We have written a few articles about the changes to the Tax Code. The change that many professionals are trying to figure out is the 20% deduction for individuals using a pass-through business entity such as a partnership, LLC, “S” corporation or sole proprietorship. Code Section 199A is not just a minor change in already settled law. It is a brand new concept. Even the AICPA has requested – twice – that the IRS and Department of the Treasury provide guidance on the pass-through deduction.
There are a couple of key concepts that are building blocks to understanding Section 199A. Some of these are:
- The business must be a “qualified business.” A qualified business is anything that is not a “specified service trade or business.” This means that service businesses such as accounting, actuaries, brokers, consultants and lawyers are not qualified businesses and cannot take advantage of the deduction. Engineers and architects are qualified businesses, and the owners may use the deduction.
Of course, this exclusion has an exception. If a business would otherwise be disqualified, but the taxpayer has a taxable income less than $207,500.00 for an individual ($415,000.00 for taxpayers filing a joint return), then the taxpayer may be eligible for the deduction. In this case the deduction is phased out depending on how close the income is to that threshold amount.
- The deductible amount requires a lot of calculation. The deduction that a taxpayer can take is the lesser of (A) 20% of the taxpayer’s business income or (B) the greater of either: (i) 50% of the W-2 wages paid by the business; or (ii) the sum of 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of qualified property of the business.
But even this confusing definition has different qualifiers. For example, qualified business income excludes net capital gain. This means that the higher the ratio of net capital gain to taxable income, the lower the pass-through deduction. The deduction favors companies with employees because 50% of the W-2 wages paid could be deductible. On the other hand, if a company has few employees, but creates income through its depreciable assets (such as landlords), they can deduct up to 2.5% of the unadjusted basis of the property.
Trying to figure out Section 199A is like trying to read the instructions on a new computer. Say that you are a financial services consultant. That is a “specified service trade or business” so you would not be eligible for the pass-through deduction. But wait. If your taxable income is less than $207,500.00, you are eligible for at least part of the deduction. Your deduction is 100% reduced by your taxable income in excess of $157,500.00 divided by $50,000.00. In this example, if you have a taxable income of $185,000.00, you would be eligible for 45% of whatever the pass-through deduction would be. Once you figure how much of your deduction is phased out, you have to figure out what the deduction amount is. Is it 20% of your business income? Or is it 50% of the W-2 wages paid by your company? Or is 25% of the W-2 wages of your company plus 2.5% of the basis of your income-producing property? Remember, your deduction is 45% of one of these three numbers.
This blog is not meant to provide tax advice. Rather, this is a simple example that just scratches the surface of the complexity of Section 199A. There are many more issues to consider in this new section. The important thing to note is that Section 199A could be a very large boost to certain taxpayers. In order to get this boost, it will require careful planning of the business throughout the year, and a very good accountant come year end.