See “A Planning Introduction to the 2017 Tax Act – The Overview” which briefly discusses this topic and helps put it in an overall perspective within many of the major tax changes enacted in December.
We indicated in that introduction that the new legislation tends to make tax planning more and more mathematical, and while that remark emphasizes alternatives and myriad tax rules, it is particularly true of the new Section 199A that we discuss here. This new law, this new concept, is effective after 2017. ((The final bill basically followed the Senate approach, with some rather significant modifications. See generally, Tax Cuts and Jobs Act, Conference Report to Accompany H.R. 1, 115th Cong., 1st Sess., House Report 115-466, December 15, 2017, which includes the text of the Act, the legislative histories of the House, Senate and Conference. Hereinafter, the Conf. Rep. For pagination cites see PDF version: https://www.congress.gov/congressional-report/115th-congress/house-report/466/1?overview=closed.))
This new tax deduction is scheduled to expire in tax years beginning after 2025.
This major new business deduction provision, which is tantamount to a significant tax rate reduction in some circumstances, is not available to corporations. The decision to incorporate and access the 21% tax rate available to C corporations after 2017, a rate reduction which is not scheduled to expire, means forgoing this new deduction which basically reaches business income of sole proprietors, partners, and shareholders of S corporations.
The details of this new provision can be complicated and there are questions of its interpretation. However, the basic idea is fairly straightforward: non-corporate taxpayers get a deduction measured by 20% of their business income beginning after December 31, 2017 and before January 1, 2026. ((See generally Conf. Rep., p. 10-18 for text of new Sec. 199A, and p. 205-224 for the legislative history.))
There are some scenarios where a taxpayer needs wages or wages and capital expenditures to qualify for a deduction unless the taxpayer has lower levels of taxable income , but there are circumstance where the taxpayer may qualify for a very worthwhile deduction without significant wages or capital expenditures.
The deduction can apparently be a million or more in some circumstances.
Certain types of service provider income won’t qualify when the business (or professional) income is significant.
The level of taxable income affects the rules concerning certain types of service providers.
We will at times distinguish the moderate-income taxpayer (whose income isn’t all that small or moderate), the middle-income taxpayer, and the larger-income taxpayer. The distinctions focus on adjusted taxable income, not gross sales or even business income. This terminology isn’t found in the law or its legislative history.
The “if less rule” says the deduction cannot exceed 20% of taxable income (before this deduction) as reduced by the sum of net long-term capital gains as reduced by net short-term capital losses and as further reduced by qualified dividends. ((See 2017 instructions to the Form 1040, p. 23 discussing “qualified dividends.”))
The odd admixture of rules is such that higher levels of taxable income can help or lower levels of taxable income can help.
Itemized deductions, such as charitable donations, as well as business expenses may materially impact the deduction under the “if less rule.” For example, charitable donations can reduce the 20% of business income deduction by reducing taxable income and increasing the impact of the “if less rule.” There are certain situations where the rules limit the 20% of business income deduction unless there are levels of wages or wages and capital but those limitations can be mitigated by reduced taxable income. In those scenarios, by removing or lessening the wage or wage and capital requirements, charitable donations, for example, may be deductible under the normal rules while also increasing the 20% of business income deduction. ((Appraisal fees related to charitable donations are mentioned in the legislative history of the repeal of miscellaneous itemized deductions as being not deductible in 2018 to 2025. Conf. Rep., p. 274. But generally, the upper annual limit on charitable donations was increased from 50% of adjusted gross income to 60%.))
There are portions of the calculations within these rules where increased taxable income helps, and other portions of the calculations where reduced taxable income helps. The level of taxable income can impact whether certain types of service providers are even included in the benefits of the new 20% of business income concept.
Nonbusiness income may even enhance the 20% of business income deduction by reducing the impact of the “if less rule” but the results may vary depending on whether such income is interest or dividends.
The rules can be quite complex and math here can sometimes be downright surprising.
What Qualifies as Business Income for Purposes of the 20% Credit?
The focus is on an active business, not the activity level of the one with the income.
The key definition pertains to “qualified business income” which can arise from a sole proprietorship, partnership or S corporation. Multi-tiered partnerships or multi-tierd LLCs should work in that the definition of qualifiers is other than a corporation. ((Sec. 199A(a); See “New Code Section 199A, Pass-through Qualified Business Income Deduction,” Leon C. LaBrecque, Michigan Association of Certified Public Accountants, MICPA.org, p. 1; http://micpa.org/docs/site/e-news/is-section-199a-of-the-code-a-windfall-for-cpa-firms.pdf?sfvrsn=6.))
Note that characterization can normally change with an S corporation; i.e., the flow-through might be actively earned at the entity level in an S corporation yet flow through as a dividend, assuming no salaries are paid to the shareholder by the corporation. This is the regular income tax rule. An area of possible dispute with the IRS in an S corporation context is whether payments classified as dividends are in fact compensatory and thus subject to payroll tax. A partnership is distinguishable; i.e., a partner’s flow-through of income from the entity may well be subject to self-employment tax at the active partner level.
But we note for this purpose, the legislative history treats both partnership and S corporation income as flowing through as business income, if business income by nature, for purposes of this special deduction. The purpose here is economic stimulus and some outreach to business taxpayers other than C corporations given the major reduction in the corporate tax rate. ((The corporate tax rate actually increased in so far as the lowest 2017 bracket.))
So business income for purposes of this new provision basically flows through as such regardless of whether the owner of S corporation stock or a partnership interest is personally active in the business. ((The concept is distinct from that applying, for example, in the self-employment tax area. See Regs. 1.1402(a)-2(b).))
