The Tax Cuts and Jobs Act (2017 Tax Act) significantly modified the treatment of certain deductions for many business taxpayers, including partners and partnerships. This article focuses on section 199A, the provision creating a new pass-through deduction that is calculated based on taxable income and in certain cases on W-2 wages. There are many variations and fact patterns that would need to be analyzed in order to fully discuss the implications of new section 199A, and, therefore, this article addresses a very limited number of the definitional issues and the practical impact as taxpayers seek to take advantage of this new deduction. In addition, the 2017 Tax Act restricts the ability of certain taxpayers to deduct interest in any given year (section 163(j)). A brief overview of the restrictions on the deductibility of interest is provided in this article.
Section 199A — Qualified Business Income Deduction
Section 199A allows a new deduction for taxpayers, other than "C" corporations, for a portion of their "qualified business income" for tax years beginning after December 31, 2017 and before January 1, 2026. The rules are applied at the individual level for sole proprietorships, at the partner level for partnerships, and at the shareholder level for S corporations. If a taxpayer meets the complex series of tests related to type of business income, type of business, source of income, and other threshold tests related to W-2 wages, character of income, etc., up to 20 percent of his or her qualified business income can be treated as a deduction for U.S. federal income tax purposes. Unused deductions in a given year can be carried over. Several new terms are created under this provision, including:
- "‘Qualified business income’ means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer."
- This generally includes items of income, gain, deduction and loss effectively connected with a U.S. trade or business. It does not include capital gains, dividend income, etc.
- "‘Qualified trade or business’ means any trade or business other than (A) a specified service trade or business, or (B) the trade or business of performing services as an employee."
- A "specified service trade or business" includes, for example, performance of services in the fields of accounting, law, financial services, health, performing arts, etc. Note, however, that for certain taxpayers with income below certain thresholds identified in section 199A, the deduction may be available, even if the income is from a specified trade or business.
- "Combined qualified business income" means, with respect to any taxable year, an amount equal to (A) the sum of the amounts determined to be deductible for each qualified trade or business carried on by the taxpayer, plus (B) 20 percent of the aggregate amount of the qualified REIT dividend and qualified publicly traded partnership income for the taxable year.
- In general, the deductible amount is the lesser of (A) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business, or (B) the greater of (i) 50 percent of the W-2 wages with respect to the qualified trade or business, or (ii) the sum of 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.
- The limitations based on W-2 wages or adjusted basis in property do not apply to taxpayers who have taxable income of $157,500 individually or $315,000 jointly, with the result that those taxpayers can also take the deduction even if they are in a specified service trade or business.
In general, if a taxpayer has taxable income in excess of $207,500, or taxpayers filing a joint return have taxable income in excess of $415,000, no deduction is permitted for income from a specified service trade or business, and the amount of the deduction is limited by the W-2 wage base restrictions and the adjusted basis restrictions, as discussed above.
Section 163(j) as Amended by the 2017 Tax Act — Limitation on Interest Deduction
Section 163(j), as modified by the 2017 Tax Act, generally provides that a taxpayer’s annual deduction of business interest expense "shall not exceed the sum of (A) the business interest income of such taxpayer for such taxable year, (B) 30 percent of the adjusted taxable income of such taxpayer for such taxable year, plus (C) the floor plan financing interest of such taxpayer for such taxable year."1 Any amounts not allowed as a deduction in the year incurred shall be treated as "interest paid or incurred in the succeeding taxable year."2
Section 163(j) applies to all businesses regardless of form, with an exception for taxpayers with average annual gross receipts of less than $25 million for the prior three-year period. There are no exceptions for financial services businesses, and the limitation applies regardless of the tax status of the payee or the payee’s relationship to the taxpayer. For financial services businesses, it is important to note that the limitation applies to net business interest expense. Thus, it only applies if the business interest expense exceeds business interest income. In determining the amount of the limitation, adjusted taxable income is taxable income computed without regard to (a) any item of interest, gain, deduction or loss that is not properly allocable to a trade or business, (b) any business interest or business interest income, (c) the amount of any net operating loss deduction, (d) the new 20 percent deduction for certain pass-through income, and (e) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion. An easy general reference is that, until 2022, the limit is based on EBITDA. After 2021, it is based on EBIT.
The IRS issued Notice 2018-28 on April 2, 2018 with respect to section 163(j) to provide guidance on the application of the limitation in advance of regulations.3 In the Notice, the IRS indicates that it will issue regulations that will generally provide that any interest deduction disallowed in the year it was paid that is carried over to a succeeding taxable year will similarly be subject to the section 163(j) limitations as if it were incurred in the succeeding taxable year. The to-be-issued regulations will also provide guidance as to the interaction between section 163(j) and the new base erosion provisions of section 59A. The Notice states that "for example, if interest paid or accrued by a taxpayer to a foreign person that is a related party as defined in section 59A(g) is carried forward to a taxable year beginning after December 31, 2017, and a deduction is otherwise allowable under Chapter 1 of the Code for such interest, then the interest is treated as a base erosion payment described in section 59A(d)(1) and is subject to the rules under section 59A(c)(3)."4
In addition, the Notice, citing the Conference Report, provides that the regulations will treat all interest paid or accrued by a C corporation on indebtedness of the C corporation as business interest under section 163(j), and all interest on indebtedness held by the C corporation that is includible in gross income of the C corporation will be business interest income within the meaning of section 163(j)(6). The Notice specifically states that the business interest assumption will not apply to S corporations. In addition, the Notice provides that affiliated taxpayers filing a consolidated return will apply the provisions of section 163(j) on a consolidated basis, such that, for purposes of calculating adjusted taxable income, the consolidated taxable income of the group will be used, disregarding certain intercompany obligations under Treasury Regulations section 1.1502-13(g)(2)(ii). Other conforming rules will be issued with respect to the application of section 163(j) to certain transactions, including, for example, when consolidated group members leave the group, separate return year limitations, noncorporate entities within the consolidated group and stock basis adjustments.
The Notice also provides that the to-be-issued regulations will address the application of section 163(j) to partners and partnerships. In general, the annual limitation is applied at the partnership level. There are certain instances, however, when the limitation analysis is applied at the partner level. For example, the IRS intends to provide in regulations that "that a partner cannot include such partner’s share of the partnership’s floor plan financing interest in determining the partner’s annual business interest expense deduction limitation under section 163(j)."
The IRS and the Treasury have indicated that their current list of regulations and other guidance projects include guidance on the section 199A qualified trade or business deduction, and, as stated in Notice 2018-28, guidance will be issued on section 163(j). With respect to section 199A, it is likely that a new form will be developed that assists taxpayers in calculating the deduction and provides additional definitions and examples that will be helpful in determining the amount of the section 199A deduction allowable, if any. In the interim, taxpayers may be tempted to restructure their businesses to seek to "structure into" a form of operation that allows a certain amount of their income to meet the tests required for an increased amount of section 199A deduction. Caution may be advisable, however, until it is clear what potential anti-abuse rules or other "step transaction" or "economic significance" type rules might be applicable to taxpayers who are seeking to benefit from the section 199A deduction when their current structure does not clearly allow for a significant deduction. In addition, section 163(j) will require additional "slicing" of a company’s income and deductions to account for the limitation with respect to interest deductions. It is also important to note that, for taxpayers subject to section 59A, the interest limitation carryforward provisions will impact the tax that may be due on base erosion payments of certain taxpayers.