Section 199A Business Deduction

On December 22, 2017, President Trump signed a “tax reform” law usually referred to as the Tax Cuts and Jobs Act (TCJA). Not only did the TCJA give a large tax cut to C-Corporations, the TCJA potentially gives individuals with taxable business income from a sole proprietorships or from pass-through entities (Partnerships, S-Corporations and LLCs), a deduction that can reduce the federal Taxable Income of that individual business owner. This Business Deduction is sometimes also referred to as the “Section 199A” deduction.

Note that there was an original House Bill of the TCJA, then a Senate Bill and then a final Conference Agreement between the House and Senate which makes sorting through the complete TCJA difficult and sometimes confusing - as the bill includes the language from all three bill versions and the IRS (as of April of 2018) has yet to provide additional guidance.

Ultimately, the maximum deduction that can subtracted by a business owner from their federal Taxable Income is 20% of the “Qualified Business Income” (QBI) of the business. This is further limited by the TCJA to a maximum of 20% of the business owner’s Taxable Income (which would be the individual’s Adjusted Gross Income minus any Standard or Itemized Deduction taken) minus any Long Term Capital Gains in the case where 20% of the QBI would exceed that amount.

The TCJA also provides for a potential phase-out or limitation of the Business Deduction based on the individual business owner’s federal Taxable Income (further discussed later this document). In addition, the way that the Business Deduction may be phased out or otherwise be limited depends on whether or not the business is a “Specified Service Trade” as defined by the TCJA.

Here is the language taken directly from the TCJA:

“For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer generally may deduct 20 percent of qualified business income from a partnership, S corporation, or sole proprietorship, as well as 20 percent of aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.”

“The taxpayer’s deduction for qualified business income is equal to the lesser of the combined qualified business income amount for the taxable year or an amount equal to 20 percent of the taxpayer’s Taxable Income (reduced by any net capital gain) for the taxable year. The combined qualified business income amount is the sum of the deductible amounts determined for each qualified trade or business for the taxable year and 20 percent of the qualified REIT dividends and qualified cooperative dividends received by the taxpayer for the taxable year".


You can bet that the IRS and accountants will be arguing for years about what is “qualified business income” (QBI) for purposes of this Business Deduction. But here is how the TCJA defines it:

“For any taxable year, qualified business income means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. The determination of qualified items of income, gain, deduction, and loss takes into account these items only to the extent included or allowed in the determination of taxable income for the year.”

And further:

“Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.”

Defining “reasonable compensation” is likely going to be an ongoing battle between the IRS and tax accountants. For an owner of an S-Corp, reasonable compensation would be in the form W-2 wages subject to payroll taxes and not part of that individual’s QBI. Most S-Corp pass-thru income, though, could likely be characterized as QBI and 20% of that QBI should be available as a potential Business Deduction to the individual owner or partner (subject to any phase-out or other limitation discussed below).

But how “reasonable compensation” relates to an individual’s income from a partnership or sole proprietorship is likely up for some speculation as the TCJA seems to be silent on the matter. Although the TCJA is clear that the potential Business Deduction is available to sole proprietors and partners, the business income from those types of entities is not classified by the IRS as W-2 wages (but rather self employment income subject to the payment of self employment taxes). Whether or not all of a sole proprietor’s or partner’s net business income can be characterized as QBI and available for the Business Deduction or if some type of “reasonable compensation” needs to be subtracted from that income is a question that will need to be answered by the IRS which has yet to chime in specifically on the matter.

The TCJA places a limitation or phase-out on the Business Deduction if the individuals Taxable Income exceeds certain income thresholds. Taxable Income is assumed to be the individual’s federal Adjusted Gross Income (AGI) minus any Standard or Itemized Deduction taken. Here is the language directly from the TCJA:

“A limitation based on W-2 wages paid is phased in above a threshold amount of taxable income. A disallowance of the deduction with respect to specified service trades or businesses is also phased in above the threshold amount of taxable income.”

For a taxpayer with taxable income within the phase-in range, the wage limit applies as follows. With respect to any qualified trade or business, the taxpayer compares (1) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business with (2) 50 percent of the W-2 wages with respect to the qualified trade or business. If the amount determined under (2) is less than the amount determined (1), (that is, if the wage limit is binding), the taxpayer’s deductible amount is the amount determined under (1) reduced by the same proportion of the difference between the two amounts as the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return).”

But under the Conference Agreement of the TCJA, this wage limit was expanded to include a capital element:

“The conference agreement modifies the wage limit applicable to taxpayers with taxable income above the threshold amount to provide a limit based either on wages paid or on wages paid plus a capital element. Under the conference agreement, the limitation is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property."