While an S corporation is generally within the sphere of the new 20% of business income deduction, we note that an S corporation can also incur a built-in gains tax. We don’t expect the new 20% deduction to grant any relief to that corporate level tax. An S corporation that was formerly a C corporation, or arose from a taxfree Section 351 transfer of assets of a C corporation, can also incur a corporate-level built-in gains tax for a certain period of years following termination of C corporation status. ((Sec. 1374.)) The basic idea of the built-in gains tax is to avoid the S election solving the double taxation problem normally inherent with being a C corporation. The tax may be illustrated by assuming an S corporation sells appreciated realty for a gain of $200,000 and $100,000 of such gain arose during the C corporation period. The S corporation could incur such tax on the $100,000, even though the shareholders would pay tax on the $200,000. The tax is imposed on “such corporation.” ((Sec. 1374(a).)) The Section 199A deduction applies to a “taxpayer other than a corporation…” ((Sec. 199A(a). See also Section 199A(f).))
In general, the 20% of business income deduction is based on combined income, and it seems clear that business losses of the year offset business income. The Conference report indicates it generally follows the Senate version. The Senate version discusses offsetting business losses against business income before computing the 20% of business income deduction, and if in a year there is a net loss, such loss carries over to potentially reduce any Section 199A deduction in a later year. ((Conf. Rep. p. 214; see also p. 233 referring to “combined” qualified business income. See also p. 211 discussing passive losses.)) We discuss later that there can be business-by-business aspects of the computations focused on wages or wage and capital that may limit the deduction.
What is the relationship of the passive activity rules to these new rules?
The passive activity loss rules can defer when items affect taxable income, and it would appear that the Section 199A rules turn on items at the time they enter into “taxable income.” ((Sec. 199A(c)(3)(A)(ii). See Conf. Rep., p. 214, which here is the Senate report which with modifications was followed in conference.))
The passive activity rules continue to have their place. Even though the new Section 199A deduction focuses on business income even if it is by nature not the results of the efforts of a particular partner or S shareholder, the more liberal concept of benefitting the passive participant in an active business doesn’t accelerate the recognition of such items that continue to be subject to the passive activity rules in so far as when they affect taxable income. These look to be the rules.
But there may well be questions of interpretation and application with respect to the passive loss rules. For example, we discuss below that middle-income and higher-income taxpayers (our terminology) may be denied access to the 20% of business income deduction unless they can show certain wages or wages and qualified property, and how does one apply such current year limitation concepts in a passive activity context where the income recognized in one year may relate to a multitude of years, and does it matter whether those losses pre-date enactment of this new statute? The unique information required by this new statute focused on wages and asset additions would obviously never be available, for example, if the passive loss related to an unrelated partnership and the passive loss carries from a year that pre-dated Section 199A. The likely answer is that, for example, the wages figure in these computations looks only to the wages of the year of computation. ((See Sec. 199A(b)(4)(A).)) But there could be issues of interpretation and fairness and special circumstances; e.g., what if the activity was winding down and the wages in such year were not representative or it was a short taxable year? The new statute tells the IRS to provide rules considering short years and major acquisition, major sell-off situations. ((Sec. 199A(b)(5) whose language includes a focus on what is a “major portion of a trade or business or the major portion of a separate unit of a trade or business…” See Conf. Rep. p. 223.))
Whether there may be unforeseen complexities or issues of interpretation under Section 199A with respect to passive activities remains to be seen. ((There is some discussion of the passive activity rules in the Sec. 199A legislative history in the House version. See Conf. Rep., e.g., p. 211 of the legislative history from the House. Conference followed the Senate version.))
The focus of the statute is on items that affect taxable income, so the authors consider it unlikely that the IRS will interpret Section 199A to remove from the computations passive losses that arise in pre-enactment years and enter into taxable income after 2017.
The potential effect of Section 199A in the various scenarios inclusive of Section 1231 gains and/or losses on the sale of business assets is important and discussed in more detail below in “A Closer Look at What Qualifies as Business Income.”
The topic of disallowed business expenses is beyond our scope, but as an example of such disallowance, we note the following in the legislative history of the 2017 Act. “Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel.)” ((Conf. Rep., p. 407.)) In the language of the new Section 199A, we note that in its definition of “qualified business income,” it basically refers to the net figure considering “income, gain, deduction and loss…” ((Sec. 199A(c)’(1).)) But query whether the IRS will require disallowed business expenses to be subtracted in computing business income subject to the new 20% deduction?
Also included in “qualified business income” are REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. Note that a Subchapter S corporation is by definition one with a limited number of shareholders, so in this list we note only publicly traded partnership income.
Toward the goal of some simplification in our discussion of these very complex rules, we won’t include the particulars of REITs and cooperatives, which are basically flow-through entities.
The basic definition of a “trade or business” is “any trade or business” with two exceptions: wages of an employee and in certain cases “specified service trade or business.” ((Sec. 199A(d).))
An employee is considered to be in business, but wage income is expressly excluded from qualifying business income for this purpose. ((Sec. 199A(c’)(4).))
“Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer.” ((Conf. Rep., p. 215.))
Planning point: Earnings as an independent contractor may qualify, so this is one more area of the Code where employee vs. contractor distinctions are important, possibly even placing new strategic emphasis on minimizing employee characterization.
