When the Tax Cuts and Jobs Act was passed in a whirlwind vote at the end of 2017, significant questions arose regarding implementation of the new law -- and one of the biggest sticking points was the 20 percent deduction under Section 199A. It took the IRS a little over seven months to officially comment. On Aug. 8, 2018, the IRS issued proposed regulations to help explain this deduction. The proposed regulations were a short, easy read of 184 pages.
The deduction will take effect in tax years starting Jan. 1, 2018, or after. Those eligible include pass-through entities (such as S corporations, LLCs, LPs, GPs, etc.), sole proprietors, and certain trusts and estates. A basic example would be for someone who owns their own business and made $100,000 in 2018. Under this example, you would get a $20,000 cash-free deduction and only pay tax on the net $80,000 of taxable income.
As with anything, there are always exceptions. In this case, certain exceptions apply to those who work in any of the following industries: accounting, health, law, consulting, athletics, actuarial sciences, financial services, brokerage services, performing arts, or any trade or business where the principal asset of the trade of business is the reputation or skill of one or more of its employees. These are known as “Specified Service Trades or Businesses” or SSTBs.
And of course, there are exceptions to the exception. The deduction is available to SSTBs whose 2018 taxable income is below $315,000 (married filing joint), and $157,500 for other taxpayers. Should a taxpayer's taxable income go above these limits, they will be subject to phase-out of the 20 percent deduction up to $415,000 (married filing joint) or $207,500 (other taxpayers).
There are limitations, however, to the 20 percent deduction even if the business is not an SSTB. If the taxpayer's income is above the higher taxable threshold and the business is not an SSTB, then the calculation is limited to:
- The lesser of 20 percent of the business’s qualified income; or,
- The greater of 50 percent of the W-2 wages of the business, or 25 percent of the W-2 wages of the business and 2.5 percent of the business’s unadjusted basis in all qualified property.
In these cases, W-2 wages are defined as wages subject to withholding, elective deferrals and deferred compensation paid during the tax year that contribute to the business' qualified income. Basis in qualified property is defined as tangible, depreciable property, available for use in the business at the end of the tax year and used in the production of qualified business income.
A not-so-basic example would look like the following: Mr. and Mrs. Smith are planning to file a joint income tax return and they have a taxable income of $800,000. Their taxable income is $500,000 of ordinary income from an S corporation that is not an SSTB. The applicable share of W-2 wages is $150,000. The unadjusted basis in the property is $400,000. In this situation, the “20 percent deduction” will be calculated as follows:
- The lesser of 20 percent of $500,000 ($100,000); or,
- The greater of 50 percent of W-2 wages, or 25 percent of W-2 wages and 2.5 percent unadjusted basis in property (($150,000 * 50% = $75,000) or ($150,000 * 25% = $37,500) + (400,000 * 2.5% = $10,000) = $47,500).
In this example the limitation is the lesser of $100,000 or $75,000; therefore, the 20 percent deduction for Mr. and Mrs. Smith will be $75,000.
But the biggest question of all is, what happens if the taxpayer's taxable income falls between the income limitations, if they have qualified business income, W-2 wages, unadjusted basis in property, and they are deciding to file separately from their spouse? That’s when clients need to talk to their tax advisors.
As you can see, this is a very complex part of the new tax law. There are many nuances within the law, and clients will be turning to their tax advisors for guidance.
