The 2018 Tax Cuts & Jobs Act
Article By: Jeff Skolnick, CPA, M.S. Taxation
The 2018 Tax Cuts & Jobs Act contains a very generous deduction for owners of Pass-Thru Entities. There are a number of rules that limit this deduction based on various factors which include occupation, taxable income, entity structure and proper recordkeeping. That being said, this is a deduction well worth understanding. The remainder of this article will break this provision down and explain it.
New Code Section
The new tax law adds a new section to the Internal Revenue Code. The new section is 199A. Qualified Business Income. This code section allows a 20% deduction for Qualified Business Income of a Pass-Thru Entity. As I mentioned before there are a number of limitations that may apply. Think of the 20% deduction on Qualified Business Income as the first hurdle.
Pass-Thru Entity
The new code section applies to pass-thru entities; therefore it makes sense to define the term pass-thru entity. Pass-thru entities are generally sole proprietorships, partnerships and S corporations. The reason I did not mention LLCs is that LLCs for tax purposes are considered disregarded entities meaning they have no tax standing on their own. The default tax position of a single member LLC is a sole proprietorship, the default position of a multiple member LLC is a partnership. The only real difference between a single member LLC and a sole proprietorship or between a multiple member LLC and a partnership is that the LLCs enjoy protection from legal liability in essentially the same manner as corporations. Lastly LLCs can also choose to be taxed as S corporations. While obviously 100% of a sole proprietorship’s income would be eligible for the deduction, partners and S corporation shareholders pick up their ratable share of the associated entities income and deductions. For example a 50% shareholder in an S corporation that had qualified business income of $250,000, W-2 wages paid of $100,000 and qualified property of $1,000,000 would use $125,000, $50,000 and $500,000 respectively on his/her return.
Qualified Business Income
Qualified business income is defined in the new law as the “net amount of qualified items of income, gain, deduction and loss with respect to qualified trades or businesses of the taxpayer”. This is basically the net income line (income less all applicable expenses). There are, however, certain items that are not counted as qualified items. The term qualified business income excludes short-term and long-term capital gains and losses as well as dividend income and interest income (unless earned in a trade or business). The law also considers Real Estate Investment Trust (REIT) dividends, qualified publicly traded partnership income and qualified cooperative dividends as qualified business income but these are more specialized situations and this ebook will not focus on these items. I only wanted to mention them to provide information that rules do exist on these types of income.
Qualified business income does not include W-2 wages or guaranteed payments to partners.
How the deduction works
This new deduction, as I mentioned earlier, is calculated by first taking 20% of Qualified Business Income (the first hurdle) followed by a number of other hurdles which I will now cover.
Taxable Income Limitation
I have labeled the taxable income limitation as hurdle number 2. The reason for this is that there are a couple of other provisions which kick in at certain taxable income levels. First of all while the 20% limitation on Qualified Business Income is hurdle number 1, if 20% of taxable income less capital gains and qualified cooperative dividends is less than Qualified Business Income than this lower limitation amount is used. Again qualified cooperative dividends are a specialized area which I am not going to delve in to here. If you see the term you know this section applies. I also mention the term so people realize that qualified cooperative dividends are not the same as the qualified dividends everyone is used to seeing on Form 1099-Div. Qualified dividends are considered capital gains for this code section.
Example 1
Scott, a single taxpayer, has qualified business income of $100,000 and taxable income of $160,000 of which $10,000 is long term capital gain income. Hurdle number 1 is 20% of qualified business income or in this case $20,000. Hurdle number 2 is 20% of taxable income less long term capital gain income ($160,000 – $10,000 multiplied by 20%), or $30,000. The deduction in this example is limited to $20,000 based on his qualified business income.
Example 2
Scott, a single taxpayer, has qualified business income of $150,000 and taxable income of $100,000, none of which is related to long term capital gains. Hurdle number 1 is 20% of qualified business income or in this case $30,000. Hurdle number 2 is 20% of taxable income, or $20,000. The deduction in this example is also limited to $20,000 although this time based on taxable income.
Specified Service Trade or Business
What I consider to be hurdle number 3 is the exception for what the code section calls “specified service trades or businesses”. Code section 199A defines these businesses based on the definition shown in another code section (1202(e)(3)(A)). Code section 1202 defines these businesses as any “trade or business involving the performance of services in the fields of health, law, engineering, architecture, 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 1 or more of its employees”.