An independent contractor gets some deduction related to the self-employment tax but pays the entire tax versus paying half the payroll tax as an employee, and bearing the incremental self-employment tax in order to access the new credit is not a persuasive strategy, with the possible exception of high compensation levels that exceed the maximums subject to FICA/FUTA. So when the employee vs. contractor classification is debatable, borderline, we wouldn’t generally expect employees to be initiating requests to be reclassified as contractors.
Planning point: Subchapter S flow-through of business income generally qualifies as being eligible for the 20% of business income deduction but the new context suggests possible disputes with the IRS over whether payouts from the S corporation are nondeductible dividends or wages that should reduce the level of Subchapter S flow-through of business income. Wage classification is normally a negative because wages don’t qualify as business income, but wages can help in scenarios where a level of wages or wages and capital are necessary to avoid limitations on the 20% deduction. These limitation rules are discussed below. Whether payouts from S corporations are dividends or wages triggering payroll taxes and withholding is a traditional area of dispute between the IRS and owners of S corporations, and this issue is still with us. ((See Rev. Rul. 59-221, 1959-1 C.B. 225, Rev. Rul. 74-44, 1974-1 C.B. 287, Ding, 200 F. 3d 587 (1999), CA-9, http://caselaw.findlaw.com/us-9th-circuit/1435681.html, PLR 20030026, 3/31/03.))
Following is an excerpt from an IRS site discussing wages in an S corporation context:
“S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.” ((“S Corporation Compensation and Medical Insurance Issues,” “Reasonable Compensation,” https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues.)
As above, to the extent there is just flow-through income and no payouts to the shareholder-employee, the flow through is a dividend and not wages.
In an S corporation context, to summarize, here are the “wages” issues we see with respect to closely-held shareholders.
To the extent there are payouts in the context of shareholder services and such payments are characterized as dividends, the IRS has traditionally argued, and will continue to argue, that the “reasonable compensation” element of such payments are really wages subject to payroll tax.
To the extent there are payouts in the context of shareholder services and such payments are characterized as dividends, the IRS will also argue that such payments reduce the business income otherwise eligible for the 20% of business income deduction because such payments are really wages. The IRS now has a second major incentive to classify S corporation payments to owners as wages.
When there are no payouts of wages and no payouts of dividends which could be challenged as disguised wages, will the IRS argue that for purposes of the new Section 199A, it is entitled to nevertheless characterize the flow-through income as wages to the degree of the value of the shareholder services? This concept is missing from the legislative history, is contrary to current IRS practice, and we would be very much surprised if the IRS takes such a position.
When there are payouts of wages to shareholder-employees, the taxpayer is conceding (a) payroll taxes; even above the annual FICA/FUTA limits, there is some incremental tax; (b) the wages are not subject to the 20% of business income tax; and (c) the wages reduce the S corporation’s business income flowing through to the shareholder-employee, as well as other shareholders if any. The taxpayer may gain wages classification when a level of wages or wages and capital is necessary to avoid limitations on the 20% business deduction. But it is difficult to envision it being a net advantage to the IRS to reclassify wages as a dividend. The more likely scenario is upon exam, the math indicates the wage limitation is already satisfied with other wages or not a factor because of the income level of the taxpayer, and the taxpayer’s representative uncovers arguments as to why wages were overstated; e.g., the taxpayer was ill, getting older and working fewer hours, etc.
Planning point: Keep in mind that reducing the historic level of wages to shareholder-employees of an S corporation may be justified in some circumstances (age, health, other responsibilities, etc.) and may be particularly advantageous under the new 20% of business income rules.
Guaranteed Payments to a Partner
A partner receiving guaranteed payments from the partnership is not receiving qualifying business income for this purpose. ((Sec. 199A(c’)(4).))
Planning point: Reviewing the level of guaranteed payments, which do affect the actual economics in a partnership context, is important because it reduces the flow-through partnership income that may otherwise qualify for the 20% of business income deduction.
The new environment of Section 199A may cause the IRS to argue that payments to partners characterized as distributions are really disguised guaranteed payments. Such an argument may be even more likely in a family partnership context.
“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.” ((Conf. Rep., p. 215, footnotes omitted..))
There are higher-income areas of the 20% of business income rules that introduce limits that require wages or wages and capital, and we wouldn’t expect the IRS to interpret guaranteed payments of a partnership to qualify as wages for this purpose.
Qualifying business income must be effectively connected with the conduct of a trade or business within the United States. ((Sec. 199A(c’)(3)(A).)) Foreign earned income doesn’t qualify for the deduction. The long-standing but limited exclusion for foreign earned income was not repealed in the new law.
In general, such items as dividends and interest income don’t qualify, albeit it is possible in some circumstances to have interest income qualify if it relates to a business. ((Sec. 199A(c)’(3)(B).)) Stock market gains, typical capital gains and losses in an investment rather than business context, do not qualify. ((Conf. Rep., p. 215.))
REAL ESTATE INCOME
One doesn’t find “rent” or “rental” in the new Section 199A which is titled “Qualified Business Income.” It was the Senate version that prevailed, but we note the following comment from the legislative history of the House.
“Unlike a C corporation, partnership, or S corporation, a business conducted as a sole proprietorship is not treated as an entity distinct from its owner for Federal income tax purposes. Rather, the business owner is taxed directly on business income, and files Schedule C (sole proprietorships generally), Schedule E (rental real estate and royalties), or Schedule F (farms) with his or her individual tax return.” ((Conf. Rep. 208 of the House provisions, footnote omitted. There is also a reference to “rental activities” on p. 211 of the House provisions in the context of passive losses.)) It may be debatable whether these references to rentals were meant to include the activities in business income, although this does seem to say among the filings of the “business owner” is Schedule E with its rental real estate.
