Tax Reform and Section 199A Deduction of Qualified Business Income of Pass-Through Entities
On Friday, December 22, President Trump signed sweeping tax reform (the “Act”) into law. The Act provides the most comprehensive update to the tax code since 1986 and includes a number of provisions of particular interest to partnerships and their partners. This alert addresses the Section 199A deduction for qualified business income of pass-through entities.
Section 199A Deduction for Qualified Business Income of Pass-Through Entities
For tax years beginning after December 31, 2017, taxpayers other than corporations will generally be entitled to a deduction for each taxable year equal to the sum of:
- The lesser of (A) the taxpayer’s “combined qualified business income amount” or (B) 20 percent of the excess of the taxpayer’s taxable income for the taxable year over any net capital gain plus the aggregate amount of qualified cooperative dividends, plus
- The lesser of (A) 20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year or (B) the taxpayer’s taxable income (reduced by the net capital gain).
A taxpayer’s combined qualified business income (QBI) amount is generally equal to the sum of (A) 20 percent of the taxpayer’s QBI with respect to each qualified trade or business plus (B) 20 percent of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
Limitation Based on Wages & Capital
The portion of the deduction attributable to 20 percent of the taxpayer’s QBI cannot exceed the greater of (1) 50 percent of his/her share of W-2 Wages paid with respect to the QBI or (2) the sum of 25 percent of his/her share of W-2 Wages plus 2.5 percent of the unadjusted basis of qualified property determined immediately after its acquisition of such qualified property. The term W-2 Wages is defined to mean the sum of total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer. W-2 Wages do not include any such amount that is not properly allocable to QBI.
For example, a taxpayer (who is subject to the limit) does business as a sole proprietorship conducting a widget-making business. The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of (a) 50 percent of W-2 Wages, or $0, or (b) the sum of 25 percent of W-2 Wages ($0) plus 2.5 percent of the unadjusted basis of the machine immediately after its acquisition: $100,000 x .025 = $2,500. The amount of the limitation on the taxpayer’s deduction is $2,500.
Phase-in of Wages and Wages & Capital Limitation
The wages or wages plus capital limitation does not apply to taxpayers with taxable income not exceeding $315,000 (joint filers) or $157,500 (other filers). The limitation is phased-in for taxpayers with taxable income exceeding these amounts over ranges of $100,000 and $50,000, respectively. For example, H and W file a joint return on which they report taxable income of $375,000. W has a qualified trade or business that is not a specified service business, such that 20 percent of the QBI with respect to the business is $15,000. W’s share of wages paid by the business is $20,000, such that 50 percent of the W-2 Wages with respect to the business is $10,000. The business has nominal amounts of qualified property such that 50 percent is W-2 Wages is greater than 25 percent of W-2 Wages plus 2.5 percent of qualified property. The $15,000 amount is reduced by 60 percent (($375,000 - $315,000) / $100,000) of the difference between $15,000 and $10,000, or $3,000. H and W take a deduction for $12,000.
Definition of Qualified Property
The term qualified property is generally defined to mean, with respect to any qualified trade or business, tangible property of a character subject to depreciation under section 167 that is (i) held by and available for use in the qualified trade or business at the close of the taxable year, (ii) which is used at any point during the taxable year in the production of QBI, and (iii) the depreciable period for which has not ended before the close of the taxable year. Importantly, the Conference Agreement defines the term “depreciable period” to mean the later of 10 years from the original placed in service date or the last day of last full year in the applicable recovery period determined under section 168.
Definition of QBI
QBI includes the net domestic business taxable income, gain, deduction, and loss with respect to any qualified trade or business. QBI specifically excludes the following items of income, gain, deduction, or loss: (1) Investment-type income such as dividends, investment interest income, short-term & long-term capital gains, commodities gains, foreign currency gains, and similar items; (2) Any Section 707(c) guaranteed payments paid in compensation for services performed by the partner to the partnership; (3) Section 707(a) payments for services rendered with respect to the trade or business; or (4) Qualified REIT dividends, qualified cooperative dividends, or qualified PTP income.
Carryover of Losses
Section 199A provides rules regarding the treatment of losses generated in connection with a taxpayer’s qualified trades or businesses. Under these rules, if the net amount of qualified income, gain, deduction, and loss with respect to qualified trades or businesses of the taxpayer for any taxable year is less than zero, such amount shall be treated as a loss from a qualified trade or business in the succeeding taxable year. In practice, this will mean that a taxpayer’s net loss generated in Year 1 will be carried forward and reduce the subsequent year’s section 199A deduction.
