The Tax Cuts and Jobs Act brought the biggest changes to both individual and corporate taxes seen in the past 30 years. Included in those changes was IRC Section 199A, which is a new section of the tax code that introduces a 20% deduction on qualified business income (QBI) for the owners of various pass-through entities (which include S corporations, limited liability companies, partnerships, and sole proprietorships). Fortunately, the QBI deduction will provide a significant tax break for many business-owners, but there are many rules and limits, is highly complicated, and may take some time before the IRS can even provide more meaningful guidance on how it will be applied. Here is some insight to this new code Section.
- Sec. 199A allows taxpayers other than corporations a deduction of 20% of qualified business income earned in a qualified trade or business, subject to certain limitations.
- The deduction is limited to the greater of (1) 50% of the W-2 wages with respect to the trade or business, or (2) the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (generally, tangible property subject to depreciation under Sec. 167). The deduction also may not exceed (1) taxable income for the year over (2) net capital gain plus aggregate qualified cooperative dividends.
- Qualified trades and businesses include all trades and businesses except the trade or business of performing services as an employee and “specified service” trades or businesses: those involving the performance of services in law, accounting, financial services, and several other enumerated fields, or where the business’s principal asset is the reputation or skill of one or more owners or employees.
- Qualified business income is the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business that are effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments, are excluded from qualified business income.
- The W-2 wage limitation does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly) and is phased in for taxpayers with taxable income above those thresholds. Income from specified service businesses is not excluded from qualified business income for taxpayers with taxable income under the same threshold amounts.
- The new law also reduces the threshold at which an understatement of tax is substantial for purposes of the accuracy-related penalty under Sec. 6662 for any return claiming the deduction, from the generally applicable lesser of 10% of tax required to be shown on the return or $5,000 before the new law, to 5% of tax required to be shown on the return or $5,000.
- The law’s many yet-unclear points include its application to rental property, the netting of qualified business income and loss for taxpayers with multiple qualified trades or businesses, determining the deduction for tiered entities, allocating W-2 wages among businesses, and whether compensation paid to an S corporation shareholder is included in W-2 wages for purposes of that limitation.