No provision in the new tax law has received more attention than the new section 199A. Section 199A defines a new term called “Qualified Business Income” (“QBI”) and further provides non-corporate taxpayers, including trusts and estates, will be entitled to receive a deduction for a percentage of QBI. The 20% deduction is not an itemized deduction from adjusted gross income, rather it is allowed as a deduction reducing taxable income.
QBI is the net amount of “qualified items of income, gain, deduction, and loss” received from any qualified trade or business of the taxpayer that is a partnership, S corporation or sole proprietorship to the extent that the items are effectively connected with a business within the United States (a “Qualified Trade or Business” or “QTB”). A non-corporate taxpayer receiving QBI is entitled to deduct:
- the lesser of the “combined qualified business income amount” of the taxpayer, or (b) 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the sum of net capital gain and the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year;
- the lesser of: (i) 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year, or (ii) taxable income (reduced by the net capital gain) of the taxpayer for the tax year.
Definitions Within Definitions
The rub is that there are definitions within definitions and understanding the 20% deduction is navigable only if you have patience.
The “combined qualified business income amount” means the deductible amount for each qualified trade or business of the taxpayer (defined as 20% of the taxpayer's QBI subject to the W-2 wage limitation discussed below; plus (ii) 20% of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income of the taxpayer for the tax year. QBI does not include reasonable compensation paid to the taxpayer; any guaranteed payment to a partner for services to QTB under (Section 707(c)); or a payment by the QTB under (Section. 707(a)) to a partner for services to the QTB or any specified investment items. Thus, all income is not necessarily QBI.
A QTB is any trade or business except that of an employee or a specified trade or business, such as the practice of law, accounting, health, investment and similar businesses that rely on reputation. Thus, a specified practice, such as medicine, is arguably excluded were it not for the income threshold. Stated simply, the prohibition does not apply until income levels exceed $315,000 for married individuals filing jointly ($157,500 for other individuals) subject to a phase-in applicable percentage. Thus, the benefits of the deduction are indirectly extended to lower paid practitioners. Note engineering and architecture are denied indirect benefit regardless the level of income.
Perhaps the key provision is the limitation on the 20% deduction because most taxpayers understand the income generated from their business. The 20% deduction cannot exceed the greater of: (1) 50% of the W-2 wages from the QTB (“W-2 wage limitation”), or (2) the sum of 25% of the W-2 wages paid with respect to the QTB plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Qualified property is defined in §199A(b)(6)) as tangible, depreciable property which is held by and available for use in the QTB by the close of the tax year, is used during the year and whose depreciation period has not ended. Perhaps the most notable provision is the later one, which allows the 20% deduction to qualify real estate operations.
There are two examples in the Joint Explanatory Statement of the Committee of Conference that may be helpful to the reader.
Example 1 – Husband (H) and Wife (W) file a joint return and show $520,000 of taxable income and receive $10,000 in REIT dividends. H’s share of QBI is $300,000 and his 20% is $60,000. H’s allocable share of wages paid by the business is $100,000 and 50% of that figure is $50,000. Because the joint income is above $315,000, the phase-in of the wage limit applies so the $50,000 is reduced by $2,000 which is 20% of the difference between $60,000 and $50,000. Thus, H’s QBI is $58,000 ($60,000-$2,000).
W has a current QBI of $325,000 and W-2 wages of $150,000 from her sole proprietorship. Once again, because the joint income is above $315,000, the phase-in of the wage limit applies. 80% is applicable percentage that is applied to QBI of $325,000 and W-2 wages of $150,000, and the results are $260,000 and $120,000, respectively. In order to determine the deduction, W’s QBI of $260,000 is multiplied by 20% (limitation) and W-2 wages of $120,000 by the 50% (wage limitation) and the results are $52,000 and $60,000, respectively. W’s deductible is $52,000, the lesser of the two figures.
H and W combined QBI is $112,000 and is comprised of the deductible amount from each ($58,000 plus $52,000) plus 20% of REIT dividends ($2,000). Their deduction is limited to $104,000 which is the lesser of $112,000 or $104,000, which is 20% of taxable income of $520,000.
Example 2 – Husband (H) and Wife (W) file a joint return and show $200,000 of taxable income and a qualified business carryover loss of $50,000. H is a sole proprietor of QTB and has income of $150,000 so his OBI is $30,000. Because the joint income is below $315,000, the wage limit does not apply. W has a current $40,000 loss so her qualified business loss is $8,000. Once again, the joint income is below $315,000 so the wage limit does not apply. H and W combined business income is $12,000 consisting of $30,000 from H less $8,000 from W less $10,000 from the carryover loss (20% of $50,000). The deduction is limited to $12,000 which is the lesser $40,000 (20% of $150,000) or $12,000.
It remains to be seen whether the section 199A will transform existing business structures to the extent that some predict although the choice of entity decision for new businesses has been made more opaque for the average person.
If you have any questions or if you would like to discuss the matter further, please contact me, James McDonough, at 201-806-3364.