Since it went into effect on January 1, 2018, our law office has been receiving a LOT of inquiries about the new IRC §199A deduction. Most don’t understand it and those that do aren’t sure exactly how to take advantage of it, or if it even applies to them. Allow me to try and simplify it so you will know if it applies to you and if so, how you can take full advantage of it going forward.
IRC §199A is a new income tax deduction from the Tax Cut and Jobs Act of 2017, which, if applicable, offers a maximum 20 percent deduction on qualified business income from pass-through entities. Pass-through entities include sole proprietorships, partnerships, disregarded LLCs and S-corporations. While it is strictly an income tax rule, many estate planners do need to have a fundamental understanding of how it works and its importance to clients. The new rules are not permanent and are set to expire in 2025.
Let’s look at it from a practical perspective so you can better determine if it is applicable for you or not. And if you have any questions, you can always contact me and we can work through it in more detail with your own personal situation. The new deduction can be best understood if broken down into three separate scenarios:
Three Scenarios to Consider
Scenario One
If you are an INDIVIDUAL with taxable income at or below a certain threshold level (for taxable year 2019 this threshold is $160,700) or if you are MARRIED, filing jointly, the threshold is $321,400. If your situation falls into one of these categories, then the 199A deduction is the lesser of the taxpayer’s combined Qualified Business Income (QBI) or 20 percent of the taxpayer’s taxable income, minus the taxpayer’s net capital gains. QBI is the net income, gain, deduction and loss with respect to any qualified trade or business. For many small business owners, this can be a significant deduction you don’t want to miss out on.
Scenario Two
In our second scenario, this applies to INDIVIDUALS and MARRIED COUPLES as well…but the difference is that you ARE ABOVE the threshold limits described above in Scenario I AND BELOW the threshold limits described below in Scenario III. Those falling into this group will get a phase-in limit on their deduction.
Scenario Three
If you are an INDIVIDUAL with taxable income above a certain threshold level (for taxable year 2019 this threshold is $210,700) or if you are MARRIED, filing jointly, the threshold is above $421,000. Those of you falling into this group may not get the benefit of the deduction…sorry about that.
Analyze Your Own Situation
If you analyze your situation with regard to the three Scenarios above, if you fall within Scenarios II or III above, then additional factors are involved. For example, you will need to determine whether the business is an “SSTB” (Specified Service Trade or Business…see below) and how much, if any, W-2 wages or UBIA of qualified property there is in the business. Here are the rules, for this situation, in their basic form:
SSTB is “Specified Service Trade or Business.” Together with the Proposed Regulations §1.199A-5(b) and Section 1202(e)(3)(A), the SSTB list includes services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and management, trading, dealing in securities, partnership interests, or commodities and any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. Notably, engineering and architecture are excluded from the definition. Any amount associated with SSTB is not allowed as a deduction under Scenario III, and a phase-in amount for Scenario II individuals is permitted based on a specific formula.
UBIA is the “Unadjusted Basis Immediately after Acquisition” of qualified property. The Proposed Regulation §1.199A-2(c)(3) offers a more detailed definition, but for majority of the cases, this will mean original basis. For those that fit Scenario III, the QBI is further modified (as compared to Scenario I individuals) to be the lesser of 20 percent of QBI or the Alternative Limitation. The Alternative Limitation is calculated by the greater of 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of UBIA of qualified property. Those in Scenario II will have a phase-in amount based on a formula.
Section 199A also applies to trusts and estates. Specifically, it applies to non-grantor trusts and estates. The trust or estate may itself be treated as an individual and qualify for the deduction, or it can be treated as an RPE (“Relevant Pass-Through Entity”) because the trust or estate passes the QBI, W-2 wages and/or UBIA of qualified property to the beneficiaries, who themselves could take the 199A deduction on their individual returns. Whew…that’s a lot to get your head around I know, but those are the facts you need to dissect (or have your attorney or accountant) help you analyze specific to your situation.
The above analysis, while seemingly complicated, is as “simple” an introduction as I can provide to the 199A deduction. There are other, more complicated rules such as how to handle negative QBI, aggregation (multiple passive business entities) and family attribution rules that come into play for families with complex structures and assets. If the deduction is applicable, it can represent a significant tax savings.
What To Do Next...
You would be well served to spend time gaining a deeper understanding of the basic rules and applications as they relate to the 199A deduction. With the proper Scenario, you could be leaving a significant amount of money on the table that should be in your pocket. Take some time and look at your situation and see how you might benefit from it based on the above Scenarios.
If it looks like you would fit into Scenario I or II specifically, my recommendation is to then get some professional advice from your attorney or accountant. If you don’t have one you feel would understand this for your situation, feel free to ASK ME YOUR QUESTION and I can give you some insight into what kind of assistance you might need or give you some insights into what to do next to maximize this discussion. I hope this has been helpful. If you do the proper work on this, I can guarantee you will have NO. MORE. TEARS. Because there will be more money in your pocket!