On December 22, 2017, President Trump signed into law the comprehensive tax reform bill (the Act) that was passed by Congress on December 20. The Act represents a major change to fundamental provisions of the Code and will affect taxpayers across a broad range of businesses and business entities.
This discussion focuses on the changes made by Section 11011 of the Act, which added new Code Section 199A. Code Sec. 199A provides that taxpayers may deduct a percentage of their income attributable to certain qualified trades or businesses. This deduction creates a tax benefit to owners of passthrough entity businesses, i.e., partnerships and limited liability companies not taxed as corporations, S corporations, and sole proprietorships (passthrough entities), which reduces their effective marginal federal income tax rate to approximately 29.6 percent for income allocable to owners in the highest marginal tax bracket (plus the Medicare tax on unearned income to the extent applicable).
Because of the complexity of the new rules, business owners must act early to determine whether they are eligible for the Code Sec. 199A deduction and whether there are steps they should take either to become eligible or to maximize the amount of their deduction. Generally, the deduction is available only for qualified business income of the taxpayer derived from a domestic business, i.e., effectively connected with a trade or business conducted within the United States. Investment income of the taxpayer and net capital gain income cannot be taken into account in determining the amount of the deduction.
Many business owners will discover that, because of the limitations built into Code Sec. 199A, the promise of the deduction, to deliver “significant tax relief to Main Street job creators” will be unfulfilled.
This Alert will focus your attention on several key features and limitations of Code Sec. 199A to help you to better understand steps you should take to maximize the availability of the deduction to your business.
Which taxpayers are eligible to claim the deduction?
Generally, individuals, trusts, and estates are eligible to claim the Code Sec. 199A deduction with respect to their shares of qualified business income. There is no requirement that the taxpayer is actively engaged in the relevant trade or business or treat the business as one in which the taxpayer is a material participant. The deduction sunsets for taxable years beginning after December 31, 2025.
How is the amount of the deduction determined?
Taxpayers are entitled to a deduction equal to the sum of:
1. The lesser of:
a. The “combined qualified income amount” of the taxpayer, or
b. 20 percent of the excess, if any, of:
i. The taxable income of the taxpayer for the taxable year in excess of
ii. The sum of (x) the taxpayer’s net capital gain, plus (y) qualified cooperative dividends, plus
iii. The lesser of: (x) 20 percent of the aggregate qualified cooperative dividends or the taxable income of the taxpayer less (y) the amount of the taxpayer’s taxable income reduced by the amount of net capital gain.
For most taxpayers (who are unlikely to have qualified cooperative dividend income), the formula can be simplified as the lesser of (x) the taxpayer’s combined qualified income amount or (y) the taxpayer’s taxable income (reduced by any net capital gain for the year).
What is the amount of the taxpayer’s Combined Qualified Income Amount?
The key definitional threshold is determining the amount of the taxpayer’s combined qualified income amount. The combined qualified income amount of the taxpayer is equal to the lesser of:
1. 20 percent of the taxpayer’s share of any “domestic qualified business income” of a passthrough entity, plus
2. The greater of:
a. 50 percent of the domestic wages (reported on a timely filed Form W-2, not a Form 1099) paid with respect to the trade or business, or
b. The sum of 25 percent of such wages and 2.5 percent of the unadjusted basis of all qualified property (tangible property, not land) used in such trade or business.
These amounts are calculated on a business-by-business basis. Included as income from a qualified business are qualified REIT dividends, qualified cooperative dividends, and the taxpayer’s share of qualified publicly traded partnership income. There are phase-ins for the W-2 limitations for taxpayers with taxable income between $157,500 ($315,000 in the case of a joint return) (the threshold amounts) and $227,500 ($415,000 for a joint return) (the fully phased-in amounts). That is, the requirement that the taxpayer satisfies the W-2 payroll floor or W-2 payroll amount plus 2.5 percent of unadjusted basis floor do not apply at all unless the taxpayer’s taxable income is at least equal to the threshold amounts and, if the threshold is met, the requirement is phased-in as the taxpayer’s taxable income scales from the threshold amount to the fully phased-in amount. The Code Sec. 199A deduction is allowable to taxpayers who do not itemize and is not a deduction in determining adjusted taxable income so that it is unlikely to reduce your state taxable income where your state’s taxable income amount piggybacks on federal adjusted taxable income.
In the case of the income of trusts and estates, rules similar to those in existence on December 1, 2017, under former Code Sec. 199 will apply for the purpose of allocating the unadjusted basis of property of the business and the W-2 payroll deduction between the trust or estate fiduciary and the beneficiaries.