For example, Taxpayer has QBI of $20,000 from qualified business A and a qualified business loss of $50,000 from qualified business B in Year 1. Taxpayer is not permitted a deduction for Year 1 and has a carryover qualified business loss of $30,000 to Year 2. In Year 2, Taxpayer has QBI of $20,000 from qualified business A and QBI of $50,000 from qualified business B. To determine the deduction for Year 2, Taxpayer reduces the 20 percent deductible amount determined for the QBI of $70,000 from qualified businesses A and B by 20 percent of the $30,000 carryover qualified business loss. Ignoring application of other potential limitations and deductible amounts, Taxpayer would be entitled to a Year 2 Section 199A deduction of $8,000 (($70,000 * 20 percent) – ($30,000 * 20 percent)).
Definition of Qualified Trade or Business
A qualified trade or business includes any trade or business other than a “specified service trade or business” or the trade or business of performing services as an employee. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or 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, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.
Specified Services Limitation
The specified service trade or business exclusion does not apply to the extent the taxpayer’s taxable income does not exceed certain thresholds: $415,000 (joint filers) and $207,500 (other filers). Application of this exclusion is phased-in for income exceeding $315,000 and $157,500, respectively. In computing the QBI with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 Wages and qualified property. The applicable percentage with respect to any taxable year is 100 percent reduced by the percentage equal to the ratio of the taxable income of the taxpayer in excess of the threshold amount, bears to $50,000 ($100,000 in the case of a joint return).
For example, Taxpayer (who files a joint return) has taxable income of $375,000, of which $200,000 is attributable to an accounting sole proprietorship after paying wages of $100,000 to employees. Taxpayer has an applicable percentage of 40 percent. In determining includible QBI, Taxpayer takes into account 40 percent (1 – (($375,000 - $315,000) / $100,000)) of $200,000, or $80,000. In determining the includible W-2 Wages, Taxpayer takes into account 40 percent of $100,000, or $40,000. Taxpayer calculates the deduction by taking the lesser of 20 percent of $80,000 ($16,000) or 50 percent of $40,000 ($20,000). Taxpayer takes a deduction for $16,000.
Taxpayers eligible to claim the full 20 percent deduction on QBI will incur a maximum effective rate of 29.6 percent on the QBI. While this rate reduction is beneficial, it will be important to consider the decrease in corporate tax rates from 35 percent to 21 percent. This rate differential is likely to cause taxpayers to reevaluate their choice of entity decisions. There are a number of factors that need to be considered but, from a simple after-tax cash flow perspective, a key determinative factor is the likelihood of the entity distributing vs. retaining operating earnings. While a common thought is to consider possibly incorporating an existing partnership in order to benefit from the 21 percent corporate tax rate, a corporate-to-partnership conversion should not be dismissed. When corporate tax rates were 35 percent, the tax liability imposed on gain recognized under Section 311(b) was typically prohibitive in a conversion transaction. However, with corporate rates dropping to 21 percent, consideration should now be given to the possible liquidation of a corporation and re-formation as a partnership, especially in situations where the corporation has net operating loss carryovers that could shelter the recognized Section 311(b) gain.
The determination of the combined QBI amount is dependent upon the QBI generated from each qualified trade or business activity. Further, the wages and capital-based limitations are determined with reference to wages and qualified property that is allocable to a particular qualified trade or business activity. It is not clear from the statute whether and the extent grouping rules under sections 469 may be applicable. Complexities are likely to arise in situations where a partnership operates multiple activities. Maintaining adequate information and documentation will be necessary to support application of the lower rates. Consequently, partners and partnerships will need to consider the extent to which additional information will be maintained, how it will be communicated to partners, and whether any incremental administrative costs should be borne by the benefiting partners.
Properly tracking partner income and loss allocations will take on greater importance in order to accurately determine a partner’s annual net business income allocations and carryover loss amounts. This importance will be further magnified as a result of the potential imputed underpayment obligations that could arise under the new partnership audit rules going into effect for tax years beginning after December 31, 2017.
Please look for future communications from Smith & Howard's tax group on additional details of the new tax bill. Keep in mind that it is important to speak with your tax professional before taking any action. If you have any questions about how the new tax bill can affect your business, contact Mark Abrams at 404-874-6244 or fill out the form below.