New Deduction for Pass-Through Entities
One of the most discussed provisions of the recently enacted Tax Cuts and Jobs Act is Section 199A, which deals with the taxation of so called “Pass-Through” entities (“pass-throughs”) and specifically, a potential 20% deduction for such entities. Pass-throughs are Subchapter S corporations, limited liability companies, partnerships, and sole-proprietorships. The goal of the deduction was to bring the tax benefits for pass-throughs in line proportionately with the tax benefits provided for C (non-Subchapter S) corporations; but the 20% deduction is subject to many limitations.
The deduction is offered to individuals, estates and trusts on business income earned in the United States. The deductible amount is 20% of a taxpayer’s “qualified business income” (“QBI”)1. The full 20% deduction is limited for taxpayers with taxable income in 2018 that exceeds $157,500 (single) or $315,000 (joint).
This is a “below the line” deduction, meaning it can be taken whether or not a taxpayer itemizes her deductions. As with most of the non-corporate tax provisions in the new law, Section 199A is set to sunset at the end of 2025.
As we were going through the new law, we found it easiest to understand if we asked a series of questions to progress through the law. Hopefully, these questions will take you through the article and then come together at the end as we walk through various examples.
The most important question is:
Does the taxpayer have any QBI for the given year?
QBI is the net amount of “qualified items of income, gain, deduction and loss” received from a qualified pass-through. This is a roundabout way to describe the taxable income from a US trade or business that is not a C corporation. In other words, this will not include income derived outside of the pass-through (e.g., dividends, interest, capital gains and losses), W-2 income as an employee of the pass-through, or any income from a foreign company. If the taxpayer’s net QBI is negative in any year, this amount can be carried over to the next tax year to be applied against any QBI in that year.
If the taxpayer has QBI in the current tax year, the next question is:
What is the taxpayer’s taxable income?
If the taxpayer has 2018 taxable income2 (this is QBI plus any other income minus deductions) less than or equal to $157,500 for a single taxpayer and less than or equal to $315,000 for a married couple filing jointly, the taxpayer will be able to claim a deduction equal to 20% of the taxpayer’s QBI (the “Deduction”).
If the taxpayer has 2018 taxable income in excess of $157,500 for a single taxpayer and $315,000 for a married couple, the Deduction will be subject to limitations which are phased in until the taxpayer’s 2018 taxable income is $207,500 for a single taxpayer and $415,000 for a married couple filing jointly (the “Threshold”).
What are the limitations applied to the Deduction?
There are three categories of limitations:
1) Specified Service Business Income
Income derived from a “Specified Service Business” will not qualify as QBI if a taxpayer’s taxable income is in excess of the Threshold. Specified Service Businesses are (i) a business involving the performance of services in the fields of athletics, law, health, accounting, actuarial science, performing arts, consulting, financial services, and brokerage services; (ii) a business where the primary asset is the reputation or skill of one or more of its owners or employees; or (iii) a business involving the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities.
Organizing businesses to avoid this limitation will likely be the most discussed implication of the new law. The Treasury has been given a directive to issue regulations on the new law; we suspect this will be a focus of any regulations.
2) Wage Limitations
When taxable income is above the Threshold, the Deduction cannot exceed the greater of (i) 50% from a non-Specified Service Business of the taxpayer’s allocable share of W-2 wages paid by the qualified business, and (ii) 25% of the taxpayer’s allocable share of W-2 wages paid plus 2.5% of the unadjusted basis of tangible depreciable assets used in the business that are on hand at the close of the taxable year and still within their depreciable period.
The 25% limitation is designed to allow businesses with large capital investments (real estate, machinery, etc.) but with low W-2 wages to utilize the Deduction.
3) Overall Limitation
Overriding everything else, the Deduction is limited to 20% of the excess of the taxpayer’s taxable income over the taxpayer’s net capital gain for the year.
If you have made it to this point in the article, you are probably thinking, “I thought they said that walking through the Deduction with steps and questions would make it easier to understand.” However, we think it is important to understand the various steps in the law; and hopefully, the following examples will help bring it all together and show you how the Deduction will be implemented.
1) Hannah, a single taxpayer, owns “Hannah’s House”, a single member LLC holding commercial real estate that was purchased 4 years ago for $6.5 million ($4.5 million for the building and $2 million for the land). Hannah has one employee who has W-2 wages of $45,000 and acts as a property manager. For 2018, Hannah receives $430,000 of QBI from Hannah’s House and $60,000 of dividend income. Hannah has $20,000 of itemized deductions.
Hannah is over the Threshold and, therefore, subject to the Wage Limitations. The Deduction will be limited to $133,750 (25% of the W-2 wages – $11,250, plus 2.5% of the depreciable property value – $112,500). Since 20% of Hannah’s QBI equals $86,000 and is less than $133,750, she will be able to take the entire $86,000 as the Deduction.
For comparison, if the building was valued at $2 million (and there were no other depreciable assets), the Deduction would be limited to $61,250 (25% of the W-2 wages – $11,250, plus 2.5% of the depreciable property value – $50,000).