There are endless fact patterns but the authors suggest that most tax practitioners wouldn’t consider, say, a “rental house” to be a business activity. The self-employment tax applies generally to a trade or business but real estate rentals are generally excluded. They are excluded if the realty is held for investment. ((Sec. 1402(a)(1); Regs. 1.1402(a)-4. See also ., Regs. 1.1411-1, 1.1411-5.))
Almost certainly, one would expect, e.g., a housing contractor or hotel/motel operator to be in a trade or business. ((The following says Section 199A was “clearly intended to apply to commercial real estate,” opines that the rule about 2.5% of basis for qualified property was intended to allow the deduction for rental entities without employees, and queries whether the definition of a trade or business will emphasize Section 162 or Section 1411. See “New Code Section 199A, Pass-through Qualified Business Income Deduction,” Leon C. LaBrecque, Michigan Association of Certified Public Accountants, MICPA.org, p. 1; http://micpa.org/docs/site/e-news/is-section-199a-of-the-code-a-windfall-for-cpa-firms.pdf?sfvrsn=6. See also “Planning for UBTI Changes,” Dennis Walsh, Planned Giving Design Center, 1/16/18; http://www.pgdc.com/pgdc/planning-ubti-changes.))
Note these comments from an IRS site discussing post-construction realty rentals in a self-employment tax context:
“Rents received from the use of or occupancy of hotels, boarding houses, or apartment houses are included in self-employment income IF you provide services to the occupants. Services considered provided to the occupants are services primarily provided for the convenience of the occupants and not normally provided with the rental of rooms or space for occupancy only. Maid service, for example, is a service provided for the convenience of occupants, while heat and light, cleaning of stairways, and the collection of trash are not.. ((“Rents,” https://www.irs.gov/individuals/tax-trails-self-employment-income-6.))
Let’s initially consider a real estate rental fact pattern where it at least may have the appearance of a trade or business.
One might find an office with employees and an integrated operation of real estate operations focused on real estate rentals, occasional projects that involve major improvements or even new construction, owned by two associates or a married couple. The details of rent collections, calling the plumber, etc., may be with this company, or related company possibly owned by a family member, or such company may be unrelated. One may argue the real estate rental income is still not subject to self-employment tax, which normally applies to a “trade or business.” One might argue the realty is held for investment despite a certain recurring level of activities inherent in owning multiple properties. But does such a position necessarily remove it from being a trade or business for purposes of the 20% of business income deduction? It is quite possible that the IRS will not consider real estate rentals as subject to Section 199A unless the activities are also subject to self-employment tax.
At the other end of the spectrum is the busy employee or business owner with one real estate rental property, perhaps a former residence, and whether this rises to the level of a trade or business for purposes of the 20% of business income deduction is another question.
It was the Senate version that prevailed albeit with significant modifications in conference. The legislative history of the Senate and conference discusses qualified business income without mentioning real estate rentals, and investment income without mentioning real estate rentals. ((Conf. Rep., p. 214, 215.))
Had it been the intent to include real estate rentals carte blanche in the definition of a trade or business for purposes of the new Section 199A, one would expect that such intent would have been made patently clear in the statute, or at least the legislative history.
At the other end of the spectrum are real estate “dealers” who are typically considered as being in a trade or business. ((Regs. 1.1402(a)-4.)) There are many cases focusing on whether the facts indicate realty sales produce ordinary income because the taxpayer was acting as a “dealer,” and the sale of realty, which often involves some level of construction or improvement, was akin to the grocer selling canned goods. ((Taxpayers sometimes unsuccessfully argue dealer status on a realty sale to avoid the annual limit on capital losses arising from the sale of investment realty. Conner, T. C. Memo 2018-6.))
Another question in this context is whether or when real estate activities, including rentals, constitute a single trade or business. Some of the details in the computations look to the income and expense of “each” trade or business. See the discussion of “Multiple Businesses.”
The real estate industry generally will have considerable focus on the development of the regulations concerning the scope of Section 199A. ((Section 199, the domestic production activities deduction, was repealed with the enactment of Sec. 199A, and there were aspects of the real estate industry that benefitted in the past from the repealed provision. Section 199 was generally repealed for taxable years beginning after 2017. For corporate taxpayers, it was repealed for taxable years beginning after 2018. Conf. Rep., p. 400. See “Domestic Production Activities Deduction – Planning and Practicality,” J. Michael Pusey, Main Street Practitioner, http://mainstreetpractitioner.org/feature/domestic-production-activities-deduction-planning-and-practicality/.))
In general, we are beginning to hear some suggestions that real estate rentals are per se subject to the new 20% of business income deduction, and we have reservations. For example, if you’re a busy executive planning to buy a rent house and include this 20% of business income in the projections, we would suggest caution.
Hopefully, the IRS will prioritize real estate industry issues in their analysis of this important new legislation.
Basically, a sole proprietorship, partnership or Subchapter S corporation can generate income that qualifies for the 20% of business income deduction.
An LLC with a single owner may be a disregarded entity, or it may elect to be taxed as a corporation in which case the income would not qualify unless electing S corporation status. ((See, e.g., Conf. Rep. p. 206.))
A publicly traded partnership is generally treated as a corporation for tax purposes but there are exceptions. ((See Conf. Rep. p. 206; Sec. 7704(a)(2).))
A sole proprietorship is generally not considered an entity apart from the owner, except for employment tax purposes. A sole proprietorship, whether just the individual or an LLC not considered an entity apart from its owner, qualifies under the 20% of business income rules if the income is of a nature to qualify. ((Conf. Rep. 208 reporting the House Report, see Regs. 301.7701-2(c)(2)(iv).))