The TCJA defines “qualified property” as:

For purposes of the provision, qualified property means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year, and which is used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year“

And the TCJA defines “W-2 Wages” as:

“W-2 wages are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer. W-2 wages do not include any amount which is not properly allocable to the qualified business income as a qualified item of deduction. In addition, W-2 wages do not include any amount which was 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 such return”

The TCJA also allows an individual to take a Business Deduction if an individual has income from an agricultural cooperative (in a similar way as described in the bill for sole proprietors, partners, and owners of S-Corps):

"For taxable years beginning after December 31, 2017 but not after December 31, 2025, a deduction is allowed to any specified agricultural or horticultural cooperative equal to the lesser of (a) 20 percent of the cooperative’s Taxable Income for the taxable year or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative.”

The current “threshold amounts” for 2018 were defined in the TCJA as:

"Under the conference agreement, the threshold amount is $157,500 (twice that amount or $315,000 in the case of a joint return), indexed. The conferees expect that the reduced threshold amount will serve to deter high-income taxpayers from attempting to convert wages or other compensation for personal services to income eligible for the 20-percent deduction under the provision. The conference agreement provides that the range over which the phase-in of these limitations applies is $50,000 ($100,000 in the case of a joint return). "

In other words, the potential phase-out of the Business Deduction for the 2018 tax filing year, begins at $157,500 and ends at $207,500 for an individual (single, head of household, or married filing separate) and begins at $315,000 and ends at $415,000 if married filing jointly. These levels will be indexed by the IRS for inflation.

Note though, that the phase-out is applied differently if the pass-through entity is characterized as a “Specified Service Trade” business in comparison to how the phase-out is applied to a business that is not a specified service trade (discussed later in this document). In particular, for a Specified Service Trade (as defined in the TCJA) the Business Deduction will always phase-out to zero if the individuals Taxable Income fully exceeds the upper end of the phase-out bracket ($207,500 for single filers and $415,000 for married jointly filers). That is not the case for a business that is not a specified service trade, as the Business Deduction will not phase-out if there are significant W-2 wages or depreciable capital assets that can be claimed by the owner for that business.

In the final version of the TCJA, a “specified service trade” means:

“any trade or business involving the performance of services in the fields of health, law, 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 one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities."

"The conference agreement modifies the definition of a specified service trade or business in several respects. The definition is modified to exclude engineering and architecture services, and to take into account the reputation or skill of owners."

In particular given that for just about any business “the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”, one could argue that most any business could be classified as a “Specified Service Trade” unless the owner’s and/or employee’s are totally incompetent. Again, we will leave that to the IRS and accountants to feud about.

One of the more confusing elements of the TCJA, is how the Business Deduction phase-out works once an individual’s federal Taxable Income reaches or exceeds the income thresholds defined in the bill. Again, the phase-out is applied somewhat differently whether the business can be classified as a “Specified Service Trade” or not - although the thresholds of the Taxable Income limits are the same.

If the business owner’s federal Taxable Income does not exceed the threshold ($157,500 for single, $315,000 married jointly), then there is no limitation or phase-out of the Business Deduction outside of haggling over what actually is the business owner’s Qualified Business Income (QBI). But otherwise, just take the lesser of 1) 20% of the QBI or 2) 20% of the business owner’s Taxable Income minus Long Term Capital Gains and deduct that amount from the individual’s federal Taxable Income. There is no difference in the Business Deduction whether the business is a Specified Service Trade or not, as long the individual’s Taxable Income does not exceed the income phase-out thresholds.

Once an individual’s federal Taxable Income exceeds the income threshold, then the Business Deduction may be limited or phased-out completely to zero. In which case, three initial calculations need to be made and the individual amounts compared to each other to determine the potential limits of the phase-out of the Business Deduction. At this point in the initial calculation, it does not matter whether or not the business is characterized as a Specified Service Trade or not.

The three amounts that need to be calculated are as follows:

1) 20% of the Qualified Business Income (QBI): The issue here is obviously what exactly is the QBI, what constitutes reasonable compensation to the owner that is not to be included in the QBI, what types of other income is not to be included in the QBI, and what is the QBI for a sole proprietor or a partner where the owner does not have W-2 wages? Go talk to the IRS or your accountant. This is of course also important even if the individual’s Taxable Income does not exceed the income thresholds and there is no potential phase-out of the Business Deduction.

