The Trump Tax Tax Cuts: What You Need to Know About Section 199A
In our Firm’s immediately preceding Newsletter that was issued in January 2018, Richard Marmon wrote an article titled The Trump Tax Tax Cuts: What You Need to Know. The article was, by necessity and design, a very broad overview of the newly enacted law called “The Tax Cuts and Jobs Act” (herein the “Act”), a massive piece of tax legislation of a scope not seen since enactment of the Tax Reform Act of 1986. Demonstrably, the Joint Explanatory Statement of The Committee of Conference is 570 pages long. Mr. Marmon’s article did include, however, a link to a page that outlined 17 “highlights” of the Act. One of those highlights was an all-new provision added to our Internal Revenue Code (the “Code”) that now offers a 20% deduction of qualified business income to certain taxpayers. That new Code provision is Section 199A. This article is intended to describe with more particularity this new Code section, albeit again for purposes of this Newsletter, it will be limited in scope. It is one of the most complex provisions ever added to the Code. [An 88-page book was just released as a definitive guide to Section 199A.]
As is the case for almost all of the new provisions in the Act, Section 199A is effective for only that eight (8) year limited window starting January 1, 2018, and ending January 1, 2026. For certain types of businesses, described below, a deduction equal to 20% of the taxpayer's "qualified business income" will be available to those businesses engaged in a "qualified trade or business." The deduction is limited, however, to the greater of: (i) 50% of the “W-2 wages” with respect to the qualified trade or business; or (ii) the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis of all “qualified property” as of the date of acquisition.
Let’s drill down into the various defined terms and key provisions of the statute:
- Taxpayers Entitled to Claim the Deduction. The Section 199A deduction is available to any taxpayer other than a C corporation. This includes: (i) individual owners of sole proprietorships, rental properties, S corporations, or partnerships; and (ii) an S corporation, partnership, or trust that owns an interest in a pass-through entity. The deduction is allowed for non‐itemizers, and the deduction applies to trusts and estates owning business interests. This new provision of the Code was added to provide some tax relief for individuals to offset what was generally considered an overly generous reduction in corporate tax rates that dropped from 35% to 21%, compared to the reduction of rates for individual taxpayers that dropped from 39.6% to only 37%. The 20% deduction results in an effective top rate of 29.6%.
- Qualified Trade or Business. A "qualified trade or business" is defined as any business other than a “specified service trade or business.” The Act does not recognize an employee as being engaged in any trade or business. So, an employee cannot claim the 20% deduction against his or her wage income. However, the service trade or business prohibition is not absolute. The deduction is still available to a service trade or business if its taxable income is below certain thresholds (the “poor man” service provider exception). A service trade or business is what you might expect: doctors, lawyers, accountants, actuaries, performing artists, consultants, athletes, financial advisors, brokers, and dealers in securities. [Note: Engineers and architects are not included in this definition. They had better lobbyists.]
- “Poor Man” Business Owner or Service Provider. If a taxpayer earns less than the applicable threshold amount, neither the W-2 wage limitation for non-service trade or businesses, nor the general specified service trade or business exclusion apply. The threshold amount is $315,000 for joint filers and $157,500 for single filers. The W-2 wage limitation is fully phased in for taxpayers who have taxable income of $415,000 for joint filers and $207,500 for single filers.
- Qualified Business Income. Qualified business income is generally the net amount of income, gain, deduction and loss from an active trade or business in the United States. But it does not include certain types of investment income, such as short-term capital gains or losses, long-term capital gains or losses, dividends income or interest income. Also excluded are (i) amounts treated as reasonable compensation paid to the business owner; (ii) guaranteed payments by a partnership to a partner under IRC §707(c); and (iii) other amounts paid by a partnership to a partner other than in his capacity as a partner for services; e.g., rent for the use of real or personal property leased to the partnership.
- W-2 Wages. Although the definition of wages is fairly straightforward, it also includes amounts that an employee has elected to be deferred (non-qualified deferred compensation plans), and amounts actually paid during the year in the nature of previously deferred income.
- Qualified Property. Qualified property is tangible property subject to depreciation under Code Section 167. As a result, raw land and inventory, for example, would not be taken into account. The basis of the property used to determine the limitation is the unadjusted basis determined “immediately before acquisition.” Thus, it is not reduced by any depreciation taken after the date of acquisition. One of the interesting tidbits of the legislative history of the wage limitation is that the version of Section 199A initially passed by the Senate only included the “50% of W-2 wages” limitation. During the conference committee meetings, the alternative of “25% of W-2 wages, plus 2.5% of the unadjusted basis of qualified property” was added, which most observers agree was motivated to allow owners of real estate to qualify for this benefit. How? Because most entities that own real estate are partnerships that do not pay W-2 wages. Instead, they pay a management fee, which is not considered W-2 wages. Therefore, without this last minute change, many large real estate partnerships would have been shut out from this deduction. [More evidence of better lobbying].
Needless to say, the devil in all of these definitions is in the details, and many of the issues are still being analyzed by practitioners trying to grapple with this. The Internal Revenue Service has promised to publish some guidelines by July. Nonetheless, if you believe your business meets all of the definitional provisions, there is a very good possibility that, if you are an owner of a business being conducted as a “pass-through” entity, you will qualify for some or all of the new 20% deduction starting in calendar year 2018. This is a pretty big deal. Better still, if you are an owner of an otherwise prohibited service trade or business, there may be planning opportunities that will allow you to qualify for this deduction. The attorneys of Reger Rizzo & Darnall’s tax and business departments are available to assist you with this type of planning.