Mechanics of the new Sec. 199A deduction for qualified business income

One of the more important provisions in P.L. 115-97, known as the Tax Cuts and Jobs Act, enacted Dec. 22, 2017, is new Sec. 199A, the deduction for qualified business income (QBI). Sec. 199A allows a deduction for up to 20% of QBI from partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships.

Sec. 199A creates a deduction based on an “artificial” calculation of business income instead of actual economic outlays required for most other business deductions. The provision is a significant tax benefit for many noncorporate businesses and was passed in part on the premise that a sizable tax rate cut for C corporations — from a maximum graduated rate of 35% down to a flat 21% rate — justified a corollary tax benefit to non—C corporation businesses. The Sec. 199A deduction is taken at the partner, S corporation shareholder, estate and trust, or sole proprietor level for tax years beginning after Dec. 31, 2017.

Most basically, the deduction is equal to the sum of 20% of the QBI of each of the taxpayer’s qualified businesses. The full calculation, however, involves a multistep process that may phase out some or all of the deduction. These steps are discussed below. Calculations involving cooperative dividends, real estate investment trust (REIT) dividends, publicly traded partnership (PTP) income, and agricultural and horticultural cooperatives are beyond the scope of this article.

OVERVIEW

The initial step in calculating the Sec. 199A deduction begins with determining QBI. QBI is determined separately for each of the taxpayer’s qualified businesses. For any tax year, QBI is the net amount of items of income, gain, deduction, and loss with respect to any qualified business of the taxpayer. Qualified items of income, gain deduction, and loss include such items that are effectively connected with the conduct of a U.S. trade or business and are included in determining the business’s taxable income for the tax year.

Certain investment items are excepted from QBI, including short-term and long-term capital gains and losses, dividends, and interest income not properly allocable to a trade or business. QBI also does not include reasonable compensation payments to a taxpayer for services rendered to a qualified business, guaranteed payments to a partner for services rendered to a business, and, to the extent provided in regulations, a Sec. 707(a) payment to a partner for services rendered to the business (Sec. 199A(c)).

Another critical definition is for the “combined QBI amount” (Sec. 199A(b)). The combined QBI amount serves as a placeholder: It is the amount of the Sec. 199A deduction before taking into account a final overall limitation. Under this overall limitation, a taxpayer’s QBI deduction is limited to 20% of the taxpayer’s taxable income in excess of any net capital gain. The combined QBI amount is the sum of the deductible QBI amounts for each of the taxpayer’s qualified businesses. The deductible QBI amount of a qualified business is generally 20% of its QBI, but the deductible QBI amount may be limited (1) by a wage and capital limitation and/or (2) when the business is a specified service trade or business.

The calculation of a taxpayer’s Sec. 199A deduction depends on whether the taxpayer’s taxable income is (1) below a lower taxable income threshold ($157,500, or $315,000 if filing a joint return), (2) above a higher taxable income threshold ($207,500, or $415,000 if filing a joint return), or (3) between the lower and higher taxable income thresholds. (When computing taxable income for this purpose, the Sec. 199A deduction is ignored.)

TAXPAYERS BELOW THE LOWER TAXABLE INCOME THRESHOLD

If a taxpayer has income below the lower threshold, calculating the Sec. 199A deduction is straightforward. The taxpayer first (1) calculates the deductible QBI amount for each qualified business and (2) combines the deductible QBI amounts to determine the combined QBI amount. If the taxpayer has only one qualified business, the combined QBI amount is the deductible QBI amount for that business. The taxpayer then applies the overall taxable income limitation to the combined QBI. Thus, the taxpayer’s Sec. 199A deduction is equal to the lesser of (1) the combined QBI amount or (2) the overall limitation (20% × taxpayer’s taxable income in excess of any net capital gain).

Example 1

H and W file a joint return on which they report taxable income of $310,000, of which $10,000 is net capital gain and $280,000 is ordinary net income from H’s interest in an S corporation. H and W’s combined QBI is $56,000 (20% × QBI of $280,000). Combined QBI is $56,000 before applying the overall limitation of $60,000 (20% × [$310,000 taxable income — $10,000 net capital gain]). H and W’s Sec. 199A deduction is $56,000.

TAXPAYERS ABOVE THE HIGHER TAXABLE INCOME THRESHOLD

If the taxpayer has taxable income above the higher threshold amount, two issues arise in the calculation of the Sec. 199A deduction. First, a business of the taxpayer will not be treated as a qualified business, and the income of the business of the taxpayer will not be included in QBI, if the business meets the definition of a specified service trade or business (see below). Thus, the Sec. 199A deduction will be denied in full for the business. Second, if a business is a qualified business (i.e., it is not a specified service trade or business), the deductible QBI amount for the business is subject to a W-2 wage and capital limitation.

