The provision in the Tax Cuts and Jobs Act for a deduction of up to 20 percent of pass-through trade or business income is one of the more complex parts of the law.
New Code Section 199A, in effect from 2018 to 2025, creates a deduction under which a non-C corporation business owner can deduct against their taxable income -- subject to a limitation and a phaseout -- an amount equal to the lesser of 20 percent of “combined qualified business income” (determined by distributive shares excluding owner wages or guaranteed payments in the case of a flow-through entity) or 20 percent of tentative taxable income less net capital gain.
At a webinar hosted by AccountingToday, David De Jong, a CPA and a partner at Rockville, Md.-based law firm Stein Sperling Bennett De Jong Driscoll PC, described the steps necessary to compute the deduction:
- Step 1: Determine the taxable income ignoring this deduction and any capital gains losses. Compute 20 percent of this number.
- Step 2: Determine the taxpayer’s business income, totaling their income net of losses from wholly owned and flow-through businesses and applying any combined qualifying business loss which has been carried forward. Ignore capital gains/losses, dividends and nonbusiness interest. Compute 20 percent of this number.
If the taxpayer’s taxable income, ignoring this deduction, is less than $315,000 on a joint return or $157,000 otherwise, their deduction is the lesser of the figures from Step 1 or Step 2. These numbers are indexed in 2019 and succeeding years for cost of living.
If their taxable income, ignoring this deduction, is more than $415,000 on a joint return or $207,500 otherwise, the computation under Step 2 is limited by the greater of:
- 50 percent of W-2 wages; or,
- 25 percent of W-2 wages plus 2.5 percent of the original basis of qualified property.
‘Sharpen your pencil’
Although preparation software will do some of the complicated calculations, now is the time to prepare your clients, according to Ruth Wimer, a CPA and a partner in the Washington, D.C., office of law firm Winston & Strawn LLP.
“Code Section 199A will keep accountants busy,” she observed. “Individual taxpayers will have to decide what trade or business they are in, and decide if it is a specified service or not. If they happen to have more than one trade or business, they have to sort out the accounts for each and separate the payroll wages for each. A single LLC might operate multiple trades or businesses, so you will have to sharpen your pencil and figure what is the income from each trade or business that is eligible.”
“There is a huge divide between specified services and non-specified services, and then there’s also the distinction of who even has a trade or business, since only a trade or business can get the deduction,” Wimer said. She noted that “trade or business” is not precisely defined by Section 199A, and that for higher-income taxpayers, W-2 wages paid both to themselves and to others is a key factor in obtaining the 20 percent deduction.
“The new deduction encourages entrepreneurship,” she noted. “For example, accountants, attorneys and journalists working as independent contractors or through their own LLC have qualified business income, whereas employees do not. And it encourages those who are not yet making a lot of money. Once they get over a maximum threshold for ‘specified Services,’ there’s no deduction at all.”
“It’s easy for lower-income individuals to obtain the 20 percent deduction for qualified business income,” she said. Individuals with total income less than $157,500 for single filers and $315,000 for joint filers can deduct 20 percent of qualified business income even if from a ‘specified service’ and also without regard to the amount of employee payroll or depreciable assets. It is only higher-income taxpayers that receive no deduction or that are subject to the Form W-2 limits.”
“The complexity starts for individuals with over $157,500 to $207,500 [single] and $315,000 to $415,000 income [joint],” she said. “In that range, ‘specified service’ income gets phased out to zero but at the same time is also subject increasingly to the Form W-2 limits until no further deduction can be had. Other than ‘specified services’ [income] just gradually becomes subject to the Form W-2 limits. The Form W-2 limit is the greater of 50 percent of wages or 25 percent of wages plus 2.5 percent of the unadjusted bases of depreciable tangible property used in the trade or business.”
For higher-income taxpayers, the new law encourages hiring employees, Wimer observed, “This is because the higher the payroll of the trade or business, the higher the permitted deduction,” she said. “Trades or businesses with depreciable assets used in the business have an alternative to using just Form W-2 wages.”
But the special definition of Form W-2 wages is not included on Form W-2 at all, she indicated. “Although not an insurmountable task, the proper number to use for Form W-2 wages must be gleaned from the payroll records and isolated as directly related to the particular trade or business,” she said, noting that one legal entity may have multiple trades or businesses. “The definition of Form W-2 wages is generally that used for withholding purposes with the addition of employee qualified plan deferrals.”
“However, remember that the ‘specified service’ deduction is completely gone once the taxpayer is over $207,500 (single) and $415,000 (joint),” she said. “Non-specified service can retain the 20 percent deduction indefinitely, subject to the Form W-2 wage limitation.”
Wimer observed that there has been much angst over the determination of “specified services” by high-income taxpayers, noting that it’s not important to lower-income taxpayers because, for them, the 20 percent deduction applies regardless of the characterization as a specified service. She noted that “specified services” includes not only those listed (attorneys, accountants) but also any business where the principal asset is the “reputation or skill” of its employees or owners. “Thus, higher-income taxpayers are put in the ironic position of stating that neither the skills nor the reputation of employees is the principal asset of the trade or business.”
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