The Section 199A deduction is one of the hottest topics among small business owners these days — and rightfully so. Through this recently passed tax provision, small business owners can deduct 20% of their business income for tax purposes, subject to certain limitations. The provision has implications for trusts, estates, and some real estate investors as well.
Did that grab your attention? It should, because it means you could be in for great tax savings, but, as with all issues concerning federal taxation, you’ll have to know the applicable rules and follow them to the letter to make sure you’re taking full advantage of Section 199A’s potential benefits.
What follows is an overview of the basics of the deduction, from how it came to be to how it could affect your taxes.
How did Section 199A become law?
The Tax Cuts and Jobs Act of 2017 was undoubtedly a positive development for corporations as the corporate tax rate dropped from 35 to 21 percent. Moreover, the corporate alternative minimum tax is scheduled to disappear. Lawmakers did not leave out the owners of closely held businesses, however, and thus Section 199A was born to give many small business owners a pass on paying income tax on 20 percent of their qualified business income.
After months of much rumbling in the tax community regarding how the provision would work in practice, in August 2018, the Internal Revenue Service (IRS) announced proposed regulations concerning the Section 199A tax deduction. These regulations have provided answers to many questions that tax professionals and taxpayers alike had been asking since the deduction came into being in late 2017, and the public was further invited to Congressional hearings on them in October 2018.
Attempts to make the deduction a permanent fixture in the Tax Code fell flat, however, once Republicans lost control of the House of Representatives in November of 2018. As of now, then, the deduction is set to expire after December 31, 2025 — if the provision remains in effect that long.
Who can use the Section 199A deduction?
Owners of business entities through which business income passes through to be taxed on their personal income tax returns (also called “pass-through entities” or PTE) may be able to use the Section 199A deduction. More specifically, we are talking about sole proprietors, partnership partners, S corporation shareholders, and trusts and estates.
Real estate investors may also be eligible for the deduction so long as their investing qualifies as a trade or business under IRS regulations, which specify that the definition of “trade or business” to be used with respect to Section 199A is that found in Section 162 of the U.S. Code.
The deduction is also subject to some limitations, including the “the type of trade or business, the taxpayer’s taxable income, the amount of W-2 wages paid by the qualified trade or business and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business.” These limitations are discussed more fully below.
In order the take the deduction, taxpayers must also pay special attention to the applicable taxable income thresholds, which are $157,500 for individual tax filers and $315,000 for those filing jointly. For those whose taxable incomes reach above those limits, the deduction is phased out gradually and fully phased out when taxable income is greater than $207,500 for individual taxpayers and $415,000 for joint filers.
A qualified trade or business does not include the trade or business of performing services as an employee or, when a taxpayer’s taxable income exceeds $315,000 for a married couple filing jointly or $157,500 for all other taxpayers, a “specified service trade or business,” which includes trades or businesses “involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.”
For taxpayers who do not reach the taxable income threshold, the deduction is the lesser of:
- 20 percent off the filer’s qualified business income plus 20 percent of real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income
- 20 percent of the taxpayer’s taxable income less net capital gains.
Once the taxable income threshold comes into play, the Section 199A deduction becomes the lesser of the following:
- 20% of their qualified business income from a qualified trade or business and
- The greater of:
- 50% of the W-2 wages of the qualified trade or business, or
- 25% of the W-2 wages of the qualified trade or business plus 2.5% of the “unadjusted basis” of the “qualified property” in the qualified trade or business.
Notably, if there are co-owners of a PTE and one owner’s taxable income is below the threshold and the other is not, the taxpayer whose income is below the threshold may still take the deduction.
Note as well that a taxpayer may take the Section 199A deduction regardless of whether they take the standard deduction or itemize deductions on Schedule A.
What is qualified business income?
Because a taxpayer may deduct only “qualified business income” under Section 199A, the definition of that term is critical. For the purposes of this deduction, qualified business income, according to the IRS, is “domestic income from a trade or business.”
In addition to foreign income, the following are notable exclusions from qualified business income:
- Employee wages
- Capital gain
- Interest
- Dividends
Real estate income qualifies only if the taxpayer’s real estate investing qualifies as a trade or business. However, as noted above, REIT dividends and PTP income are included in the computation of the deduction.
Qualified agricultural and horticultural cooperative dividends may also be eligible for the deduction, but the IRS has stated that it will release separate guidelines regarding co-ops.
How does the Section 199A deduction affect trusts?
The Tax Code generally treats non-grantor trusts as pass-through entities so long as they distribute or are required to distribute their “distributable net income.” These types of trusts receive a deduction for the distributions and the beneficiaries pay income tax on them. The trust, then, in this situation, may be eligible to take the Section 199A deduction, subject to the $157,500 threshold with a $50,000 phase-in amount.
The trust’s taxable income includes its share of the qualified business income, W-2 wages, and the unadjusted basis of the qualified trade or business. Because of the threshold, it is essential that trustees understand how to best make distributions to maximize the benefit of the Section 199A deduction or potentially face allegations that they didn’t act with the proper duty of care.
Through Proposed Regulation Section 1.643(f)-1, the IRS has already anticipated potential attempts to create multiple trusts that each hold the threshold amount. Accordingly, the IRS has said it will aggregate any two or more trusts that have substantially the same grantor(s) and “primary” beneficiary or beneficiaries and when “a principal purpose for establishing such trusts or contributing additional cash or other property such trusts is the avoidance of Federal income tax.” In such an instance, the IRS will treat the multiple trusts asa single trust for the purposes of the Section 199A deduction.
Where the creation of multiple trusts “results in a significant income tax benefit,” the IRS will presume that “a principal purpose” in their creation was tax avoidance “unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved with the creation of these separate trusts.”
The IRS will treat spouses as one person under this provision, which means that even if each spouse creates a trust separately, the IRS will consider them to be the same grantor for the purposes of determining whether to treat the trusts as one.
With grantor trusts, the IRS considers the grantor to be the owner of trust income and property. For the purposes of Section 199A, then, if the trust owns any interest in qualified business income, W-2 wages, or the unadjusted basis of the qualified trade or business of the PTE, the IRS will consider that interest to belong to the grantor.
Electing Small Business Trusts (ESBT) are also entitled to the Section 199A deduction.
When can you claim the Section 199A deduction?
The Tax Cuts and Jobs Act of 2017 created the deduction for qualified business income for tax years beginning after December 31, 2017, which means that the first time you can take the deduction will be when you file your 2018 tax returns in 2019.
The Section 199A deduction could save an individual taxpayer tens of thousands of dollars, but it’s crucial to understand all of the details surrounding it. It’s never too early to start tax planning, so if you want to ensure you’re getting the most benefits from this tax provision, contact Charles Jones or Robert Snyder for more information.