By Phil Jelsma
The recently enacted Tax Cuts and Jobs Act (the "Act") institutes sweeping changes to the tax code on many levels, but one of the most significant adjustments is the new Code Section 199A which provides for a 20% deduction on certain qualified business income earned by pass-through entities such as sole proprietorships, partnerships, LLCs and S Corporations.
This deduction reduces the effective maximum tax rate on eligible pass-through income from 37% to 29.6% and is available to all taxpayers except C Corporations. As a result, individuals, trusts and estates that hold interests in pass-through entities are entitled to the 20% deduction on their qualified business income. The deduction also applies to qualified business income earned as sole proprietorships and single member LLCs.
This new tax break is very complicated -- following are some important issues to consider:
What is a Qualified Business?
The 20% deduction only applies to income from qualified businesses: any trade or business other than certain specified service businesses -- or a trade or a business performing services as an employee.
A specified service business includes the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial/brokerage services, investing/investment management, trade/securities, partnership interests or commodities or any other trade or business where the principal asset is the reputation or skill of one or more of the owners or employees.
The Senate Finance Committee to the Act makes reference to Section 448 regulations that provide illustrations of specified service businesses. As an example, performing arts includes the services of actors, actresses, singers, musicians, entertainers and similar artists in their capacity as such but does not include the provision of services by persons who are not performing artists. So someone who manages or promotes the artist, provides services to the artist such as catering, set design or costumes is entitled to the deduction.
The regulations referenced in the Senate Finance Committee Report also discuss the performance of services in the field of health, including medical services by physicians, nurses, dentists and other similar healthcare professionals yet does not include services related to the medical field such as health, fitness and nutrition.
The provision most likely to cause the greatest discord is "any trade or business where the principal asset of such trade or business is the reputation or skill level of one or more of the owners or employees." Needless to say, it is certainly feasible that many professionals could fall into this category.
Implicit in Code Section 199A is the question of whether the activity arises to a trade or business. The most common example is rental real estate where the property is either a single-family residential property or a triple net lease property.
Case law is not clear whether either activity rises to a trade or business. In what some have seen as a loophole, Section 199A does specifically include dividends as qualifying business income entitled to the 20% deduction. REITs are precluded from engaging in the kinds of real property rental activities where a significant service is provided to tenants.
Most REITs generate passive rental income similar to property subject to a triple net lease. Whether this means that triple net lease property would automatically qualify for the 20% deduction, remains to be seen.
Exclusions from Qualified Business Income
Not all income earned by a pass-through entity is entitled to the 20% deduction. Generally, the income must be earned by a trade or business within the United States. Such investment income also excluded:
Short-term and long-term capital gains
Dividends, income equivalent to dividends and payments in lieu of dividends
Net income from national principal contracts
Foreign currency gains
Interest income other than interest income generated as part of a business
Gains from commodity transactions, including futures, forward and similar transactions unless used in connection with the hedging by the business, or selling commodities is the business of the taxpayer
Income from annuities not related to the business.
Reasonable compensation paid to the taxpayer with respect to the business and any guaranteed payments are also not included in qualified business income.
What are the Limitations?
Although initially the deduction is 20% of the qualifying business income, it is subject to a limitation based on the W-2 wages paid by the business. In fact, the W-2 limitation is the greater of the following: (a) 50% of the W-2 wages paid by the business or (b) 25% of the W-2 wages paid by the business plus 2.5% of the original cost of depreciable property and acquisition costs for that property that are capitalized in the business.
Depreciable property is only included for as long as the asset is subject to depreciation. Once the asset is fully depreciated, it then comes out of the 2.5% asset base -- the unadjusted basis of the property determined immediately after the acquisition. This would include both the purchase price and capitalized costs subject to depreciation -- whether subsequent capital improvements can be included is unclear.
The treatment of separate businesses is also a bit murky. Qualified business income (QBI) is computed separately for each business. Losses from a qualified trade or business produce a negative QBI and carry forward. This is a novel concept since it is effectively a negative deductible amount.
If there are multiple owners of the qualifying business, then each owner only gets a share of the W-2 wages. For example, if there are two equal owners of an S Corporation or an LLC, each would get 50% of the allocation of payroll. Single member LLCs and sole proprietorships would get a 100% of the allocation.
If a partnership or LLC has several qualifying businesses as well as some that don't, for example investment activities, there would need to be an allocation of the wages among the qualifying activities and those that are excluded from Code Section 199A.
Code Section 199A(f)(1)(A) provides in the case of a partnership or LLC, the allocation must follow the allocation of expenses to the partners or members related to wages. For an S Corporation, the allocation must be in proportion to stock ownership of each shareholder.
The Limitation on Taxable Income
The amount of the deduction is cannot exceed 20% of the taxpayer's taxable income before the deduction reduced by net capital gain.
For example, a taxpayer who has more itemized and non-business deductions than non-business income will be subject to this limitation.
And if the taxpayer's income is only qualified business income, but has deductions for home mortgage interest, state and local taxes, charitable contributions, 20% of taxable income will be less than 20% of qualified business income.
This prevents the deduction from creating a loss for the year. The deduction cannot cause a taxpayer's taxable income to be negative.
Below a Certain Income Level
Despite the prohibition on select service businesses, taxpayers below income thresholds can still earn the deduction. Joint taxpayers whose income is $315,000 or less or single taxpayers whose taxable income is $157,500 or less are entitled to the deduction.
On a joint return, the benefit is phased out between $315,000 and $415,000 of taxable income, and for a single taxpayer the benefit is phased out between $157,500 and $207,500 of taxable income.
Impact of the Deduction
As a result of this new deduction, many businesses will consider restructuring. In particular, businesses that segregate the payment W-2 wages may look to combine them with the qualified business income. This means that the entity that would otherwise be the employer may be used as a holding company to hold interests in qualified businesses. Alternatively, the entity that would be the common law employer may be treated as a subsidiary of the operating entities.
Ultimately, the new 20% pass-through deduction has planners re-examining choice of entity and organizational structures -- many businesses who have isolated W-2 wages from operational income are re-thinking their set-ups.
Phil Jelsma is chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson LLC (CGS3), a San Diego-based commercial real estate law firm. He is recognized as a leading joint venture and tax attorney, with a 30-year background in real estate exchange transactions, syndications, nonprofit corporations and international tax planning.