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

4-Jun-18

IRC 199A’s 20% Deduction: Planning for Eligibility

Take-Away: We can expect to spend a lot of time during the balance of 2018 counselling clients on the new IRC 199A pass-through business deduction, which permits some, but not all, taxpayers to deduct up to 20% of their qualified business income. It is possible (no guarantee) that a basic ‘rule-of-thumb’ can be used to help many of these business owners qualify for the business deduction by adjusting the wages  paid by their business. In addition, other service business owners will want to reduce their taxable income below the income thresholds in order to qualify for the deduction.

IRC 199A Overview: The 2017 Tax Cut Act ( the Act) created IRC 199A. The Act provides a 20% tax deduction for the non-wage portion of pass-through income of a business. This new deduction is limited to a percentage of an entity’s W-2 wages and the unadjusted basis of qualified property.  The deduction is available for married and jointly filing taxpayers who report income over $415,000 and single taxpayers who report income over $207,500. There is a phase-in of the W-2 wage test when the taxpayer’s income is between $315,000 and $415,000 for married joint filers,  and between $157,500 and $207,500 for single taxpayers. The purpose for the use of a relatively low threshold amount ($415,000/$207,500) is to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income that is eligible for the 20% deduction.

Calculating the Deduction: The deductible amount for each trade or business is the lesser of: (i) 20% of the taxpayer’s qualified business income with respect to that qualified trade or business; or (ii) the greater of: (a) 50% of the W-2 wages with respect to the qualified trade or business, or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. Accordingly, the IRC 199A deduction is the sum of the following:  (1) the lesser of (a) the taxpayer’s combined qualified business income, or (b) an amount equal to 20% of the excess of (i) the taxpayer’s taxable income for the tax year, over (ii) the sum of the taxpayer’s net capital gain plus the aggregate amount of qualified cooperative dividends; plus (2) the lesser of: (i) 20% of the aggregate amount of the taxpayer’s qualified cooperative dividends for the tax year, or (ii) the taxpayer’s taxable income reduced by the net capital gains for the tax year. The IRC 199A deduction claimed cannot exceed taxable income reduced by the taxpayer’s net capital gain for the tax year.

Basic Eligibility Rules: The eligibility to claim this new business deduction is tied so several income limits, phase-outs of the deductible amount, and types of businesses that generate the business income. [Nothing, it seems, is ever easy.]

  • Qualified Trade or Business; Qualified Property: These are technical terms of art provided in the Act, which are supposed to be fleshed out in implementing Regulations that we hope to see sometime this fall.
  • Income dollar Ceilings: Married couples with taxable income(s) of no more than $315,000 in the year; a single taxpayer with taxable income no more than $157,500 in the year (income for these purposes is all income reported on a tax return,  not just qualified business income.)
  • Deduction Phase-Outs: The deduction is phased out for married couples with reported income ranging from $315,000 to $415,000 for the year; for a single taxpayer, the deduction is phased out if their income ranges between $157,500 and $207,500.
  • Some Specified Service Businesses Excluded: For the owners of specified service businesses, no IRC 199A deduction is available if their income exceed the ceiling amounts described above. A specified service business includes performing services in the fields of: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading or dealing is securities, partnership interests, or commodities. Added to this list is the vague ‘catch-all’ definition of 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. [Your guess is as good as mine as to what would be covered under this loose reputation or skill exclusion.]
  • Wage and Capital Tests: For a business that is not a specified service business, the deduction is available to a business owner whose taxable income exceeds the ceiling dollar amounts described above. But the deduction will be limited to the greater of (i) 50% of W-2 wages of the business or (ii) 25% of the W-2 wages plus5% of qualified property of the business, e.g. depreciable property like buildings and equipment.
  • Form of Business Can Dictate the Deduction: The form of business will affect the availability of the IRC 199A deduction. Example: Assume the business has qualified business income but not qualified property for the year: (i) Sole Proprietorship: it would have income of $1.0 million, but no W-2 wages, so its 199A deduction would be $0.00; (ii) Partnership: Its income would be $1.0 million, but no W-2 wages, so its 199A deduction would also be $0.00; (iii) S Corporation: Added assumption is that corporation pays reasonable wages of $200,000, so its qualified business income is $800,000; applying the W-2 wage ‘test’ [which is 50% of $200,000] means that the IRC 199A deduction is limited to $100,000 for the S corporation and its shareholders (because the deduction passes through to the owners of the business.]

