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Tax Reform Series: Section 199A Deduction for Qualified Business Income of Pass-Through Entities

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UPDATE: Section 199A

The December 22 Tax Cuts and Jobs Act contained major tax changes and reform affecting both businesses and individuals.

The following is a summary of Section 199A – the Deduction for Qualified Business Income of Pass-Through Entities, a component of the recent tax reform.

For Berntson Porter’s White Paper on the full impact of the new tax legislation, click here.

Section 199A Overview
While C-Corporations enjoy a lower income tax rate, pass-through entities (Sole proprietorships, S-Corporations, LLCs, partnerships, and trusts and estates) were given the Section 199A Qualified Business Income deduction. For tax years beginning after December 31, 2017 pass-through entities are entitled to a deduction of up to 20 percent of their “Qualified Business Income.” This deduction can produce tremendous savings for qualifying entities, but the deduction does come with limitations.

Qualified Business Income (QBI)
As stated above, Qualified Business Income is used to determine the amount of the 199A deduction. Qualified Business Income, or QBI, is defined as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” The sum of these values is a pass-through entity’s QBI. Put simply, an entity’s QBI is its ordinary income less its ordinary deductions.

It is important to note that three types of income do not count towards QBI. The first type of income not included in QBI is reasonable compensation paid to S-corporation shareholders & guaranteed payments paid to partners. The second type of income that does not count as QBI is foreign income. The third type of income is capital gain income, which is already taxed at favorable rates.

Wage and Capital Limitation
Once the entity calculates their QBI, the next step in determining the deduction amount is to calculate their “combined qualified business income.” The combined qualified business income is calculated as the lesser of:

1. 20 percent of QBI or;
2. The greater of: (a) 50 percent of allocable W-2 wages for the trade or business or (b) the sum of 25 percent of allocable W-2 wages plus 2.5 percent of the unadjusted basis of qualified property.

Number two above, which can be labeled the “wage and capital limitations,” comes with a caveat. The limitations do not apply to taxpayers whose taxable income does not exceed $157,500 for single taxpayers or $315,000 for those married filing jointly. Once the taxpayer’s taxable income exceeds the base threshold, the 20 percent deduction is phased-in over the next $50,000 for single taxpayers or $100,000 for those married filing jointly. If the wage limitation does not apply, a taxpayer’s combined qualified business income equals 20 percent of their QBI.

The next step in calculating the final deduction is subjecting the combined qualified business income to another limitation. The final QBI deduction is limited to the lesser of:

1. Combined qualified business income or;
2. 20 percent of taxable income.

After subjecting the entity’s QBI to both limitations, the entity will know its final 199A deduction, but it is important to note that not every pass-through entity will get to utilize the full deduction.

Specified Service Business Limitation
Under Section 199A, entities classified as a “specified service trade or business” are not able to take advantage of the deduction. Section 199A defines a specified service trade or business as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, 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.” It is this last catch-all about skill and reputation that will cause much debate and requires clarification from the IRS in the form of regulations.

However, a specified service business will enjoy the full 20 percent deduction if their taxable income is below the $157,500 or $315,000 threshold. The wage limitation starts to phase in once the taxpayer reaches their threshold, but once taxable income reaches $207,500 for single tax payers or $415,000 for those married filling jointly, the deduction is completely phased out.

What Does This Mean for My Business?
With the advent of this deduction many business owners are left with questions as to how they should structure their businesses, how they should track partner income and loss, or whether they should switch the type of entity that they operate as. Until further guidance is issued by the IRS, we would not recommend any major changes to your business composition and structure without a detailed analysis specific to your specific situation. In order to take full advantage of the deduction for the 2018 tax year it is important to start planning today.

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Your team at Berntson Porter looks forward to working with you on this historic change to our tax system. If you have any questions, please contact your tax professional at Berntson Porter & Company, PLLC at 425-454-7990.