A Publication of WTVP

The Tax Cuts and Jobs Act made significant changes to flow-through entity taxation with the enactment of new Code Section 199A: pass-through deduction. Overall, the deduction can lower stated ordinary tax rates by a maximum of 20 percent. Therefore, the new top individual rate of 37 percent could be as low as 29.6 percent. What follows is a discussion of this new deduction, excluding the specific REIT dividend, publicly traded partnership income, and cooperative dividend provisions of the new law.

Who is eligible for the 20% deduction?
All taxpayers, other than a C corporation (S corporation, partnership/LLC, trust or estate, sole proprietor) are eligible. Therefore, unincorporated businesses are eligible for this deduction as long as the underlying business is eligible. On the surface, there is no need to incorporate or form an LLC to make a taxpayer eligible for the deduction. However, as discussed later in this article, limitations in the 20% deduction may occur for taxpayers who reach certain taxable income thresholds. Ultimately, a taxpayer may choose to incorporate their business to maximize the 20% deduction under Code Section 199A.

How is the deduction computed?
In its simplest form, the deduction is equal to 20 percent of Qualified Business Income (QBI). This is generally “trade or business” net income (non-investment income). QBI does not include reasonable compensation (wages) paid to S corporation owners or guaranteed payments to partnership owners. QBI could potentially include rental income as well, although the definition of a “trade or business” is found nowhere in the Internal Revenue Code. In particular, a triple net lease may not constitute a trade or business in the eyes of the IRS. QBI is any trade or business other than a Specified Service Business or the trade of being an employee (wages reported on a W-2).

What is a Specified Service Business (SSB)?
Businesses that involve the performance of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, or trading or dealing in securities, partnership interests or commodities are classified as SSBs. In addition, there is a “catch-all” category which includes any business whose principal asset is the reputation or skill of one or more of its employees or owners. It is quite unclear how to interpret these definitions, particularly the “catch-all” category.

Are there limitations to the 20 percent of QBI deduction?
In short, the answer is yes. For taxpayers who have taxable income less than $315,000 (married) or $157,500 (single), the only limitation is that the deduction cannot also be more than 20 percent of taxable income excluding investment income (capital gains). Note: this 20 percent of taxable income limitation applies to all taxpayers, no matter their income level.

For taxpayers with taxable income over $415,000 (married) or $207,500 (single), there are two additional limitations to the deduction. First, specified service business pass-through income would not be eligible for the deduction. Second, for non-specified service businesses, the 20% deduction cannot be more than the greater of:

  1. 50 percent of wages paid by the entity (owner share of wages paid at the entity level); or
  2. 25 percent of wages paid by the entity, plus 2.5 percent of qualified property unadjusted cost basis.

The practical impact of the first limitation is that wages must be 40 percent of net business income. Or similarly, for the second limitation, the combination of wages and 2.5 percent of qualified property needs to be 40 percent of net business income.

If a taxpayer falls within the phase-out range—$315,000 to $415,000 (married) or $157,500 to $207,500 (single)—there are additional computations to both limitations which effectively serve to gradually reduce the benefit over the range of income—$100,000 (married) or $50,000 (single).

Bradley University professor William A. Bailey has written an excellent article published in the May 2018 issue of the Journal of Accountancy, which provides several examples regarding the various calculations under Code Section 199A. I would highly recommend his article for additional details that are beyond the scope of this article.

What is qualified property?
Qualified property is property that is depreciable (not land), held at the end of the tax year, used in the production of QBI, and for which the “depreciable period” has not ended. The “depreciable period” is the longer of 10 years or the depreciable life of the property for tax purposes. For property with lives of three, five or seven years, these assets will be a factor in the §199A computation for 10 years. For property over 10 years (15, 27.5 or 39 years), these assets would be a factor for the entire depreciable life of the property.

Is this a deduction for Illinois income tax purposes?
The Section 199A deduction is after the computation of Adjusted Gross Income on the federal return; therefore, it does not reduce Illinois taxable income.

Planning opportunities?
Changes to the tax law provide the perfect opportunity to review the business structure for possible income tax savings. There are a variety of strategies that could be applicable to your business or personal situation, including: choice of entity type for your business, employee vs. independent contractor status, compensation structure to business owners, or a review of your personal income tax situation to ensure you will be eligible for the Section 199A deduction. Broad planning techniques may not be applicable to everyone, and seeking the expertise of an advisor would be recommended.

There are several more complications to this deduction that are unable to be discussed in an article of this length. Additionally, the Internal Revenue Service expects to issue guidance on the Code Section 199A pass-through deduction by the end of July 2018. The guidance is expected to provide some clarification on the definitions and items discussed here, but is unlikely to answer all questions. iBi

Nathan Isenberg, CPA, ABV is a shareholder at Heinold Banwart, Ltd. He can be reached at (309) 694-4251 or [email protected].