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George F. Bearup, J.D. Senior Legal Trust Advisor

2-Aug-21

Small Business Tax Fairness Act Proposal

Take-Away: A bill has been filed in Congress that would make significant changes, both good and bad, to the qualified business income tax deduction under IRC 199A. Anything that would make this tax deduction easier to understand and implemented would be welcome.

Background: IRC 199A generally allows business owners of pass-through entities, like LLCs, to take an income tax deduction of up to 20% of their pass-through income, subject to a variety of income limitations, phase-outs and other restrictions.

  • Taxable Income Limits: If the taxpayer’s taxable income reaches $429,800 (married filing jointly) or $214,900 (for single filers) for a non-service business, the taxpayer can only take into account under IRC 199A the lesser of: (i) 20% of qualified business income; or (ii) the greater of (a) 50% of W-2 wages paid to employees or (b) 25% of W-2 wages paid to employees plus 2.5% of the unadjusted basis of qualified property in the business. [Head spinning yet?]
  • Income Tax Deduction: The final income tax deduction authorized under IRC 199A is generally going to be the lesser of:  (A) the taxpayer’s combined qualified business income (as identified above) or (B) an amount equal to 20% of the excess of the taxpayer’s taxable income for the year over the taxpayer’s net capital gain. The tax deduction cannot exceed taxable income reduced by the taxpayer’s net capital gain for the year. However, for what is called a specified service trade or business, once the taxpayer’s taxable income reaches the $429,800/$214,900 threshold, there is no income tax deduction available whatsoever. [Feel that headache coming on?]
  • SSTB: A specified service trade or business [SSSTB] is any business that has income from the following activities: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more employees.

Proposed Legislation: Senator Wyden (D. Oregon) would change many of the highly technical qualifying rules under existing IRC 199A. Some of those proposed changes included in this bill would:

  1. $500,000 Ceiling: Not allow any IRC 199A deduction at all when taxable income exceeds $500,000. The bill changes the threshold amount to $400,00 and the IRC 199A income tax deduction would be phased-out until $500,000, at which point there would be no tax deduction. Accordingly, the ‘50% of W-2 wages paid to employees’ and the ‘25% of W-2 wages paid to employees plus 2.5% of the unadjusted basis of qualified property in the business’ calculations would no longer apply. In short, a taxpayer whose income is over the threshold amount would see his or her IRC 199A tax deduction phased-out, regardless of how much W-2 wages are paid to their employees.
  2. Trusts and Estates Denied the Deduction: Disallow any IRC 199A income tax deduction to an estate or a trust regardless of income levels or W-2 wages paid to employees.
  3. Forced Joint Filing:  Require a married couple to file jointly in order to prevent married couples who both are business owners from filing tax returns separately in order to have two $400,00 income thresholds.
  4. Drop Qualifed Trade or Business: Remove the term qualified trade or business. Thus, any trade or business other than the trade or business of performing services as an employee. This could be good new to the owners of specified service trades or businesses, but recall that the current SSTB limitations do not apply unless a taxpayer’s taxable income is above the current threshold amounts($329,800/$164,900 for 2021) so SSTB taxpayer’s who have taxable income below the threshold are already eligible for the IRC 199A deduction
  5. Single Taxpayers Benefit: Benefit single taxpayers since the $400,000 threshold gives that individual an expanded opportunity to claim the IRC 199A income tax deduction (as the current threshold for the single filer is $164,900.)
  6. Maybe Help Married Taxpayers: Mildly benefit a married SSTB taxpayer whose income falls in between the current threshold ($329,800) and the new $400,000 threshold, before their income tax deduction starts to be phased-out.
  7. Securities Traders: Provides that qualified business income does not include securities traders’ mark-to-market gainsor losses;
  8. Publically Traded Partnerships: Deletes all references in IRC 199A to publically traded partnerships.

Summary: Under the bill, the IRC 199A income tax deduction would be equal to 20% of the lesser of: (i) the qualified business income of the taxpayer; or (ii) the threshold amount of $400,000; or (iii) the taxable income of the taxpayer for the year, reduced by the net capital gain of the taxpayer for that year. Since the threshold amount under the bill is $400,000, the maximum IRC 199A income tax deduction could not exceed $80,000, i.e. 20% of $400,000. If the taxpayer’s taxable income exceeds $400,000, the tax deduction would start to phase-out and would be completely phased-out at $500,000 of reported taxable income.

Conclusion: IRC 199A was not mentioned in President Biden’s proposals to fund either the American Jobs Plan or the American Families Plan. That being said, these proposed changes to IRC 199A could provide a source of tax revenues, if adopted, to help fund those major legislative initiatives the President is pushing. Simplifying the conditions to qualify to claim the IRC 199A income tax deduction for small business would certainly be welcome, although with simplification comes both ‘winners’ and ‘losers’ using pretty arbitrary threhold and ceiling reported incomes.