EXCEPTION FOR A SPECIFIED SERVICE TRADE OR BUSINESS

As described above, taxpayers with taxable income of more than $415,000 (the “higher threshold”) are denied the Sec. 199A deduction for the income from any business that is a specified service trade or business. A specified service trade or business is defined in Sec. 199A(d)(2) as “any trade or business — (A) which is described in section 1202(e)(3)(A) (applied without regard to the words ‘engineering, architecture,’) … or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” Sec. 1202(e)(3)(A) describes:

any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees [or owners].

Thus, service trades or businesses (e.g., engineering, architecture, manufacturing, etc.) that are not specified service trades or businesses are eligible for the deduction regardless of the taxpayer’s taxable income, but businesses providing specified services (e.g., law, accounting, consulting, investment management, etc.) — of taxpayers who have taxable income above the higher taxable income threshold limit — are barred from the deduction.

Example 2

H and W file a joint return on which they report taxable income of $450,000, of which $300,000 is ordinary income from W’s interest in an S corporation. W’s S corporation is a specified service trade or business because it performs consulting services. H and W cannot take a Sec. 199A deduction based on the income from the S corporation.

W-2 WAGE AND CAPITAL LIMITATION ON QBI

If a taxpayer has taxable income above the higher taxable income threshold and owns a business that is not a specified service trade or business, the QBI deductible amount for the business is subject to a limitation based on W-2 wages and/or capital (capital here is measured as the unadjusted basis of certain business assets) (Sec. 199A(b)(2)(B)). The deductible QBI amount for the business is equal to the lesser of (1) 20% of the business’s QBI, or (2) the greater of: (a) 50% of the W-2 wages for the business, or (b) 25% of the W-2 wages plus 2.5% of the business’s unadjusted basis in all qualified property. Thus, two alternative limitations under Sec. 199A(b)(2) may limit the deductible QBI amount for each business that is included in a taxpayer’s combined QBI amount: (1) a pure 50% wage test, or (2) a combined 25% wage and capital test.

W-2 wages are total wages subject to wage withholding, elective deferrals, and deferred compensation paid during the tax year that are attributable to QBI (Sec. 199A(b)(4)). However, amounts not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for that return are not included (Sec. 199A(b)(4)(C)). A partner’s allocable share of W-2 wages is required to be determined in the same manner as the partner’s share of wage expenses.

The basis of qualifying property is calculated as the unadjusted basis immediately after acquisition of that property. Qualifying property means (1) tangible, (2) depreciable property (3) held by, and available for use in, the business at the close of the tax year, (4) used in the production of QBI at any time during the year, and (5) for which the “depreciable period” has not ended before the close of the tax year (Sec. 199A(b)(6)).

The depreciable period starts on the date the property is first placed in service and ends on the later of (1) 10 years after the beginning date, or (2) the last day of the last full year of the applicable recovery period under Sec. 168 (ignoring Sec. 168(g)). This rule allows “qualified property” to include property that has exhausted its modified accelerated cost recovery system (MACRS) depreciation period if it is still in its first 10 years of service. The statute directs Treasury to provide anti-abuse rules to prevent the manipulation of the depreciable period of qualified property through related-party transactions, and for determining the unadjusted basis immediately after the acquisition of qualified property in like-kind exchanges and involuntary conversions.

Example 3

H and W file a joint return on which they report taxable income of $450,000, of which $300,000 is ordinary income from W’s interest in an S corporation that is not a specified service trade or business. W’s allocable share of the business’s W-2 wages is $80,000, and her share of the business’s unadjusted basis in its qualified property is $600,000.

H and W’s wage and capital limitation is the greater of (1) 50% of W-2 wages, $40,000, or (2) the sum of 25% of W-2 wages, $20,000, plus 2.5% of the unadjusted basis of the qualified property immediately after its acquisition: $600,000 × 0.025 = $15,000, for a sum of $35,000. The amount of the wage and capital limitation is therefore $40,000.

H and W’s combined QBI is the lesser of 20% of QBI, $60,000, or the wage and capital limitation of $40,000, or $40,000. Combined QBI is $40,000 before applying the overall limitation of $90,000 (20% of $450,000). H and W’s Sec. 199A deduction is $40,000.

