Explaining Section 199A, the new qualified business income deduction

The Tax Cuts and Jobs Act of 2017 created a new tax break, Section 199A, where individuals and certain noncorporate taxpayers can deduct up to 20 percent of qualified business income (QBI) on their 2018 federal income tax returns.

It applies to flow-through entities, such as an S corporation, partnership, limited liability corporations and sole proprietorships, where QBI is taxed on the individual, estate or trust return, and subject to higher tax rates. The idea is that with the C corporation rate down to 21 percent, Section 199A allows flow-through entities to operate on a similar playing field.

“Section 199A will reduce the amount of taxes they pay on trade or business income. But it can be a very complex calculation, figuring out your QBI and what limitations apply. It’s not just a simple 20 percent deduction,” says Donna Deist, CPA, MST, senior manager at Ciuni & Panichi Inc.

Smart Business spoke with Deist about how Section 199A will work, now that the IRS has issued the final regulations.

What is considered eligible income?

QBI will include income, gains, deductions or loss from trade or business conducted in the United States. QBI, however, doesn’t include capital gains or losses, qualified dividends, guaranteed payments made to partners, or reasonable compensation paid to owners or taxpayers for their services to that trade or business.

You mentioned that the 20 percent is subject to limitations. What are those?

Once your taxable income exceeds certain thresholds, the 20 percent deduction is subject to limitations. If your taxable income is anywhere between $315,000 and $415,000 for married filing jointly, or $157,500 to $207,500 for all other taxpayers, such as single, head of household, estates, trusts, etc., then you’ll phase out of being able to deduct the 20 percent and will need to phase in the use of the wage and property limitation to determine the amount of the deduction.

Once your taxable income is higher than $415,000 for a joint return or $207,500 for other returns, the wage and property limitation is fully used. To calculate the 199A deduction, you’ll determine which is greater:

  • 50 percent of the W-2 wages for that trade or business.
  • 25 percent the W-2 wages of that trade or business, plus 2.5 percent of unadjusted basis immediately after acquisition (UBIA) of property. (This is directed at those in real estate who usually have much lower W-2 wages, if any at all.)

Then, you must weigh the greater of those two against 20 percent of QBI and take the lesser deduction on your tax return.

In addition, once your taxable income is in this high-income bracket, service providers no longer qualify for the Section 199A deduction. This mostly applies to doctors, lawyers and accountants, but all high-income service providers should check the qualifying list.

How do you think taxpayers will handle the complicated wage and property limitation?

This wage and property limitation requires a complex calculation, but those who have higher taxable income normally work with a tax adviser who can help. People in the real estate business, especially, will have to obtain more information, such as the UBIA, which is basically the cost of the property. However, only some property qualifies.

Even though the pass-through entity doesn’t have to calculate the deduction, it has the responsibility to keep records and report all of the information needed by the owners, shareholders or partners, so they can make the calculations on their returns. That includes W-2 wages and UBIA.

What about when taxpayers have multiple flow-through trades or businesses?

It may be more beneficial for you to aggregate or combine trades or businesses, if they fall within certain guidelines.
Aggregating businesses, however, is not something that can change year to year. Once you elect to aggregate those businesses, until the facts or circumstances of a trade or business change so that it no longer falls in the guidelines of being able to be aggregated, you must continue with that aggregation. You can still add other businesses to that aggregation, though.

This isn’t a decision to be taken lightly. So, carefully consider past activities and future plans with your tax adviser to make the right choice.

Insights Accounting is brought to you by Ciuni & Panichi, Inc.