One of the more complex provisions of the Tax Cuts and Jobs Act (TCJA) is the Section 199A deduction which provides individuals a 20% deduction of “qualified business income” (QBI) from a partnership, S corporation, LLC or sole proprietorship. The deduction is an attempt to narrow the federal tax rate difference between corporations (21%) and pass through entities (37%). The 37% is the top individual tax rate under the TCJA.
About qualified business income
QBI is defined as the amount of items of income, gain, deduction and loss with respect to each trade or business. Specified investment-related items are not included, such as capital gains or losses, dividends and interest income (unless the interest is properly allocable to the business). Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business. The deduction will be calculated separately for each trade or business and then the taxpayer will combine the deductions from each trade or business. If net QBI is less than zero it is treated as a loss from a qualified business in the following year.
How does this impact me?
The deduction reduces your taxable income but not your adjusted gross income. It is available regardless of whether you itemize deductions or take the standard deduction.
Section 199A specifically excludes “specified service trade or business” income from qualifying for the deduction. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
While this type of income generally does not qualify for the deduction, there is an exception based on taxable income. Joint filers with taxable income below $315,000 ($157,500 for all others) before taking into consideration this deduction would be eligible for the deduction. If taxable income is between $315,000 and $415,000 for joint filers, only a percentage of the income is eligible. Once taxable income becomes more than $415,000, the specified service income does not qualify for the deduction.
Additionally, for taxpayers with taxable income more than the above thresholds, a further limitation comes into play. The deduction cannot exceed the greater of: a) 50% of the W-2 wages from the trade or business, or b) 25% of the wages from the trade or business plus 2.5% of the unadjusted basis of the depreciable assets from the trade or business. Each owner will use their allocable share of wages and basis of depreciable assets to calculate this limitation. These limits are phased in similarly to how they are phased in for specified service trades or businesses noted above.
The final limitation that must be taken into consideration is one based upon the taxable income of the individual. The deduction cannot exceed 20% of taxable income over net capital gains, which include capital gains and dividends that qualify for a favorable tax rate.
Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
The complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the thresholds discussed above. But this potential tax break also comes with a great deal of uncertainty until further guidance is issued. For example, the deduction is to be calculated separately for “each trade or business.” “Each” is not defined in the statute or committee reports and read literally the calculation may need to be done separately for every entity that constitutes a separate taxpayer. Conversely, the regulations might allow for, or require, aggregating separate taxpayers into a single trade or business for purposes of the calculation.
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