TAXPAYERS BETWEEN THE LOWER AND HIGHER THRESHOLDS

Taxpayers with taxable income between the lower and higher thresholds (i.e., between $315,000 and $415,000 for married taxpayers filing jointly; between $157,500 and $207,500 for others) are subject to a ratable phase-in of the wage and capital limitation (thereby avoiding the full burden of the wage and capital limitation). For taxpayers owning a specified service trade or business who are between these thresholds, the deduction limitation is also phased in — allowing taxpayers with a specified service trade or business at this taxable income range to be able to qualify for at least part of the Sec. 199A deduction.

Wage and capital limitation phased in

Taxpayers between the taxable income thresholds and who are not in a specified service trade or business are subject to only a partial wage and capital limitation. The deductible QBI amount for a business of a taxpayer with taxable income between the thresholds is 20% of QBI, less an amount equal to a “reduction ratio” multiplied by an “excess amount.”

The “reduction ratio” is calculated as the amount of taxable income in excess of the lower threshold amount of $315,000 for married filing jointly ($157,500 for other taxpayers), divided by $100,000 for joint filers ($50,000 for other taxpayers) (Sec. 199A(b)(3)(B)(ii)). The more taxable income, the higher the reduction ratio, and the more the wage and capital limitations apply until they are fully phased in at $415,000 (or $207,500).

The “excess amount” (determined under Sec. 199A(b)(3)(A)(ii)) is the amount of the difference between (1) the deductible QBI amount of the qualified business with no wage and capital limitation (i.e., 20% of QBI); and (2) the deductible QBI amount of the qualified business with a fully phased-in wage and capital limitation (see W-2 wage and capital limitation on QBI, above). The reduction ratio is applied to this hypothetical amount to determine the reduction of the wage and capital limitation.

Example 4

H and W file a joint return on which they report taxable income of $330,000, of which $300,000 is ordinary income from H’s interest in an S corporation. The S corporation is not a specified service trade or business. H’s allocable share of the business’s W-2 wages is $80,000, and his share of the business’s unadjusted basis in its qualified property is $600,000. Because H and W’s taxable income is between the lower and higher thresholds, only a partial wage and capital limitation applies.

The reduction ratio is calculated as $330,000 less $315,000 = $15,000 of excess taxable income above the lower threshold, divided by $100,000 = 15%.

Next, the excess amount is calculated. The deductible QBI amount of the business with no wage and capital limitation applied is 20% of QBI of $300,000 = $60,000. The deductible QBI amount for the business with a full wage and capital limitation is the greater of (1) 50% of W-2 wages, or $40,000, or (2) the sum of 25% of W-2 wages ($20,000) plus 2.5% of the unadjusted basis of the qualified property immediately after its acquisition: $600,000 × 0.025 = $15,000, for a sum of $35,000. The deductible QBI amount with a full wage and capital limitation is therefore $40,000. The difference between $60,000 and $40,000, or $20,000, is the excess amount.

The 15% reduction ratio multiplied by the excess amount of $20,000 is $3,000. The deductible QBI amount for the business is therefore 20% of QBI, $60,000, less $3,000, or $57,000. Because H and W have only one qualified business, their combined QBI amount is also $57,000 before applying the overall limitation of $66,000 (20% of $330,000). H and W’s Sec. 199A deduction is $57,000.

Applying the limitation on a specified service trade or business

To calculate the specified service trade or business limitation for taxpayers with QBI from a specified service trade or business and taxable income between the higher and lower thresholds, the taxpayer first calculates an “applicable percentage.” The applicable percentage is 100% less the ratio of taxable income in excess of the lower threshold amount of $315,000 ($157,500 if not a joint filer), all divided by $100,000 ($50,000 if not a joint filer) (the applicable percentage is calculated inversely to the reduction ratio). The taxpayer multiplies the applicable percentage by (1) QBI, (2) W-2 wages, and (3) unadjusted basis of all qualified property to arrive at the includible amount of these items. These amounts are then used in calculating the deductible QBI amount for the business, as described above in “Wage and Capital Limitation Phased In.”

Example 5

H and W file a joint return on which they report taxable income of $330,000, of which $300,000 is ordinary income from H’s interest in an S corporation that is a specified service trade or business. H’s allocable share of the business’s W-2 wages is $80,000, and his share of the business’s unadjusted basis in its qualified property is $600,000. Because H and W’s taxable income is between the lower and higher thresholds, and they have a business that is a specified service trade or business, H and W must calculate their specified service trade or business limitation phase-in.

The applicable percentage is 100% less the ratio of ([$330,000 — $315,000] ÷ $100,000) = 1 — 0.15 = 0.85, or 85%. Multiplying their QBI, W-2 wages, and unadjusted basis of qualified property by 85%, H and W have $255,000 of includible QBI, $68,000 of includible W-2 wages, and $510,000 of includible unadjusted basis of qualified property after the limitation on a specified service trade or business.