In order for the specified service trades and businesses to utilize the deduction of this new code section fully the taxable income of the taxpayer(s) must be at or below $315,000 for married taxpayers filing a joint return and one half or $157,500 for everyone else. Once the taxpayer(s) exceeds the taxable income limitation the deduction phases out. In the case of taxpayers with a threshold of $315,000 the deduction phases out over the next $100,000 of taxable income. In the case of a taxpayer with a threshold of $157,500 the deduction phases out ratably over the next $50,000 of taxable income.
In each of the examples that follow there were no capital gains. In addition when the taxpayer exceeds the applicable limits ($315,000 for married taxpayers filing jointly and $157,500 for everyone else) hurdle 4 (explained later) also kicks in. For purposes of examples 3 through 7 assume there is enough W-2 wages and/or Qualified property that hurdle 4 does not come into play. Again I will explain hurdle 4 shortly, however I do not want to further complicate these examples at this time.
Example 3
Scott, a single taxpayer, has qualified business income of $100,000 from a specified service business and taxable income of $150,000. Hurdle number 1 is 20% of qualified business income or in this case $20,000. Hurdle number 2 is 20% of taxable income, or $30,000. Hurdle number 3 is that Scott’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $20,000 and because Scott’s taxable income is below $157,500 he is allowed the full $20,000 deduction even though his qualified business income was earned in a specified service business.
Example 4
Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $300,000 on her jointly filed income tax return. Hurdle number 1 is 20% of qualified business income or in this case $50,000. Hurdle number 2 is 20% of taxable income, or $60,000. Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income is below $315,000 she is allowed the full $50,000 deduction even though her qualified business income was earned in a specified service business.
Example 5
Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $500,000 on her jointly filed income tax return. Hurdle number 1 is 20% of qualified business income or in this case $50,000. Hurdle number 2 is 20% of taxable income, or $100,000. Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $415,000 ($315,000 plus the $100,000 phase-out) she is allowed no deduction.
Example 6
Kathy, a married taxpayer, has qualified business income of $250,000 from a specified service business and taxable income of $360,000 on her jointly filed income tax return. Hurdle number 1 is 20% of qualified business income or in this case $50,000. Hurdle number 2 is 20% of taxable income, or $72,000. Hurdle number 3 is that Kathy’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out. The phase-out is calculated by subtracting the threshold amount from the taxable income. In this case $360,000 less $315,000 equals $45,000. $45,000 is 45% of the $100,000 phase-out. Kathy’s deduction is therefore limited to $50,000 multiplied by 55% (again she loses out on 45% of this deduction). The allowable deduction is 55% of $50,000 or $27,500. Please keep in mind that in addition to the three hurdles listed here Kathy would also be subject to hurdle 4. For purposes of this example assume that hurdle 4 would not limit the deduction in any way.
Example 7
Scott, a single taxpayer, has qualified business income of $150,000 from a specified service business and taxable income of $190,000. Hurdle number 1 is 20% of qualified business income or in this case $30,000. Hurdle number 2 is 20% of taxable income, or $38,000. Hurdle number 3 is that Scott’s qualified business income was earned in a specified service business; therefore the third hurdle has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $30,000 and because Scott’s taxable income exceeds $157,500 but is below $207,500 part of his deduction will be phased out. The phase-out is calculated by subtracting the threshold amount from the taxable income. In this case $190,000 less $157,500 equals $32,500. $32,500 is 65% of the $50,000 phase-out. Scott’s deduction is therefore limited to $30,000 multiplied by 35% (again he loses out on 65% of this deduction). The allowable deduction is 35% of $30,000 or $10,500. Please keep in mind that in addition to the three hurdles listed here Scott would also be subject to hurdle 4. For purposes of this example assume that hurdle 4 would not limit the deduction in any way.
Other limitations based on taxable income
The last hurdle (what I call hurdle number 4) applies to all businesses; remember hurdle 3 only applies to specified service trade or businesses. Once the threshold limits of $315,000 and $157,500 are reached the code section states that the deduction will be the “lesser of 20 percent of the taxpayer’s qualified income or the greater of 50 percent of the W-2 wages with respect to the qualified trade or business or 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.” That certainly is a mouthful and I will now explain it in English.
The first part discussing 20% of qualified business income is the same number we’ve been using from earlier. This is the calculated figure after leaping over hurdles 1 and 2. The newly introduced complication is the greater of 50% of W-2 wages (a number very easily attained from the payroll tax filings of an entity) or 25% of W-2 wages plus 2.5 % of the unadjusted basis of qualified property.