“While sole proprietorships generally may have no more than one owner, a married couple that files a joint return and jointly owns and operates a business may elect to have that business treated as a sole proprietorship under section 761(f).” ((Conf. Rep., 208 reporting the House Report.))
In general, a husband and wife in a community property state may disregard their LLC for tax purposes and report results directly on the joint return. ((See Rev. Proc. 2002-69, 2002 CB 831.))
Whether a partnership or S corporation, the computations focus on the individual taxpayer; i.e., there aren’t computations that begin and end at the partnership or S corporation level for purposes of this new concept.
SOME GENERAL RULES AND ISSUES
This deduction is available in arriving at taxable income but not adjusted gross income. This deduction, for example, won’t affect such areas as medical expense deductions which arise above a percentage of adjusted gross income. This new deduction is available whether or not the taxpayer itemizes. ((Conf. Report, p. 224.))
The deduction is available to trusts and estates with provision for apportioning of the deduction between the entity and beneficiaries. ((Conf. Rep. p. 224.))
This particular deduction doesn’t increase the taxpayer’s net operating loss, so if there is an incremental deduction under the rules of the new Section 199A, the rules seemingly restrict its use to current year’s tax return. There is no provision to carry over the Section 199A deduction itself.
There is some possibility of carryover within the Section 199A rules for unused business losses. ((Conf. Rep. p. 214. “If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business in the next year.”)) This carryover is only a negative; i.e., can only lessen future deductions measured by a percentage of future business income. Presumably this carryover goes away at the death of the taxpayer.
This deduction isn’t available in computing the self-employment tax. ((Conf. Rep. p. 220 reporting the Senate Report.))
While the corporate alternative minimum tax was repealed, the individual alternative minimum tax is still with us. The beginning point in computing such tax is taxable income, and apparently the new 20% of business income deduction is a deduction for AMT purposes. Seemingly this would be the deduction after applying the 20% and considering the “if less” computation which looks to 20% of taxable income as reduced by the sum of net long-term capital gain in excess of short-term capital loss and qualified dividends, as well as the myriad detailed rules and limitations, such as wage or wage and capital limitations. The basis for such statement is the absence of anything to the contrary in the new statute and its legislative history and the absence of any amendments in this regard in the AMT statute.
There is a “side note” statutory provision in the new 199A that apparently amends the minimum tax rules in prescribing how this new provision relates to those rules. It is headed “Coordination with Minimum Tax” and provides, “For purposes of determining alternative minimum taxable income under section 55, qualified business income shall be determined without regard to any adjustments under sections 56 through section 59.” ((Sec. 199A(f)(2); Conf. Rep., p. 17. Sections 56 through 59 are within the minimum tax rules.)) The legislative history says, “Qualified business income is determined without regard to any adjustments prescribed under the rules of the alternative minimum tax.” ((Senate report at Conf. Rep. p. 220.)) The trail here is short and terse but remembering the multitude of items entering into “qualified business income,” the implication seems to be to re-compute the Sec. 199A deduction separately for AMT purposes but when it comes to measuring “qualified business income,” don’t re-compute its elements when the measure for AMT purposes is different than for regular income tax purposes. We gather the new Sec. 199A deduction is a potential benefit in so far as the AMT but there may be a regular tax vs. AMT tax difference in measuring the deduction.
The legislative history has some broadly-worded anti-abuse language:
“In the case of property that is sold, for example, the property is no longer available for use in the trade or business and is not taken into account in determining the limitation. The Secretary is required to provide rules for applying the limitation in cases of a short taxable year where the taxpayer acquires, or disposes of, the major portion of a trade or business or the major portion of a separate unit of a trade or business during the year. The Secretary is required to provide guidance applying rules similar to the rules of section 179(d)(2) to address acquisitions of property from a related party, as well as in a sale-leaseback or other transaction as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital. Similarly, the Secretary shall provide guidance prescribing rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital.” ((Conf. Rep. p. 223. See also Sec. 199A(b)(5).))
THE BASIC 20% MATH AND THE “IF-LESS RULE”
As discussed below, special rules may apply to certain service providers.
The computation measures the deduction looking to “combined qualified business income amount” or if less, 20 percent of any excess of taxable income over any net capital gain as defined in Section 1(h). ((Sec. 199A(a).)) The latter might be termed the “if less rule.”
In general, the “if less” component introduces a new complexity to planning. In the opinion of the authors, the statute here refers to taxable income from all sources, not just business income. ((One author opines, “It is unclear whether the taxpayer’s taxable income refers to the taxpayer’s taxable income from all sources or just income from all qualified trades or businesses. My best guess is that it refers to all sources.” “Qualified Business Deduction Under New Section 199A,” Teresa Rankin Klenk, Gentry, Tipton, McLemore, 12/20/17, http://www.tennlaw.com/12/can-you-qualify-for-the-sec-199a-qualified-business-deduction/.)
The concept of “combined” qualified business income nets income and losses. For example, one of only two examples in the Senate Report shows one spouse with a business loss and another spouse with business income, and the loss offsets income in figuring the net business income that gives rise to the 20% deduction in a joint return. ((The conferees were relatively terse in their explanations but they made some very significant changes while basically following the Senate version. Conf. Rep., p. 221, 222.))
We noted above that there is a concept of carrying forward a loss within the Section 199A rules from a previous year. Within this concept of a loss related to Section 199A calculation, presumably such a carryover could only be post-2017; i.e., couldn’t precede the Section 199A rules.
