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

2-May-18

IRC 199A – Overview of the ‘new’ Income Tax Deduction

Take-Away: The details of IRC 199A are now coming a bit more into focus, but it is still an extremely confusing income tax deduction to understand or calculate. It is even more challenging to provide guidance on the deduction for individuals who are owners of multiple businesses.

Background: With the reduction in income tax rates imposed on C corporations from 35% to 21%, Congress wanted to achieve some level of parity in the income tax treatment for S corporations, LLCs, partnerships and sole proprietors.  That effort to achieve parity came in the form of an ‘up-to-20% deduction’ against taxable income of the owners from  businesses that are not C corporations,  so long as the owners are engaged in qualified trades or businesses.  This deduction under IRC 199A, sometimes called the pass-through-deduction, can result in a greater than 7% reduction in the effective federal tax rate of an applicable business owner. But the many exceptions,  limitations and phase-in rules that apply make the IRC 199A deduction a challenge to both comprehend and then compute. Some of the high level definitions, exceptions and limitations (but definitely not all) follow. Warning: what follows is extremely tedious reading.

  • Sunset: Unlike the drop in the maximum income tax rate to 21% for C corporations which is permanent, the IRC 199A income tax deduction sunsets after 2025. [IRC 199A(i).]
  • Qualified Trade or Business: The deductible amount for each qualified trade or business is 20% of its qualified business income from a qualified trade or business. Excluded from the definition of a ‘qualified trade or business’ are specific service trades or business. Generally excluded from this definition of ‘qualified trade or business’ are the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. There are special exceptions for engineering and architecture professions from this ‘professional exclusion.’ [Engineers and architects must have had a strong lobby presence in Washington D.C. when the exceptions of the 2017 Tax Cut Act were negotiated, as no explanation is given why they were excepted but not the other professions.] Adding to the complexity is that lower earning professionals who are normally excluded can still claim some level of the IRC 199A deduction. In sum, many professionals are excluded from claiming the income tax deduction, unless they do not earn much income.
  • Income Limits: If an individual earns too much (or too much when their spouse’s income is added to the professional’s income!) then the IRC 199A deduction is phased out, or completely lost. The threshold amount for single taxpayers in 2018 is $157,500, with a complete phase out of the IRC 199A deduction if the individual’s reported income exceeds $207,500. If the individual is married, the threshold reportable income is $207,500, and the IRC 199A deduction is fully phased out if the individual’s reported income on their Form 1040 is greater than $415,000. These threshold dollar amounts and phase-out limitations will be adjusted annually for inflation, just to add another twist to understanding when and how they apply.
  • Taxable Income: If the taxable income of the business owner is above the thresholds amounts, the  IRC 199A deduction is computed as follows, but only if it produces a smaller amount of the deduction. The IRC 199A deduction is the greater of: (i) The W-2 wages paid by the trade or business (called the W-2 test); or (ii) the W-2 wages of the business plus the capital expenses of the trade or business (called the W-2 wages and capital test.) The ‘W-2 wages and capital expense test’ limits the IRC 199A deduction to the sum of (i) 25% of W-2 wages paid by the trade or business, plus (ii) 2.5% of the unadjusted basis of capital assets immediately after acquisition of all qualified property used in the trade or business.
  • Qualified Business Income: The IRC 199A income tax deduction is claimed against qualified business income. That is defined as a businesses’ net taxable income. But excluded from this calculation are: (i) capital gains and losses; (ii) foreign sourced income; (iii) interest income that is not properly allocable to the trade or business; (iv) annuity income; and (v) guaranteed payments and reasonable compensation for services. [IRC 199A(c).] Net income from activities other than a ‘trade or business’ will not qualify for this income tax deduction. Thus, if all a business owns is rental real estate,  that business is probably too passive, e.g. it conducts business solely in reliance on triple net leases, it would not qualify for the IRC 199A deduction.
  • Only Income Tax Deduction: The IRC 199A deduction does not reduce self-employment taxes or the net investment income tax of 3.8%. [IRC 199A(f)(3).]
  • Below the Line Deduction: The IRC 199A deduction is a ‘below the line’ tax deduction. This means that the tax deduction is not used to determine adjusted gross income. Nor is it an itemized deduction. Therefore a business owner is entitled to claim both the IRC 199A deduction against qualified business income,  and also the standard deduction on his/her Form 1040 return for the year. [Joint Explanatory Statement of Congress, page 39.]
  • NOL Carry Forward: The IRC 199A deduction cannot be taken as part of a net operating loss (NOL) that is carried forward and used in later years. [IRC 172(d)(8).]
  • Net IRC 199A Loss Carry Forward: If the net annual amount of the qualified business income from all qualified trades or businesses owned by the business owner is a loss, this ‘carryover of qualified business loss’ is treated as a loss from a trade or business in the following year’s application of IRC 199A. This thus reduces the Section 199A deduction for that subsequent income tax year. [IRC 199A(c)(2).]
  • Qualified Trade or Business Losses: If a qualified trade or business generates a ‘qualified loss’ for the business owner in a year when other trades or business produce positive qualified business income, a ‘reduction to the deduction’ [sounds like a ‘rap’ song!] is made by 20% of the qualified business loss against the IRC 199A deductible amount derived from the positive trade or businesses’ qualified business income. [Joint Explanatory Statement of Congress, page 37.]
  • Trusts and Estates: No one is sure how IRC 199A applies to a trust or estate and its beneficiaries when the trust or estate holds a qualified trade or business and distributions are made from the trust or estate to beneficiaries. If the trust is a grantor trust for federal income tax purposes, then the grantor reports all the tax items on his/her Form 1040 return. If the trust is not a grantor trust, the applicable business income will be allocated between each of the trust or estate (a separate tax paying entity) and its beneficiaries based on the proportion of distributable net income each is allocated, with the income allocated to corpus attributable to the trust or estate.
  • Unanswered Question: Also unclear is the availability for the IRC 199A deduction for a trade or business that is inherited in light of the transferee’s ‘step-up’ in basis that results from the trade or business being included in the decedent’s taxable estate. Is the ‘stepped-up’ income tax basis the unadjusted basis of capital that the IRC 199A refers to when it applies the ‘W-2 wages and capital expense’ test to limit the IRC 199A deduction?