H and W must then apply the wage and capital limitation using these includible amounts. The reduction ratio is $15,000 ($330,000 less $315,000) of excess taxable income above the lower threshold, divided by $100,000, or 15%.

Next, the excess amount is calculated. H and W’s deductible QBI amount, calculated as if no wage and capital limitation applied, is 20% of includible QBI ($255,000), or $51,000. Their deductible QBI amount calculated as if the full wage and capital limitation applied is (1) 50% of includible W-2 wages ($68,000), or $34,000, or (2) the sum of 25% of includible W-2 wages ($17,000) plus 2.5% of the includible unadjusted basis of the qualified property immediately after its acquisition: $510,000 × 0.025 = $12,750, for a sum of $29,750. Therefore, the hypothetical full wage and capital limitation is $34,000. The excess amount is the difference between these two amounts, $51,000 — $34,000 = $17,000.

The deductible QBI amount after the wage and capital limitation is the deductible QBI amount calculated as if no wage or capital limitation applied ($51,000) less the reduction ratio of 0.15 × the excess amount of $17,000 ($2,550), or $48,450. Because the taxpayers have only one qualified business, the combined QBI amount is also $48,450 before applying the overall limitation of $66,000 (20% of $330,000). H and W’s Sec. 199A deduction is $48,450.

Overall limitation applied after combined QBI is calculated

After the deductible QBI amount is calculated for each of a taxpayer’s qualified businesses under the various taxpayer scenarios above, the deductible QBI amounts are combined to determine the taxpayer’s combined business amount. Therefore, if the taxpayer has only one qualified business, the combined QBI amount is the same as the deductible QBI amount for that business. After determining the taxpayer’s combined QBI amount, the overall limitation is applied. Under the overall limitation, the Sec. 199A deduction is the lesser of the combined QBI or 20% of the taxpayer’s taxable income in excess of net capital gain.

OTHER FACTORS TO CONSIDER

The Sec. 199A deduction is a below-the-line deduction, meaning that it will not have an impact on various adjusted-gross-income thresholds. The deduction is available to both itemizers and nonitemizers. Additionally, the taxable income thresholds (e.g., $315,000 and $415,000) are indexed for inflation (Sec. 199A(e)(2)(B)).

The Sec. 199A deduction cannot be taken in loss years. If QBI is less than zero in a year, the amount will be treated as a loss from a qualified business in the next year (Sec. 199A(c)(2)).

The deduction is allowed only for federal income tax purposes (i.e., not for payroll taxes). Sec. 199A will expire in 2026 absent congressional action to extend it (Sec. 199A(i)).

Much of the Sec. 199A deduction’s complexity comes from congressional concerns of potential abuse. Undoubtedly, more administrative guidance will be issued to further define and clarify the law’s parameters (e.g., cloudy areas such as “reputation and skill” and definitions of specified service trades or businesses). Until then, CPAs reading this article have a general idea of how the rules’ mechanics will apply to most taxpayers, and CPAs can be of great service in explaining how these rules affect individual taxpayers and offer opportunities for tax planning.

About the author

William A. Bailey (wbailey@bradley.edu) is an assistant professor who teaches both undergraduate and graduate accounting courses in the Foster College of Business at Bradley University in Peoria, Ill. He has previous tax experience in public accounting as a CPA at KPMG, and also as a tax attorney.

To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, a JofA senior editor, at Sally.Schreiber@aicpa-cima.com or 919-402-4828.

AICPA resources

Article

• “Congress Enacts Tax Reform,” JofA, Feb. 2018

CPE self-study

• Getting to the Heart of Tax Reform: Individual Tax and Estate Planning Strategies (#166350, online access; #GT-CL4RIND, group pricing)
• Tax Reform Bundle (#165490, online access; #GT-CL4TRBUND, group pricing)
• Tax Reform’s Impact on Corporations and Pass-Through Businesses (#166340, online access; #GT-CL4TRBUS, group pricing)

Webcast

• Tax Reform: The New Qualified Business Income (QBI) Deduction (#WC1637943, May 7; #WC1637956, May 14; #WC1639316, June 6)

For more information or to make a purchase, go to aicpastore.com or call 888-777-7077.

AICPA advocacy

AICPA Tax Executive Committee, “Request for Immediate Guidance Regarding IRC Section 199A — Deduction for Qualified Business Income of Pass-Through Entities (Pub. L. No. 115-97, Sec. 11011),” letter addressed to the IRS, Feb. 21, 2018, available at aicpa.org.

The Tax Adviser and Tax Section

The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies, and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/interestareas/tax. The current issue of The Tax Adviser and many other resources are available at thetaxadviser.com.