But query the impact of a net operating loss carryover from 2017 or earlier on the calculations under Section 199A? The issues here should be considered in deciding whether to elect to carryover any NOL incurred in 2017.
First, how does an NOL carryover affect the basic 20% of business income computation? The 20% is applied to “qualified business income with respect to the qualified trade or business,” subject to some limitations, or more specifically, “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business.” ((Sec. 199A(b)(1)(A) and 199A(c).)) We also note Section 199A(c)(3) defining the relevant items as “effectively connected with the conduct of a trade or business within the United States…” It goes on to ask if such amounts are “included or allowed in determining taxable income for the taxable year.” ((Sec. 199A(c)(3)(A)(ii).)) One could argue the language here includes an NOL deduction arising even from pre-enactment years, at least as it relates to business losses.
Computing the NOL under Section 172 is complicated but it basically works from taxable income with adjustments, such as removing personal exemptions and nonbusiness deductions except to the extent of nonbusiness income. So it is roughly true that an NOL carryover would reflect losses from a trade or business. Yet an added complication is that it is possible an NOL would reflect non-business casualty losses as all or part of the NOL, which could also raise issues of order of absorption if the NOL also includes business losses.
When losses of non-corporate taxpayers exceed $250,000 or $500,000 in a joint return in tax years beginning after 2017, there is a new rule which can add such losses to the NOL carryover rather than allow such losses to offset non-business income. ((Conf. Rep. p. 19, 238-239, amending Sec. 461(l) for losses in tax years beginning after December 31, 2017.)) A possible argument for including consideration of the NOL deduction in Section 199A is that due to new Section 461(f), there are some scenarios where business losses don’t seem to get deducted except as NOL carryovers. The express language of the statute refers to “disallowance.” ((Conf. Rep., p. 19; Act Sec. 11012.)) Rather than press an argument based on such an unusual provision, one could also argue for special computations but that would also raise issues of order of use when the figures include such amount as only one of the NOL components.
One could also argue that to include the NOL deduction in measuring business income under Section 199A runs counter to the focus of the statute on the results of the particular year and whose goal was to encourage business and reward post-enactment results.
One could add the following argument, emphasizing that pre-2018 law permitted NOL carryovers up to twenty years and the new law permits indefinite carryforwards. Congress envisioned a new concept which focuses on trade or business income post-2017 and it added rules that in some circumstances can even require separating such income into the income or loss of “each” separate trade or business. An NOL deduction arising from carryovers from many distant years could require analyzing such figures to segregate losses into separate trades or businesses when the returns and records may no longer even be available, and require practically impossible calculations looking to absorptions of such losses in years after they were incurred. The years of absorption may also be very distant. One would reasonably argue that Congress did not contemplate integrating an NOL carryover deduction into this mix of considerations within Section 199A.
Also, Section 199A has its own carryover rule which focuses on post-2017 net losses that arise within its rules. ((Sec. 199A(c’)(2).)) Seemingly this raises the question of duplication. How would the taxpayer apply the carryover rule within the new code section and also the normal NOL carryover rules?
Within the Section 199A rules, there is statutory provision dealing with carryover of unused, excess loss, but not carryback, which may raise such questions as this: Does the taxpayer losing $100,000 in year 1 and earning $100,000 in year 2 get no 20% deduction in either year, but as to the person who earns $100,000 and then loses $100,000 in the second and last year of the business, does this person, whom we assume retires, get to deduct 20% of $100,000 in year 1 and the $100,000 loss from the discontinued business just carries over until his/her death, then disappears? This would seem to be the result given the new law contemplates carryover of unused losses but no carryback.
As to the basic question of whether the NOL deduction should reduce the base of the 20% of business income calculation, we would argue that this particular deduction should not reduce the base, and this should hold true of NOLs from pre-enactment and post-enactment years.
On the other hand, the authors would anticipate that the IRS will likely conclude an NOL carryover, even though from a year or years before enactment of the Section 199A concept, would reduce taxable income under the “if less” portion of the calculation. This figure is just basically taxable income with certain adjustments times 20%, and the list of adjustments doesn’t include any NOL carryover deduction. For example, if a taxpayer elects to carryover a large NOL from 2017 to 2018, we would caveat that this would likely have a significant detrimental effect on any benefit under the new Section 199A rules.
Planning point: In deciding whether to carryback an NOL from 2017, consider that as an NOL carryover, it may have a detrimental effect in so far as accessing the 20% of business income deduction.
Planning point: Not to suggest that a couple will often opt out of a joint return because of these rules but it may arise in some circumstances; e.g., if one spouse has a business loss that offsets business income of the other spouse that might otherwise benefit from the 20% deduction. It is not impossible the regulations may try to limit such planning.
As one reads the statute, the term “qualified business income amount” doesn’t have a “20%” beside it, but it is a 20% figure. ((See Sec. 199A(a)(1)(A), (b)(1)(A), (b)(2)(A).))
Planning point re business expense elections: Assuming the basic computation looks to 20% of qualified business income and the “if less” concept focusing on taxable income doesn’t otherwise apply, one can see that decisions that maximize business expenses have to be viewed from the standpoint of their effect on the Section 199A deduction. For example, if the taxpayer opts to expense a capital expenditure rather than claim normal depreciation, this reduces taxable income and saves tax. But while one can normally calculate tax savings of an incremental deduction by applying the marginal tax rate to the deduction, one needs in these circumstances to factor in the fact that the decision to call a capital expenditure an expense will also reduce the 20% of qualified business income deduction directly. By reducing taxable income, it may also bring into play the “If less rule” that focuses on 20% taxable income with adjustments.