Strange Result: As several scholarly articles with regard to IRC 199A have noted, since Congress has adopted an income tax,  this is the first time a higher income tax rate would be applied to employee wages and salaries than to income earned by independent contractors and the owners of  S corporations.

‘Rule of Thumb’ Wage Limit?: A couple of commentators have run numbers under the IRC 199A ‘tests’ and have come up with a possible ‘sweet spot’ for the percentage W-2 wages of the overall qualified business income: 28.57%. Let’s revisit the simple example used above. Assume the W-2 wages of the S corporation are increased from 20% to 28.57% of its qualified business income; the wages paid would increase from $200,000 to $285,700, while the qualified business income would correspondingly be reduced to $714,300. Thus, 50% of $285,700 wages paid leads to a $142,850  IRC 199A deduction. Compare this to the slightly higher: 20% of qualified business income IRC 199A deduction [ 20% of $714,300 = $142,860]. The deduction using the 50% of W-2 wages ‘test’ is the smaller of the two numbers (by $10.00). In short, by increasing W-2 wages of the business to 28.57% of the projected qualified business income, the IRC 199A deduction is maximized for the business owners.

Let the Games Begin- Spread Income Through Trusts:  Aggressive Example: Assume the married business owner (Father) transfers (gifts) part of the business to a separate non-grantor trust established for each of the settlor’s spouse, 3 children and3  grandchildren. Each separate non-grantor trust has its own separate ability to stay within the $157,000 taxable income ceiling for IRC 199A.  Assume further the same amount of qualified business income of $1.0 million for the year for the business. Again, the business has no qualified property. The business is formed as an LLC, so it is taxed like a partnership, with the pass-through of its income and deductions to its LLC members. Father retains 30% of the LLC membership interests. Father gifts 10% of the LLC membership interests to several separate non-grantor trusts, one established for his wife and one established for each of his 3 children and one established for each of his three grandchildren. (Yes, its doubtful father would be this aggressive in gifting an income producing business just to qualify for the IRC 199A deduction, but these aggressive facts are used simply to prove the point.) After the gifts, father’s share of the LLC’s qualified business income for the year is $300,000; each non-grantor trust’s share of the LLC’s qualified business income is $100,000. Since all of the LLC members qualify for the IRC 199A pass-through business deduction, this results in the full $200,000 IRC 199A deduction available to the LLC and thus  each of its members. Compare this outcome to the S corporation described above, where the W-2 ‘test’ leads to an IRC 199A deduction for the business of $142,850.

  • Arbitrage: Note that even more tax savings can be achieved if each non-grantor trust distributes its income (derived from the LLC distribution, after taking the deduction) to its primary beneficiary,  a child or grandchild, who probably will be in a lower income tax bracket than the Father.
  • Multiple Trust Caveat: When multiple trusts are created, it is always a good idea to check first with IRC 643(f) which provides:

For purposes of this subchapter, under regulations prescribed by the Secretary, 2 or more trusts shall be treated as 1 trust if- (1) such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose of such trusts is the avoidance of the tax imposed by this chapter. For purposes of the preceding sentence, a husband and wife shall be treated as 1 person.

But: No regulations have yet been issued to implement IRC 643(f), which makes you wonder if the IRS has any intention of enforcing IRC 643(f).

Conclusion: The IRC 199A qualifying rules are highly complex and probably do not lend themselves to simplistic ‘rules of thumb.’ Each business needs to be evaluated on its own merits. Simply increasing W-2 wages to improve the amount of the IRC 199A deduction ignores other payroll taxes that are involved with an increase in wage income. Nonetheless, hopefully these simplistic examples will assist with your working knowledge of this new business deduction which was added to the Act in an attempt to put tax pass-through business entities on an equal footing with C corporations which just had their income tax rates permanently reduced.