The following example illustrates the application of Code Sec. 199A to a simple set of facts. The principal takeaway from this example should be that, for even straightforward returns, the calculation will be complex and could vary year-to-year based on other items on the taxpayer’s return.
Example: Lucy and Ricky file a joint income tax return on which they report taxable income of $520,000 (before taking into account the Code Sec. 199A deduction). Lucy is a partner in a qualified trade or business that makes and distributes chocolate candy (not excluded as a specified service business) and Ricky has a business as an antiquarian bookseller operating through a single-member LLC (not electing to be taxed as a corporation). Lucy and Ricky have $25,000 of investment income, $10,000 of which is from qualified REIT dividends. Lucy and Ricky have no net capital gains for the taxable year.
The calculation of their respective shares of income from a qualified business and Code Sec. 199A deduction are as follows. Because their combined qualified business amount is less than the 20 percent of taxable income cap, Lucy and Ricky’s Code Sec. 199A deduction is limited to $117,000.
In the example, the amount of Ricky’s qualified business income amount was limited by the 50 percent of W-2 wages ceiling ($50,000 in the example), rather than being a straight 20 percent of Ricky’s qualified business income.
In determining the items of qualified business income, Code Sec. 199A excludes investment income from the computation of qualified business income, including all items of capital gain and loss, dividends, payments in lieu of a dividend, interest income other than interest allocable to the trade or business, and items of loss or deduction allocable to the excluded sources of income. Reasonable compensation and guaranteed payments by a partnership (or LLC) for services are also excluded. On the face of the statute, guaranteed payments for the use of partner or member capital are not excluded (the way that interest on indebtedness is excluded), implying that the holders of preferred partnership interests are entitled to claim the deduction based on their shares of partnership income (and subject to the W-2 and unadjusted basis limitations).
What limitations were placed on the availability of the Code Sec. 199A deduction?
It should go without saying that the deduction is available only for a business that is generating net taxable income.
- If the business is operating at a loss, it will not generate a deduction to the owners.
- If the net amount of income, gain, loss, and deduction of a taxpayer for a year is less than zero, the loss is carried forward and treated as a loss from a qualified business in the succeeding taxable year. The taxpayer will not be able to utilize the deduction until the taxpayer is in an overall net income position with respect to the taxpayer’s qualified trades or businesses. Code Sec. 199A aggregates the trades or business of taxpayers owning two or more trades or businesses in determining the amount of the deduction.
- There is no guidance in the statute or legislation concerning how losses otherwise limited by the at-risk or passive activity rules are counted in determining the amount of the taxpayer’s qualified business income amount in a taxable year.
- Because the Code Sec. 199A amount is limited to 20 percent of a taxpayer’s taxable income without regard to the taxpayer’s net capital gain, a taxpayer owning a business that incurs losses up until its exit at a significant capital gain may be limited in the amount of the deduction in the year of a sale.
- Further, if the exit strategy involves a tax-free sale of the business to a corporation for shares of stock, gain on the later sale of the stock will not be eligible for the deduction.
There is a specific exclusion from the definition of qualified business income for income earned by the taxpayer from performance of services (a specified services business): (i) in health, law, accounting consulting, financial services, brokerage services businesses, 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 or owners (e.g., actors, artists, and athletes), or (ii) consisting of investing or investment management, trading, or dealing in securities, partnership interests, or commodities. Engineering and architectural services businesses were carved out of the specified services exclusion. Given the breadth of clause (i) above, it seems hard to argue that the income of a professional sports franchise (other than from product sales), a NASCAR racing team, or a performer on a reality TV show is qualified business income.
- Although the definition of a specified service may have seemed apparent on its face to the drafters of Code Sec. 199A, in practice the definition is unlikely to be so simply applied. We should expect that taxpayers will likely reconfigure their businesses (or at least their marketing or pitch materials), to the extent possible, to characterize themselves as in the business of selling a product and not providing a service. Where the income of a magician performing at a children’s’ birthday party is arguably from a specified services business, if that same magician also provides balloon creatures and hand-marked Mylar balloons as part of the presentation, the performer could argue that he or she is providing a product and not simply a specified service so that the income is from a qualified trade or business.