Planning point re Keogh contributions: A Keogh contribution can also bring into play the taxable-income-if-less rule when the deduction would otherwise be based on net business income. Such decisions as whether have a Keogh or whether to maximize the deduction may now have to be weighed against projected or potential long-term reductions in the new Section 199A deduction. It may also be an issue whether or to what degree Keogh or other benefit programs may be considered as directly reducing the 20% of business income calculation, and whether, e.g., one distinguishes payments benefitting owners.
Planning point re nonbusiness expenses and nonbusiness income: Under the basic concept that the deduction is 20% of qualified business income or, if less, 20% of taxable income as reduced by the sum of net long-term capital gains in excess of short-term capital losses and qualified dividends, one can see certain areas where the 20% deduction is pared down by nonbusiness deductions, including the standard deduction, which was increased with the new legislation. For example, under the “if less rule” looking to 20% of taxable income, assuming a taxpayer with just qualified business income and the standard deduction, the standard deduction triggers a reduced 20% deduction, whereas it would not if there were, say, interest income in an amount equal to the standard deduction. One can envision circumstances where if this particular scenario applied, the taxpayer would have been better off investing in high-yield bonds versus low-yield growth stocks.
There can be scenarios in which the 20% of business income deduction goes up with incremental nonbusiness income. Nonbusiness income planning can significantly affect planning here if the deduction looks to taxable income.
Planning point re charitable donations: One can envision the Section 199A rule being a disincentive in some circumstances for charitable donations because the contributions increase itemized deductions and bring into play the “if less rule” looking 20% of taxable income with adjustments rather than 20% of business income. We later show another scenario in which the charitable donation looks to enhance the deduction.
Planning generally gets much more mathematical, particularly considering the breadth of the two components we discuss, one being combined “business income” which includes flow-through income which is often difficult to predict, and the other being “taxable income.”
An IRS exam that adjusts taxable income may well result in a re-computation of this deduction and it could affect either of the two major components that determine the basic deduction. One can envision circumstances where an IRS exam would increase taxable income without adjusting business income and the result would be diminution of the if-less limitation, such that the Section 199A deduction increased and mitigated the tax increase arising from the IRS adjustment.
There is a third rule saying the deduction can never exceed taxable income as reduced by net capital gain as defined in Section 1(h). ((Sec. 199A(a), last sentence.)) As discussed below, net capital gain for this purpose appears to be net long-term capital gains in excess of short-term capital losses plus qualified dividends
GAINS AS A COMPONENT OF BUSINESS INCOME
In the beginning of this complex statute, Section 199A(a) has two sentences; the first sentence is a “whopper.” We will disregard the portion dealing with cooperative dividends.
Section 199A(a)(1)(A) and (B) provide two basic rules governing the deduction. The taxpayer gets the lesser of these two calculations.
The language of Section 199A(a)(1) (A) says the taxpayer gets to deduct “the combined qualified business income amount of the taxpayer.” The real rule is 20% of such amount; the “20%” is there although it isn’t expressed in this particular sentence. ((See Sec. 199A(a)(1)(A), (b)(1)(A), (b)(2)(A).)).
The definition of qualified business income generally means “any amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” ((Sec. 199A(c’)(1).)) The new law goes on to define the above as related to a trade or business within the United States. ((Sec. 199A(c’)(3).)) It goes on to except “investment items” of income, gain, deduction or loss, including capital gains or losses, dividends, interest, etc.
But we note that within the statute defining the base for computing the 20% of business income deduction is included not only ordinary operating income and loss but also “gain” and “loss.”
Sales of inventory, including sales of say constructed homes or buildings by a contractor, are ordinary income and conspicuously within the concept of the type of income that is the focus of this statute.
In general, the sale of fixed assets used in the business, including say a building that houses the employees and operating assets, would fall within the concept of “Section 1231” gains and losses. If the business has a net Section 1231 loss in a year, such loss is generally an ordinary loss. If the business has a net Section 1231 gain in a year, such gain is generally treated as long-term capital gain. Within the complex mix of these rules are such concepts as depreciation recapture which can convert gains to ordinary income that might otherwise be treated as long-term capital gains. (( See generally Sec. 199A(c)(1) defining business income as inclusive of gains. See generally the following discussion of Sec. 1231 gains; https://taxmap.irs.gov/taxmap/pubs/p544-015.htm.))
An argument for including gains under Section 199A even when such gains are tax advantaged might stress this example. Assume a sole proprietor has inherently a break even situation, $1,000 of unrealized loss on one machine and $1,000 of unrealized gain on another machine. The sale of both machines in one year would yield zero gain or loss, and no impact because surely one can net gains and losses on the sale of business equipment in this scenario. If one machine was sold in December and the other machine was sold a month later, one would argue that similarly, the $1,000 gain or loss should enter into the Section 199A computations in each year regardless of whether the $1,000 loss is ordinary as a Section 1231 loss, and whether the $1,000 gain is ordinary income due to depreciation recapture or Section 1231 gain treated as long-term capital gain.
Given the overall context and purpose of the statute, it would make sense to provide that, say, an ordinary loss of $1,000 on a truck used in the business would be in the mix that determines the overall measure of business income.
But what about a $1,000,000 gain on the sale of a building used in the business which may be subject to favorable long-term capital gain treatment? Did Congress intend to include such income in the measure of business income subject to the 20% deduction, even though already subject to reduced tax as a long-term capital gain?