Qualified Property
The code section defines qualified property as property held by, and available for use in the qualified trade or business. The unadjusted basis is used (original cost without any reduction for depreciation). The only other limiting factor on property is that property no longer qualifies as of the later of 10 years after the date it is placed in service or the last full year that the property is depreciated.
Example 8
Kathy, a married taxpayer, has qualified business income of $250,000 not from a specified service business and taxable income of $360,000 on her jointly filed income tax return. Kathy’s business paid $60,000 in W-2 wages and has no qualified property. Hurdle number 1 is 20% of qualified business income or in this case $50,000. Hurdle number 2 is 20% of taxable income, or $72,000. There is no hurdle number 3 because Kathy’s qualified business income was not earned in a specified service business. Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out. Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $0). Hurdle 4 therefore limits the deduction to $30,000. The phase-out is calculated by subtracting the threshold amount from the taxable income. In this case $360,000 less $315,000 equals $45,000. $45,000 is 45% of the $100,000 phase-out. The phase-out is 45% of the difference between the $50,000 deduction calculated by using the first 2 hurdles and the $30,000 calculated by hurdle 4. $20,000 multiplied by 45% equals $9,000. Kathy’s deduction is therefore limited to $50,000 less the $9,000 phase-out or $41,000.
Example 9
Kathy, a married taxpayer, has qualified business income of $250,000 not from a specified service business and taxable income of $360,000 on her jointly filed income tax return. Kathy’s business paid $60,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $50,000. Hurdle number 2 is 20% of taxable income, or $72,000. There is no hurdle number 3 because Kathy’s qualified business income was not earned in a specified service business. Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $50,000 and because Kathy’s taxable income exceeds $315,000 but is below $415,000 part of her deduction will be phased out. Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $25,000). Hurdle 4 therefore limits the deduction to $40,000. The phase-out is calculated by subtracting the threshold amount from the taxable income. In this case $360,000 less $315,000 equals $45,000. $45,000 is 45% of the $100,000 phase-out. The phase-out is 45% of the difference between the $50,000 deduction calculated by using the first 2 hurdles and the $40,000 calculated by hurdle 4. $10,000 multiplied by 45% equals $4,500. Kathy’s deduction is therefore limited to $50,000 less the $4,500 phase-out or $45,500.
Example 10
Scott, a single taxpayer, has qualified business income of $450,000 not from a specified service business and taxable income of $500,000 on his income tax return. Scott’s business paid $800,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $90,000. Hurdle number 2 is 20% of taxable income, or $100,000. There is no hurdle number 3 because Scott’s qualified business income was not earned in a specified service business. Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $90,000 and because Scott’s taxable income exceeds $207,500 he is limited by hurdle 4. Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $400,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $200,000 + $25,000). Hurdle 4 therefore limits the deduction to $400,000. The deduction is calculated by using the first 2 hurdles ($90,000) and the $400,000 calculated by hurdle 4. Scott’s deduction is $90,000. Notice there is no phase-out since Scott’s taxable income exceeds $207,500.
Example 11
Scott, a single taxpayer, has qualified business income of $450,000 not from a specified service business and taxable income of $500,000 on his income tax return. Scott’s business paid $60,000 in W-2 wages and has $1,000,000 of qualified property. Hurdle number 1 is 20% of qualified business income or in this case $90,000. Hurdle number 2 is 20% of taxable income, or $100,000. There is no hurdle number 3 because Scott’s qualified business income was not earned in a specified service business. Hurdle 4 has to do with the taxable income threshold. The deduction in this example is preliminarily limited by the first 2 hurdles to $90,000 and because Scott’s taxable income exceeds $207,500 he is limited by hurdle 4. Hurdle number 4 limits the deduction to the greater of 50% of W-2 wages (in this case $30,000) or 25% of W-2 wages plus 2.5% of the acquisition cost of qualified property (in this case $15,000 + $25,000). Hurdle 4 therefore limits the deduction to $40,000. The deduction is calculated by using the first 2 hurdles ($90,000) and the $40,000 calculated by hurdle 4. Scott’s deduction is $40,000. Notice there is no phase-out since Scott’s taxable income exceeds $207,500.
How to take the deduction
Another great thing about this deduction is that it is available to both those who itemize and those who do not itemize their income tax deductions.
CONCLUSION
This is a deduction that will be very beneficial to many that own sole proprietorships, interests in partnerships, S corporations and LLCs. There are a few limitations that must be followed and in some instances action such as restructuring your business type (for example from a sole proprietorship to an S corporation) may be required. While this article is intended to provide a certain level of knowledge regarding this new provision it does not replace the expertise of a professional or further research if you are a professional.
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