The tax code is a living document, constantly changing, growing ever-more complicated. Take the new section 199A for example; this 20% pass-through deduction has had numerous changes since first being introduced by Congress and enshrined in the law as part of Tax Cuts and Jobs Act (TCJA) in 2017.
I’m all for tax cuts－and this a big one, if you qualify－but understanding how it works is tricky. What part of your income is subject to the deduction? The answer to this has actually changed since it was first floated by President Trump during his first few months in office.
If you’re at all like me and you are fascinated by the process of creating these types of regulations, here’s a little background:
Congress first proposed the regulation and submitted over 500 pages of nearly incoherent statutory language to the IRS just over a year ago. Based on that 500-page proposal, over 330 letters and recommendations were submitted to the IRS from tax attorneys, accountants and specialists to help craft the final version of the regulation.
In the end, the IRS published 274 pages just last week, along with two key Revenue Procedures.
What does this mean for you? Essentially, the Section 199A deduction gives owners of pass-through business entities an extra deduction equal to 20% of their business income. However, it is dependent on several factors.
So what’s going on exactly? The IRS has a thorough FAQ to help.
“Section 199A of the Internal Revenue Code provides many taxpayers a deduction for qualified business income from a qualified trade or business operated directly or through a pass-through entity.” – IRS.GOV
So what is considered “qualified business income?” (QBI) That gets a little trickier, but nothing we can’t handle.
Basically, QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business. Only items included in taxable income are counted. In addition, the items must be connected with a U.S. trade or business. Items such as capital gains and losses, certain dividends and interest income are excluded.
At this point, it’s important to remember that this deduction is for individuals. It is not a business deduction. The reason it sounds confusing is because you can only deduct business income, not W-2 wages. This is why it’s important to understand what the IRS means by a “qualified trade or business” and what constitutes a pass-through entity.
Pass-through entities are generally either sole proprietors, partners in partnerships, or S corporation shareholders, and LLC’s structured as S-corps. The reason that these business types are “pass-throughs” is because there are no taxable events that occur at the business level. All the profit and losses from the business literally pass through to the owner’s, or in some cases, the shareholder’s personal taxes.
Most business owners I work with have an LLC, which can be confusing for them when it comes to tax time because no one ever explained to them that an LLC does not have a tax structure. LLCs are a legal entity that do not have an inherent tax structure and they must adopt one, although generally, the IRS defaults you to be taxed as a sole proprietor.
Once you know how to calculate your QBI and how your business is being taxed, you will then know how much of your personal taxable income will be affected by the 199A deduction.
The deduction is limited to the greater of (1) 50% of the W-2 wages with respect to the trade or business, or (2) the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (generally, tangible property subject to depreciation under Sec. 167). The deduction also may not exceed taxable income for the year.
The W-2 wage limitation I just mentioned does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly).
So there you have it. Simple right? The tax break of the century!
Actually, as with most things the government does, it’s not at all simple, but for those who know how to take advantage of the system, the benefits are huge.
If you are part of a C-corp there is good news for you too. The TCJA didn’t completely forget about C corporations.
Income earned by a C corporation is always subject to double taxation: first at the entity level, and then a second time at the shareholder level when the corporation distributes its income as a dividend. Part of the Act reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%. While the Act retained the top rate on dividend income of 20%, the dramatic decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.
The bottom line is this. The TCJA is definitely a business-friendly tax bill, but only for those who know how to qualify.
The best advice I can give you－if you are wondering how this affects you－is to work with a tax professional when filing your taxes. Don’t try to be a hero.
Here is the link to the IRS.GOV FAQ page that I quoted, as well as a button to book an appointment with a member of our advisory team. Just leave a note that you would like to discuss your tax situation when you make the appointment, and we can walk you through what you need to do for your business this tax season to see if you qualify for this new deduction, as well as many others.