In this two-part eBulletin, Seiler LLP, an accounting firm based in Redwood City, sheds light on a new provision, referred to as the Qualified Business Income, under Section 11011 (IRC §199A) of the Tax Cuts and Jobs Act, and its effects on pass-through entities. The first part discusses the background and the definition of the terms and explains the mechanics of the 20% deduction. The second part addresses the limitations and losses allowed under the provision in “Tax Cuts and Jobs Act, Part II: Specified Service Business Limitation, Treating Losses and Analysis.” The Treasury Department is expected to issue guidance to carry out the purposes of this provision. Taxpayers should be aware of the additional compliance costs as a result of the provision.
The Basics: Definitions, and Deductions
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the Act). The Act represents the first major overhaul of the tax system since the Tax Reform Act of 1986. One of the goals of tax reform is to simplify an archaic tax system which many attorneys, accountants and tax professionals think, was getting too complex.
“Qualified business income” (QBI) is defined in the Act as the net amount of qualified items of income, gain, deduction and loss with respect to any qualified trade or business. Items are treated as qualified items of income, gain, deduction and loss to the extent they are effectively connected with the conduct of a trade or business within in the United States. QBI does not include the following items of income, gain, deduction or loss:
1) Investment income, such as interest income, dividends, short-term and long-term capital gains, commodities gains, foreign currency gains and similar items;
2) Reasonable compensation paid by an S corporation to its shareholder;
3) Guaranteed payment paid by a partnership to its partner for services rendered with respect to the trade or business under IRC §707(c); and
4) Payment made by a partnership to a partner, who is acting other than in his or her capacity as a partner, for services under IRC §707(a).
QBI is determined without regard to any adjustments prescribed under alternative minimum tax rules.
“Qualified property” means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year; which is used in the production of qualified business income; and for which the depreciable period has not ended before the close of the taxable year. Under the Conference Report, the term “depreciable period” is defined as the period beginning on the date the qualified property is first
placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period determined under section 168 of the Internal Revenue Code. In the case of qualified property that is sold, the property is no longer available for use in the trade or business and is not taken into account in determining the limitation based on W-2 wages (defined below) and capital.
“W-2 wages” are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer. W-2 wages do not include any amount which is not properly allocable to the qualified business income as a qualified item of deduction. In addition, W-2 wages do not include any amount which was not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return.
Prior to the effective date of the Act, business income after deductions from pass-through entities was proportionately passed through to entity owners, who would pay the corresponding tax on their individual income tax returns. As a result, many owners end up paying tax on the pass-through income at ordinary income tax rates capped at 39.6%.
Under the Act, individuals with QBI from pass-through entities, such as S corporations and partnerships, may be provided a 20% deduction against their taxable income. The 20% deduction, combined with the top ordinary individual income tax rate of 37%, would result in an effective tax rate of 29.6% for such income in the absence of other limitations.
The 20% deduction, which was added to the tax code under Section 199A of the Internal Revenue Code, is available for years after December 31, 2017, and before January 1, 2026. The deduction is not allowed when computing adjusted gross income, and instead is allowed as a deduction reducing taxable income.
The deduction, as computed under the Act, is equal to the sum of (a) and (b) as defined below:
a) the lesser of:
i. the combined qualified business income amount for the taxable year, or
ii. an amount equal to 20% of the excess of taxpayer’s taxable income over any net capital gain and qualified cooperative dividends
b) the lesser of 20% of qualified cooperative dividends or taxable income, reduced by net capital gain.
This sum may not exceed the taxpayer’s taxable income for the taxable year, reduced by net capital gain. The combined qualified business income amount for the taxable year is the sum of the deductible amounts determined for each qualified trade or business carried on by the taxpayer and 20% of the taxpayer’s qualified REIT dividends and qualified publicly traded partnership income. The deductible amount for each trade or business is the lesser of:
a) 20% of the taxpayer’s qualified business income with respect to the trade or business; or
b) The greater of 50% of the W-2 wages with respect to the trade or business or the sum of 25% of the W-2 wages with respect to the trade or business and 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (limitation based on W-2 wages and capital).
The 20% deduction is available to taxpayers who are not engaged in a “specified service trade or business”, as defined to include the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services (including investing and investment management trading), or dealing in securities, partnership interests, or commodities and 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 or owners. Engineering and architecture services are excluded from the list of specified service businesses. Taxpayers, who are engaged in the specified service trade or business as defined above, are eligible to claim the 20% deduction subject to the specified service business limitation, discussed in the next installment of this e-bulletin.
Taxpayers with taxable income below $315,000 for joint filers ($157,500 for other filers) are not subject to the limitation based on W-2 wages and capital above. The deductible amount for each qualified trade or business is 20% of the QBI with respect to each of its corresponding trade and business. The limitation is phased in for taxpayers with taxable income exceeding these threshold amounts over ranges of $100,000 and $50,000, respectively.
H and W file a joint return on which they report taxable income of $380,000. W has a qualified trade or business such that 20% of the QBI is $15,000. W’s share of wages paid by the business is $20,000, so 50% of the W-2 wages is $10,000. The business has nominal amounts of qualified property such that 50% of W-2 is greater than 25% of W-2 wages plus 2.5% of qualified property. The $15,000 amount is reduced by 80% (($380,000 - $315,000)/$100,000) of the difference between $15,000 and $10,000, or $4,000. H and W can claim a deduction of $11,000 against taxable income on their Federal income tax return.
This e-bulletin was prepared by Mel Nguyen, Tax Senior Manager, Seiler LLP, in Redwood City, CA.