- The experience of taxpayers and the government under Code Sec. 199 (enacted in 2004 and since repealed) is instructive. The Code Sec. 199 deduction was equal to a percentage of the lesser of the taxpayer's qualified production activities income (QPAI) or taxable income. Several IRS/taxpayer disputes arose around the issue whether certain activities, e.g., creating and distributing gift baskets, involved the production of property. The IRS position required, for example, that a person in the business of buying, roasting, and distributing coffee separate out the revenue stream attributable to its sales of brewed coffee at retail establishments from its other, non-service, income. This portends ongoing disputes between the types of small businesses that were the intended beneficiaries of the provision and the IRS because of the complete lack of guidance concerning the scope and meaning of the provision in the hastily drafted legislation and the propensity of tax return preparers to be aggressive in the application of provisions that were ill-conceived and badly drafted.
- Taxpayers not identified by profession in the legislation should give consideration, at a minimum, to de-emphasizing the service aspect of their business in marketing and pitch materials describing the business in favor of emphasizing the delivery of products to the customer. Specified service businesses, including those identified specifically in the Act by their profession, should consider restructuring their operations to separate their production functions from purely service functions. For example, a dental practice might spin-off the part of the practice that owns the physical facility and the diagnostic equipment (e.g., chairs, drills, and x-ray machines) and fabricates the dental implants. The spun-off business would not be a “service” business. Rather, it would be in the business of producing items sold or leased to the professional services business or renting personal property. By unbundling the services part of the profession from the products used or installed, the income from the spun-off business might qualify as business income rather than income from a specified service. Of course, this could put pressure on the ability of the IRS to reallocate income among controlled business entities if the unbundling were pursued too aggressively.
- If the answer appears to be that service businesses may have to break their businesses into separate segments in order to maximize the non-service income, the key issue will be whether that can be accomplished and to what extent do third-party customers of the service business need to know or be aware of the difference. Could a law firm, for example, create a separate operation for its document processing function, provide that function with the equipment and personnel necessary to accept dictation and produce a finished (or draft) document, and take the position that the document processing group was not providing a service. Rather it was producing a physical piece of paper (or an electronic document) that happened to have a significant service component in the same way that a gift basket filled with chocolates that was assembled by the taxpayer was “produced” notwithstanding the significant service element in the production.
As described above, the Act imposes limits on the amount of the taxpayer’s deduction based on a percentage of the W-2 payroll expense of the business (50 percent) or a combination of the W-2 payroll expense (25 percent) plus 2.5 percent of the original cost of depreciable tangible property (not land) used in the qualified business (qualified property). The latter calculation was added to provide a path to the deduction for businesses with relatively low W-2 payrolls, but with significant investments in depreciable property, e.g., commercial real estate businesses.
- ·Because of the increased availability of expensing for the cost of business assets, Code Sec. 199A created a new defined term to permit capital-intensive business to capture both the benefit of expensing and the new deduction. Although depreciable property of the taxpayer is removed from the calculation base when no longer used in the business or its adjusted tax base has been reduced to $0, the Code Sec. 199A rules allow businesses to compute their deduction on its original cost throughout its “depreciable period,” which is defined as the longer of 10 years or the last day of the last full year of its statutory recovery period. As a result, capital-intensive businesses are not penalized if they expense the cost of equipment, select a faster method for depreciation, or use a cost segregation study to identify shorter-lived assets in order to accelerate their overall depreciation deduction.
Obviously, this provision was inserted to encourage employers to hire additional employees. It is not helpful for businesses that rely on independent contractors for much of their workforce and do not have substantial W-2 payroll expenses or investment in capital equipment or improvements used in the business. This likely provides an additional hurdle for startup businesses that rely on collaborative co-working and workspace-sharing arrangements in that they are unlikely to have very much W-2 payroll or investment in property or equipment. Special rules apply to partnerships and S corporations to dictate the manner in which the W-2 payroll expense and share of depreciable property basis can be allocated among the partners, shareholders, and members.
As a result of these limitations, businesses should review their operations with their tax adviser and financial planner early in the taxable year. Otherwise, they may find themselves unable to access this deduction. Closely held businesses that are taxable as C corporations, but do not forecast the need for significant capital investments in the business, should consider structuring the ownership of their business assets in favor of ownership by business entities owned by the family that lease the assets to the C corporation. Such an arrangement would permit the excess cash to be disbursed from the corporation to the owners of the plant or equipment at the passthrough rate, which would be lower than the combined corporate income tax rate (federal and state) plus the rate payable on dividend distributions or compensation income. For example, land for a factory that might otherwise be acquired by the corporation could be acquired by a family owned LLC that would then lease the land to the C corporation in exchange for a deductible rental payment.