2) 50% of the W-2 Wages Paid: This can be W-2 wages paid to the owner of an S-Corp, or W-2 wages paid to an employee of the business (for any type of business entity). It does not appear to include the business income taken by a sole proprietor or partner which instead would be characterized as income subject to self-employment tax and not by the IRS as W-2 wages. For a partnership, it would include the allocable share of W-2 wages paid to employees. In other words, for a 50/50 partnership, each partner would be able to allocate 50% of the employee W-2 wage paid for purposes of the Business Deduction. It all depends on the partnership agreement. Same goes for an S-Corp as it would likely depend on the ownership agreement. But for an S-Corp, the business owner would certainly add his own W-2 wages received along with any allocable share of W-2 wages paid to employees. For an S-Corp, the owner’s individual W-2 wages would not be included in the QBI that is passed thru to the owner. For a sole proprietorship, this would include all of the W-2 wages paid to employees but not to independent contractors performing services for which no W-2 wages were reported to the IRS by the business

3) 25% of W-2 Wages Paid plus 2.5% of percent of the unadjusted basis, immediately after acquisition, of all qualified property: OK, perhaps time to talk to your tax accountant. But again for an S-Corp or Partnership, this would be the partner’s or owner’s allocable share of the cost of all accumulated depreciable capital assets. For a sole proprietorship, it would simply be the sole business owner’s original cost of all acquired capital assets for that business that have not yet been fully depreciated.

Once these three items listed above are determined, then take the greater of 2) or 3) above, and then compare to 1), taking the lesser amount. This lesser amount will be the Lower Limit of the Business Deduction and 1) from above will be the Upper Limit of the Business Deduction.

So, for the mathematically inclined, the phase-out calculation for a business that is not a specified service trade would look like this:

Business Deduction = UpperLimit – (UpperLimit – LowerLimit) X %Factor

Where:
UpperLimit = Always 20% of QBI
LowerLimit = Either 1), 2) or 3) from above
%Factor = (TaxableIncome – 157,500)/50,000 for a Single filer; (TaxableIncome – 315,000/1000) for married filing jointly.
Note that the %Factor will range from 0 to 1 depending on how much the individual’s taxable income exceeds the threshold

Therefore for a business that is not specified service trade, once a business owner’s Taxable Income fully exceeds the end of the phase-out bracket ($207,500 for single and $415,000 for married jointly), the Business Deduction will be the Lower Limit of the Business Deduction as described above.

For a business that is not specified service trade, when a business owner’s Taxable Income falls between the phase-out threshold and the end of the phase-out bracket, the Business Deduction will proportionally fall between these upper and lower Business Deduction limits based on the where the individual’s Taxable Income proportionally falls within the phase-out bracket.

Note that for a business that not a specified service trade, if 20% of QBI is less than either 2) or 3) above), then the Lower and Upper Limits of the Business Deduction will be the same and there will be no phase-out or reduction of the Business Deduction. On the other hand, if that business has no W-2 employee wages to declare or no depreciable assets, then the Lower Limit of the Business Deduction will be zero resulting in a complete phase-out of the Business Deduction once the individual’s Taxable Income exceeds the end of the phase-out bracket ($207,500 for single and $415,000 for married jointly).

Now for a Specified Service Trade business, the Upper and Lower Limits of the Business Deduction are determined as above, but the formula is different. Again for the mathematically inclined, the phase-out calculation would look like this:

Business Deduction = UpperLimit *%RFactor – (UpperLimit X %RFactor – LowerLimit X %RFactor)
which, if you are not algebraically challenged, is the same as:

Business Deduction = LowerLimit X %RFactor

Where:
LowerLimit = Either 1), 2) or 3) above
%RFactor = 1 - (TaxableIncome – 157,500)/50,000 for a Single filer; 1 - (TaxableIncome – 315,000/1000) for MFJ

Note that the %RFactor will now range from 1 to 0 depending on how much the individuals taxable income exceeds the threshold. This is just the reverse as how the %Factor worked above for a business that is not specified service trade.

Therefore for Specified Service Trade Business, the Business Deduction will always be reduced to zero once the individual’s Taxable Income fully exceeds the end of the phase-out bracket. If 20% of QBI is less than either 2) or 3) above), then the Lower Limit and Upper Limit of the Business Deduction will be the same and the Business Deduction will be phased out in the same proportion as the individual’s Taxable Income that exceeds the range of phase out threshold.

If the Specified Service Trade business has no W-2 Wages to declare and has no depreciable capital assets, then the Lower Limit of the Business Deduction will be zero such that once an individual’s Taxable Income exceeds the phase-out threshold, by even one dollar, the Business Deduction will cliff down to zero even if that individual had a Business Deduction equal to 20% of QBI before their Taxable Income exceeded the phase-out threshold. The TCJA is thus not very favorable towards the owner of a Specified Service Trade business that does not have any paid employees or significant capital assets.