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The Republican tax plan that was passed at the end of 2017 altered many well-established tax provisions for C corporations, flow-through entities and sole proprietorships alike. This tax reform bill, now called the Tax Cuts and Jobs Act (TCJA), changed a few guidelines for non-corporate entities when it added Section 199A into the tax code. Section 199A allows owners of flow-through entities to take a 20% deduction against their business income in tax years 2018 through 2025. If you are the owner of a small or medium-sized business, your tax return may look quite different come April 15th, so you should prepare yourselves for these changes sooner rather than later. The essential details of the proposed regulations are covered in this blog, note the final regulations have been published and we will provide information on any differences that impact clients and prospects.
Why Section 199A Was Written Into Law
Lobbyists sold the Section 199A (§199A) deduction to the general public as a commeasure to the C corporation tax rate reduction. When Congress called for this reduction, which brought the C corporation rate from 37% down to a historically low 21%, they put flow-through businesses (like partnerships and S corporations) at a disadvantage. The income from these flow-through entities was getting taxed at the much higher individual income tax rates. By allowing the owners of flow-through entities to take a 20% deduction on their business income, the playing field was leveled for all business entities once again.
How it Works
The QBI Deduction is reported on the individual income tax returns of flow-through business owners – shareholders in an S corporation, partners in a partnership, etc. The deduction is used as a tool to lower their effective tax rates. These business owners can deduct up to 20% of their portion of the business’s “qualified business income.” Qualified business income is all of a business’s income, gain, deduction and loss from a qualified trade or business, less certain unearned income like capital gains and losses.
Section 199A has four distinct limitations taxpayers must consider before calculating their deduction.
The deduction is limited to owners of pass-through entities and sole proprietorships.
This includes partnerships, S corporations, unincorporated businesses, and in some instances, trusts and estates. This deduction is not available to owners of C corporations.
The deduction is limited to the taxpayer’s taxable income for the year reduced by their net capital gain.
If the deduction as calculated exceeds the taxpayer’s taxable income less capital gains and losses, they can carry over unused amounts to the following year.
The deduction is subject to a limitation based on the taxpayer’s reported taxable income.
The more taxable income reported, the smaller the deduction gets. Section 199A divides taxpayers into three categories in order to calculate their limitation. (1) Married taxpayers whose taxable incomes do not exceed $315,000 (or $157,500 for non-married taxpayers) will be eligible for the full deduction. (2) Married taxpayers whose taxable incomes exceed $415,000 (or $207,500 for non-married taxpayers) will face a wage limitation described below. (3) Married taxpayers whose taxable incomes are greater than $315,000 but do not exceed $415,000 (or $157,500 and $207,500 for non-married taxpayers, respectively) must gradually apply the wage limitation as their taxable incomes approach the upper threshold.
The §199A deduction will be limited to the greater of (1) 50% of the taxpayer’s share of the business’s W-2 wages, and (2) the sum of 25% of those same W-2 wages plus 2.5% of their share of the basis the business holds in qualified business property.
The deduction is further limited for taxpayers who work in specified service trades or businesses (SSTBs).
SSTBs are businesses that perform services in the following fields:
- Actuarial science
- Performing arts
- Financial services
- Brokerage services
SSTBs also include businesses whose services rely on the reputation or skill of its employees.
Owners in SSTBs will begin to lose their deduction once their taxable incomes exceed the lower thresholds ($315,000 married and $157,500 non-married). The deduction will be eliminated completely when their taxable incomes exceed the upper thresholds ($415,000 married and $207,500 non-married).
The §199A deduction was a never-before-seen deviation from our existing tax code. When it was passed, there remained quite a few unknowns. Taxpayers wondered how people with multiple businesses could calculate the deduction. Would that deduction change if their businesses were related? Could the incomes from multiple businesses be aggregated to calculate the deduction? Many of these questions were answered by the IRS in the proposed regulations and confirmed in the final regulations. If you have questions about the Qualified Income Deduction and how you can benefit from it, JLK Rosenberger can assist. For additional information, please call us at 949-860-9893 or click here to contact us. We look forward to speaking with you soon!