2) Tom and Maggie Smith are a married couple who will be filing jointly in 2018. Tom is a W-2 worker and makes a salary of $175,000. Maggie is a shareholder in an S-Corporation, “The Other Shoe”, which produces the plastic tips for shoelaces. The Other Shoe distributes $750,000 to Maggie in 2018. There are $450,000 in W-2 wages attributed to Maggie’s allocable ownership share in The Other Shoe. There are also $75,000 of dividends in 2018 from a jointly owned brokerage account and $50,000 worth of itemized deductions.
Since Maggie and Tom are over the Threshold, they are subject to the Wage Limitations. Assuming The Other Shoe has no depreciable tangible property, the Deduction will be limited to 50% of the W-2 wages attributed to Maggie. Because 20% of Maggie’s QBI ($150,000) is less than 50% of her allocable share of W-2 wages ($225,000), the Deduction is $150,000.
3) Maggie’s sister, Siobhan, and her spouse Liz are a married couple who will be filing jointly in 2018. Siobhan is also an owner of The Other Shoe, but with a smaller ownership stake. Liz owns a sole proprietorship that is a coffee shop and bakery, “Dough and Joe”.
Siobhan receives $150,000 of QBI from The Other Shoe and $25,000 of W-2 income from working part time at Dough and Joe. She has $90,000 of W-2 wages from The Other Shoe attributed to her ownership share.
Liz receives $170,000 of QBI from Dough and Joe and pays $35,000 in W-2 wages in 2018. She also owns the building in which Dough and Joe operates and tangible depreciable assets with an aggregate unadjusted cost basis of $800,000.
Liz and Siobhan also have investment income of $94,750 in dividends. They have $80,000 of itemized deductions in 2018.
The Deduction for each qualified business interest must be calculated separately and then added together. The total taxable income for Liz and Siobhan exceeds the Threshold, but is not fully phased out.
Siobhan’s Wage Limitation will be calculated using 50% of the W-2 wages. Because 50% of the W-2 wages ($45,000) is greater than the Deduction (20% x $150,000 = $30,000), the Deduction will not be limited; therefore, Siobhan is entitled to a Deduction of $30,000.
Liz’s Wage Limitation will be calculated using 25% of the W-2 wages ($8,750) plus 2.5% of the depreciable tangible property ($20,000) for a total of $28,750. If Liz was subject to a full phase out, she would be limited to a Deduction of $28,750, rather than 20% of her QBI – $34,000. The phaseout applies a percentage to the difference between the limitation and the full Deduction until it reaches 100% at $207,500 ($415,000 for a married couple). Therefore, Liz and Siobhan’s total taxable income ($359,750) is reduced by the beginning value of the phase out limit ($315,000) and that number ($44,750) is divided by $100,000 to get a percentage (44.75%). That percentage is then applied to the difference between the full Deduction and the limited amount ($34,000 minus $28,750 = $5,250; $5,250 x 44.75% = $2,349.38). Lastly, the full Deduction is reduced by this number to get the deductible amount: $34,000 minus $2,349.38 = $31,650.62
Liz and Siobhan will be able to take a Deduction of $61,650.62 against their QBI of $320,000.
4) Joe, a single taxpayer, owns “Joe’s Two Cents”, a consulting business structured as a single member LLC. Joe is the sole member. He receives $100,000 of W-2 wages and a $50,000 distribution of profits in 2018 which is his QBI. He has no other income and no deductions for purposes of this illustration.
Joe is entitled to a Deduction of $10,000.
5) Assume that Joe in the previous example is married filing jointly and is the only income producing spouse — with $200,000 of QBI, $50,000 of W-2 wages, $150,000 of net capital gain and $90,000 of itemized deductions, resulting in taxable income of $310,000.
Since Joe’s and his spouse’s taxable income is under the Threshold, the Specified Service Business Limitations and the Wage Limitations do not apply. The Deduction is equal to 20% of QBI of $200,000, or $40,000. The amount of taxable income less net capital gain is $160,000 ($310,000 minus $150,000). However, the Deduction cannot be greater than 20% of taxable income less net capital gain. Therefore, the Deduction will be reduced from $40,000 to 20% of $160,000, or $32,000.
This article is meant to help explain a complicated and new area of tax law. It is not all encompassing and should not be relied upon for your own tax planning. Hopefully, it was helpful in putting some context on this concept and will lead to you discussing your specific situation with a tax professional. As we get closer to 2019 and various options for structuring businesses and tax planning are further refined, we hope there will be greater clarity, especially if/when the Treasury issues regulations.
1The deduction also applies to dividends of qualified real estate investment trusts (“REITS”) and qualified publicly traded partnership income; but for simplicity’s sake this article will use QBI to discuss all qualified income.
2It is important to note that this deduction is calculated using taxable income (which is income net of deductions other than the Deduction) rather than adjusted gross income (which is income before deductions).
This material is provided for illustrative purposes only. The material is not intended to constitute investment, financial or tax advice. You should contact your accountant or tax professional for advice regarding your specific situation. Effort has been made to ensure that the material presented is accurate at the time of publication. This information, however, is meant as an overview and not a full and exhaustive review of a complicated law. It should not be relied upon for actions, as it may not be applicable for your specific situation.
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