By Steven E. Howell, CPA, DABFA – Client Service Partner, and Davide DiGenova, CPA – Tax Partner
RBT CPAs, LLP, a Council of Industry Associate Member
“A provision of the TCJA might benefit Council of Industry member firms organized as pass through entities. This provision “199A,” provides for a deduction of as much as 20% for business activates conducted by these firms.”
On December 22, 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law by the President of the United States. Many of these tax law changes will apply to individual and business taxpayers commencing with their 2018 federal income tax filings. One of the key provisions of the TCJA provides the ability for taxpayers to receive a deduction for Qualified Business Income, which for simplicity purposes can be referred to as “net income”, generated by a trade or business that is conducted within a partnership, S corporation, or sole proprietorship. One might refer to this deduction as the 20% deduction or, more technically, the 199A deduction.
The amount of the 20% deduction allowed will be based on the taxpayer’s individual taxable income less income which has a preferred federal tax rate such as preferred dividends. This amount will be referred to as “adjusted taxable income”. The 20% deduction allowed in a given year will be limited to the lesser of 20% of the adjusted taxable income or 20% of the qualified business income that flows through to the taxpayer.
Determining whether a taxpayer will qualify for the 20% deduction and to what extent this deduction will be allowed is more complicated than its name may suggest. In order to understand this 20% deduction, one must first understand what types of businesses and income thresholds will disqualify a taxpayer from taking this deduction. The first threshold that must be reviewed is whether the trade or business being conducted is considered a specified service trade or business (SSTB) or if such trade or business is a business of providing services as an employee (generally, referred to as changing from an employee to an independent contractor in order to benefit from this deduction when the taxpayer is truly an employee). A SSTB is any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial or brokerage services, investing and investment management, trading, dealing in securities, and where the principal asset is the reputation or skill of one or more employees or owners (generally referred to as an endorsement). The second threshold that must be met is that the trade or business being operated is conducted within a partnership, S corporation, or sole proprietorship. This deduction will not apply to trades or business conducted within a C corporation. The third threshold is whether taxable income exceeds $157,500 for a single income tax filer ($315,000 married filing joint).
Once the three basic thresholds have been analyzed, one can begin to determine the amount of the 20% deduction that will be allowed. If a taxpayer conducts a trade or business which generates net income and a taxpayer’s taxable income does not exceed $157,500 ($315,000 married filing joint), regardless as to whether such trade or business is a SSTB, the taxpayer will be allowed a 20% deduction for that specific trade or business.
If a taxpayer’s taxable income exceeds the $157,500 ($315,000 married filing joint) but doesn’t exceed $207,500 ($415,000 married filing joint), then there needs to be an analysis done as to the type of trade or business that the taxpayer is operating. A taxpayer who operates a SSTB and exceeds the lower threshold but not the higher threshold, will begin to lose the 20% deduction based on an income limitation and a wage limitation phase-in. If the taxpayer doesn’t operate a SSTB, the 20% deduction will be reduced by a wage limitation phase-in only.
When a taxpayer’s taxable income exceeds the $207,500 ($415,000 married filing joint), the taxpayer will be disqualified from taking a 20% deduction on the net income generated by a specific trade or business that is considered a SSTB. However, if a taxpayer doesn’t operate a SSTB, the 20% deduction will equal the lesser of 20% of the net income generated by the trade or business or the greater of 50% of wages paid by the trade or business or 25% of wages paid plus 2.5% of the unadjusted basis of assets held by the trade or business (excluding land).
As was mentioned earlier, the 20% deduction is a complex area of the TCJA. It would be worthwhile to consult with your tax advisor as to whether you will qualify for this deduction. The Internal Revenue Service issued proposed regulations during mid-August of 2018 which has provided additional guidance and has answered many questions for tax practitioners, but there are still areas which need additional clarification.