Pass Through Entities
The new section applies only to “pass through entities.” The IRC defines this to include LLCs, Limited Partnerships, Sub Chapter-S Corporations, as well as sole proprietors and general partnerships. These entities are disregarded for tax purposes and all income and expenses are “passed through” to the owners. The new rules do not apply to Subchapter-C Corporations.
The new section 199A allows owners of pass through businesses to deduct 20 percent of “qualified business income” (QBI) on their personal tax returns. The deduction is limited to the lesser of the combined QBI amount or 20 percent of taxable income.
What is Qualified Business Income?
Section 199 limits the deduction to “Qualified Business Income.” The IRC defines QBI as “Business income other than investment income, wages, dividends, investment interest income, capital gains (whether short-term or long-term), commodities gains, or foreign currency gains.
QBI does not include amounts paid to owner-employees; (e.g. compensation to S corporation shareholders; guaranteed payments or payments for services to partners in a partnership).
Specified Service Business Limitation
The IRS carved out an exception to the 199A deduction for a “specified services business.” A specified service business is any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, or brokerage services. This exception generally applies to any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.
If you or your business falls into this exception, you are not necessarily out of luck. Taxpayers with annual adjusted gross income below $157,000 ($315,000 if married filing jointly), still qualify for the deduction. An AGI between $157,000 ($315,000 MFJ) and $207,500 ($415,000 MFJ), is subject to the Wage and Capital Limitations built into 199A.
Wage and Capital Limitations
If you are a Services Based Business and fall within the income range described above, your deduction will be limited to the greater of :
- 50% of the W-2 wages with respect to the trade or business or
- the sum of 25% of the W-2 wages with respect to the trade or business and a capital component consisting of 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property
Taxpayer is married and operates a law firm (sole proprietorship) that produces $250,000 per year. He also owns real property that produces $50,000 per year, bringing his total annual income to $300,000.
Taxpayer is operating a specified service business, so his income is not QBI under the general rule, HOWEVER, his income from all sources is below the $315,000 threshold for MFJ, so he is entitled to the full deduction.
If the taxpayer made $400,000 and paid $100,000 in W-2 wages, he is subject to the wage limitation. His deduction under the normal rule is $80,000 (20% x $400,000). Under the limitation his deduction is limited to $50,000 (50% x $100,000).
In one last example, if the taxpayer is a serviced based business, and purchased multifamily real estate five years ago for $1,000,000. In 2018, he earns $200,000 in rental income and pays $20,000 in salary to a part time assistant.
Under the normal calculation, taxpayer is entitled to a $40,000 deduction (20% x $200,000). Assuming taxpayer is in a service based business, taxpayer is subject to the wage and capital limitation. The taxpayer gets the greater of:
- 50% of W-2 wages: $20,000 x 50% = $10,000
- 25% of W-2 wages ($5,000) and
- 2.5% of the unadjusted basis of a qualified capital component ($1,000,000 x 2.5% = $25,000)
Under the wage/capital limitation the taxpayer takes the second option, giving him a $30,000 deduction under section 199A.
Bifurcating business income is something a business owner may want to consider as a tax strategy under the new deductions. Creating separate business entities to separate service income from other income can delineate the source of income and optimize deduction.
If you’d like to find out more about the 199A deduction or other aspects of the new tax code changes. Please contact us at Cherewka Law.