Business Income Deductions at the federal level have remained largely standard for years. Perhaps that is why there was so much anticipation around the 2017 Tax Cuts and Jobs Act. A wide-ranging piece of legislation, the bill included the enactment of Internal Revenue Code Section 199A which provides a deduction of up to 20% of income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate (effective December 31,2017). Over the past year additional modifications have been made to this already complex and complicated piece of legislation, leaving many business owners to wonder just what they can expect from these evolving deductions and how they can make tax breaks – if any – work in their favor. Let’s take a closer look at Sec. 199A and the considerations you need to know as you prepare to file.
2017 Federal Tax Cuts and Jobs Act
One of the most anticipated pieces of the Tax Cuts and Jobs Act new law was the significant reduction in the C Corporation tax rate from 35% to 21%. Section 199A was enacted to provide a similar benefit for the owners of “flow-through businesses” that pay income tax at the business owner’s individual tax rate. Contractors, real estate professionals, manufacturers, architects, and engineers are among the many types of businesses eligible for the deduction.
However, the deduction may be taken by individuals and by some estates and trusts. Notice the word“some” – when it comes to this deduction nuances abound!
Section 199A has been cited as one of the most complex and complicated provisions of the new tax law. Final regulations were just issued by the IRS on January 18th that answer most of the remaining questions around this new code section. In order to optimize the deduction, it is essential for taxpayers to be informed of their choices and the understand the residual impact of these regulations.
Qualified Business Income: Finding the 20%
Qualified Business Income (QBI) is the net amount of qualified items of income, gain, deduction,and loss with respect to a qualified trade or business. It’s worth noting that QBI does*not* include wages; guaranteed payments; capital gains/losses; interest or dividends.
For this process, the Qualified Business Income Deduction is calculated through a detailed step by-step process. First, the deduction is subject to an overall limitation of 20% of the business owner’s individual taxable income. Section 199A then limits the taxpayer’s deduction when taxable income exceeds a statutory defined amount based on:
- The type of trade or business that the taxpayer is engaged in;
- The amount of W-2 wages paid by the business, and/or;
- The cost of qualified property held for use in the trade or business.
Keep in mind, the limitations are subject to phase-in rules based upon the taxable income of the business owner. For example, the phase-in rules begin at individual taxable income of$315,000 (married filing joint) or $157,000 (all others). Taxpayers with individual taxable income below these thresholds are not subject to the phase-in rules
Noted Exception: Specified Service Trade or Businesses (SSTBs)
With this legislation, there are more strict rules for business owners of “specified service trade or businesses” (SSTBs). This type of business is generally classified as any trade or business involving the performance of services in fields such as healthcare, law firms, accounting firms,consultants, and financial service firms, among others. As an SSTB, the deduction is fully phased out if individual taxable income is in excess of $415,000 (married filing joint) and $207,500 (all others).
What About Real Estate?
Recent IRS guidance confirmed that the 20% deduction is applicable to the business income of real estate agents and brokers. The new IRS guidance also provides a safe harbor for rental activities as those expenditures can also qualify for the 20% deduction if certain requirements are met. Most notably:
- 250 hours or more of “rental services” performed per year per activity;o Includes typical landlord activities of maintaining and repairing property, collecting rent, and paying expenses;
- Separate books and records for each activity are required;
- Contemporaneous records including time reports or similar documents are required.
The January guidance also confirmed that a “self-rental” activity will qualify if it is rented to a commonly controlled trade or business that is owned by the taxpayer.
The Option to Aggregate
For taxpayers who own two or more businesses Section 199A states that not every business has to stand on its own for purposes of passing the wages and qualified property tests that can limit the deduction. However, each business must pass several tests to be allowed in the aggregation. For example, if the requirements for aggregation are met, wages from one business can be used to qualify the income from another business for the deduction.
The option to aggregate has given rise to new reporting and disclosure requirements. Once an individual taxpayer elects to aggregate two or more businesses, the individual must consistently report the aggregated businesses in all subsequent tax years.
Savvy business owners know that deductions are not just about reducing your tax burden today.
Determining how your company qualifies for Section 199A and the nuances that impact your business over time is also critically important. To effectively take advantage of the new regulations a thorough understanding of your businesses’ specific facts and circumstances is required in order to determine the best strategy to optimize the deduction. Our team at EJ Callahan has already been helping clients navigate the complexities associated with this legislation. Get in touch today and see how we can help your business make the most out of Section 199A as part of your overall tax strategy.