so taxpayers must decide whether their rental income is from a trade or business as defined by section 162. The determination is fact-specific to each circumstance. The Supreme Court has provided guidance in this area by noting that an activity may rise to the level of a trade or business for tax purposes if the taxpayer is involved in the activity with continuity and regularity and that the primary purpose of the activity is making income or profit.[1]
If you’d like to explore the proposed regulations further, you can find the full document here. Your tax advisor or financial advisor can also be a valuable resource as you navigate this complex issue.
[1] https://en.wikipedia.org/wiki/Commissioner_v._Groetzinger
