Like the equivalent House bill, the U.S. Senate’s version of the Tax Cuts and Jobs Act adds a new business deduction to tax law: the Sec 199A Qualified Business Income Deduction.
In a nutshell, the Sec 199A Qualified Business Income tax cut gives the owners of pass-through businesses like sole proprietors, partnerships, S corporations and then real estate investors a deduction equal to 23% of qualified business income.
This deduction will produce big savings for many pass-through entities and real estate investors. But the deduction comes with some tricky calculations and complicated limitations. To understand and begin planning for the deduction, therefore, you need to dig into the details.
What is Sec 199A Qualified Business Income?
The qualified business income talked about in Sec 199A—that’s the new section of law that creates the deduction—includes the profit from an active trade or business and then also rental income as long as you operate as a pass-through entity.
More specifically, this means your qualified business income includes the bottom-line profits from an active trade or business as shown on the Schedule C form and in box 1 of a partnership or S corporation K-1, the rental income shown on a Schedule E form and in boxes 2 and 3 of a partnership or S corporation K-1, and then not the capital gains but rather the Sec. 1231 gains that may occur when a business sells assets used in the business.
As noted in the opening paragraphs, to calculate the deduction, you add up all this stuff and then multiply the total by 23%.
If you have $100,000 of qualified business income, for example, you potentially get a $23,000 deduction.
If you have a $1,000,000 of qualified business income, you potentially get a $230,000 deduction.
A technical point: Qualified business income also includes REIT dividends and qualified coop dividends. This logically makes sense since REITs (real estate investment trusts) and qualified coops are also pass-though entities.
What is not Sec. 199A Qualified Business Income
Two types of income you might at first think “count” as qualified business income don’t count…
First of all, the Sec. 199A qualified business income amount does not include reasonable compensation paid to S corporation shareholders nor does it include guaranteed payments paid to partners.
For example, if you own and operate an S corporation making $150,000 before your shareholder-employee salary and then you pay yourself $50,000 in wages, you get the 23% deduction (potentially) on that leftover $100,000 of profits.
The situation works the same way if you’re a partner receiving a guaranteed payment from the partnership. If your share of partnership profits equal $150,000 and you receive $50,000 as a guaranteed payment, you get the 23% deduction only on the remaining $100,000 chunk of the profits.
And a second type of income also doesn’t count for purposes of Sec 199A: Qualified business income does not include foreign earned income.
If your business operates outside the United States, for example, you don’t get to use the Sec. 199A deduction.
Note: This domestic business requirement matches, apparently, the old Sec. 199 “Domestic Production Activities Income” logic and language.
Limitations on Sec 199A Deduction
The Sec 199A qualified business income deduction gets limited in a couple of situations.
A first limitation applies if you’re single and earn more than $250,000 or you’re married and earn more than $500,000. In this case, you can’t deduct more than 50% of your W-2 wages. For example, say you have $1,000,000 of qualified business income and you’re potentially entitled to a $230,000 deduction. If your business’s wages equal $400,000, you can only deduct $200,000 because 50% of $400,000 equals $200,000.
By the way, this wages-based limitation will mean that high income sole proprietors, partnerships and real estate investors without W-2 employees will miss out on the deduction. (Again, this logic sort of matches the old Sec. 199 deduction just mentioned.)
Further, this housekeeping point: You count as wages only amounts your business timely reports to the Social Security Administration.
A second limitation exists, too… You can’t deduct more than 23% of your taxable income after subtracting your net capital gains.
Say, for example, that you should theoretically get a $23,000 Sec 199A qualified business income deduction based on the qualified business income flowing out of a pass-through entity. If due to deductions your taxable income actually equals $80,000 and this $80,000 includes $30,000 of net capital gains, your deduction equals 23% of the net $50,000 ($80,000 taxable income minus $30,000 net capital gains), or $11,500.
Specified Service Trade or Business Disqualification
Not every pass-through entity gets to use the Sec 199A Qualified Business Income deduction.
The law, for example, disqualifies “specified service trades and businesses” including all the traditional white collar professions (medicine, law, engineering, architecture, accounting, actuarial science, financial services and consulting) and then also performing artists and athletics and finally a vague catchall for any trade or business that relies on the “reputation or skill of one or more employees.”
Professional service firms with high-income owners, therefore, potentially don’t get to use the Sec. 199A deduction.
I say “potentially” because this disqualification doesn’t apply if you operate a specified service business and your taxable income falls under $250,000 ($500,000 if you’re married).
Furthermore, if your taxable income exceeds these thresholds ($250,000 or $500,000 in taxable income), the Sec 199A deduction doesn’t immediately zero out. The deduction phases out as you move from $250,000 to $300,000 in taxable income if you’re single (or from $500,000 to $600,000 if you’re married).
Three Other Things to Know
Let me also cover three other things you want to know…
First, the Sec 199A qualified business income deduction starts in 2018 and ends after 2025. The deduction, in other words, only works for the next few years…
Second, the deduction reduces your income subject to federal income taxes. But not self-employment taxes or alternative minimum taxes.
Third, you and I can’t plan for this deduction yet. The House version (described here) works differently. So we’ll need to wait to see how the House and Senate meld their different versions of this new deduction. And then ideally we really want to get some more detailed guidance from the Internal Revenue Service.
Oh and one final thing: Here’s the best version of the actual text that I could find as of Saturday morning a few hours after the Senate voted: Senate version of Tax Cuts and Jobs Act.
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