Possible Planning Steps: A couple of planning steps quickly come to mind if an individual business owner wishes to exploit this new 20% income tax deduction:

  • Real Estate Entity: Consider an LLC that is formed to hold real estate, which is then leased to operating businesses. If the LLC’s sole source of income is rents generated under triple net leases, then it probably will not qualify as a qualified trade or business. The LLC might consider exchanging the ‘triple net leases’ in exchange for leases where the landlord takes a more active role in the management of the real estate business, e.g. landlord provides custodial services, pays real estate taxes, or part of the rents paid are a gross sales override of the tenant. That change in how that real estate business is conducted would permit the landlord-owner to claim the IRC 199A income tax deduction, since the business would then qualify as an active trade or business.
  • Partnerships: If a partnership pays a guaranteed payment to one or more of its partners (or an LLC which is taxed as a partnership) consider abandoning the guaranteed payment arrangement, as the taxable income attributable to the guaranteed payment will not be subject to the IRC 199A income tax deduction.
  • Independent Contractors: If a trade or business has entered into lucrative independent contractor agreements with several individuals, it may be more beneficial to convert those independent contractors to employees who are paid wages. This then enables  a business owner whose income exceeds the threshold amounts, and who thus needs to meet, if possible, the ‘50% of W-2 wages test’ to calculate their IRC 199A income tax deduction with a higher wage base.

Conclusion: Certainly when Treasury gets around to writing proposed Regulations there will be plenty of examples provided so that there will be a better understanding of when IRC 199A applies, when it does not, and how to calculate the 20% income tax deduction using the various optional ‘tests’. Until then, probably sometime this fall,  it will be a slow learning curve for many of us in trying to figure out if a business owner will qualify for the IRC 199A income tax deduction against their qualified business income.