It is a fair question but as the authors read the new statute and its legislative history, it would appear that such gain would be included as business income subject to a 20% deduction under the basic rule of Section 199A(a)(1).
But the taxpayer’s deduction is the lesser of the general rule, or the “if less rule” that focuses on 20% of taxable income as reduced by “net capital gain (as defined in section 1(h)).” The authors believe our $1,000,000 long-term capital gain on the sale of a building used in the business would be a limiting factor; i.e., a reduction of taxable income for purposes of the if less rule of Section 199A(a)(1)(B).
This is a brief illustration, admittedly simplified to illustrate the math. Assume the taxpayer has a business Schedule C in the Form 1040 breaking even but it is a year in which the taxpayer also has interest income equal to the standard deduction, so taxable income is $1,000,000 before considering the Section 199A deduction. Under Section 199A(a)(1)(A), we compute such deduction as 20% of $1,000,000 (the Section 1231 gain on sale of business asset) or $200,000. Under the “if less rule” of Section 199A(a)(1)(B), the computation would be taxable income of $1,000,000 less the net capital gain of $1,000,000 times 20%, such that the deduction is zero, and our taxpayer apparently does lose out on any benefit from Section 199A.
But what if the taxpayer also had an additional $1,000,000 of interest income, such that taxable income is $2,000,000 with the $1,000,000 of Section 1231 gain before considering the 20% of business income deduction. Under Section 199A(a)(1)(A), we compute such deduction as 20% of $1,000,000 or $200,000. Under the “if less rule” of Section 199A(a)(1)(B), the computation would focus on taxable income of $2,000,000 less the net capital gain of $1,000,000 times 20%, such that the “if less” limitation should not apply. So despite the “if less” rule’s incorporating a capital gain adjustment, there are some scenarios where the long-term capital gain appears to also yield a 20% of business income deduction.
Planning point: There are some scenarios in which taxpayers with large amounts of nonbusiness income may be better off under the 20% of business income concept because they may more easily avoid the limitation focused on taxable income.
We turn to discussing in some more detail the capital gains aspects. We note that it may be important in these calculations whether the taxpayer’s other income emphasizes qualified dividends.
“Net capital gains” are expressly mentioned in this part of the “if less” statute but not Section 199A(a)(1)(A) looking to qualified business income. Both rules incorporate a 20% factor. Yet “gain” is mentioned in the more detailed definition of qualified business income at Section 199A(c)(1). Capital losses are not mentioned but seemingly a net capital loss for the year deductible to the extent of $3,000 would simply reduce the taxable income figure. “Loss” is also mentioned in Section 199A(c)(1).
The term “net capital gains” is defined in Section 1222(11) as net long-term capital gains over net short-term capital losses. But the language within the if less rule refers not to Section 1222(11) but rather the definition in Section 1(h), which would appear to say the term means net long-term capital gains over short-term capital losses plus qualified dividends. ((The legislative history confirms but does not expand on the reference to Section 1(h). See Conf. Rep., p. 219, footnote 60, which is the Senate Report which was with modifications followed in conference.))
It would appear that even dividends can affect our if less limitation results in a unique manner, unlike other income. ((See Sec. 1(h)(11) which reads: “Dividends taxed as net capital gains. For purposes of this subsection, the term `net capital gain” means net capital gain (determined without regard to this paragraph) increased by qualified dividend income.” So investing for, say, tax-advantaged dividends versus interest income may need to consider in such analysis the potential difference such investments may have on the 20% of business income deduction. Qualified dividends are a plus and minus in the if-less limitation computation, whereas net short-term capital gains in excess of long-term capital losses and interest income would just increase taxable income, and muni-bond interest would not increase taxable income. New Section 199A may well impact basic investment strategy.
There’s a second sentence (the last sentence) in Section 199A(a) which says the result of the first sentence cannot exceed the taxable income as reduced by the net capital gain as so defined.
Following are notes from the legislative history concerning gains and losses
“Qualified business income is determined for each qualified trade or business of the taxpayer. 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.” ((Conf. Rep., p. 214, which here is the Senate report which with modifications was followed in conference.))
“Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States.” ((Conf., Rep., p. 215; footnote omitted.))
The legislative history here goes on to talk of the “Treatment of investment income,” which is introduced with a sentence saying, “Qualified items do not include specified investment-related income, deductions, or loss.” It goes on to specifically say qualified items of income, gain, etc. that do not qualify for the 20% deduction include “any item taken into account in determining net long-term capital gain or net long-term capital loss.” Later in the paragraph, it mentions as qualifying income gains on sale of inventory. Still later in the list, the discussion goes on to mention exceptions; i.e., property used in the trade or business, or supplies regularly used or consumed in the trade or business..” ((See items #1 and #4 in “Treatment of investment income,” page 215.))
One of the debates on this topic would be whether in the above paragraph, the reference to net long-term capital gain should include gains on the sales of business assets if after applying the rules, the taxpayer ends up with net long term capital gain – tax favored income because of Section 1231. We would stress that the heading here is “investment income” and within the same paragraph there is an expressed exception for property used in a trade or business. Also, the overall context is one of encouraging business.
In general, the new Tax Cuts and Jobs Act maintained the long-term capital gain rules, such that depending on the taxpayer’s bracket on the tax schedule, the federal tax rates on just the long-term capital gain may be zero, 15% or 20%. The rates have basically stayed the same but the range of incomes where different capital gains rates apply has changed.
Following are the long-term capital gain rates in 2018 (the amounts are subject to annual adjustments.)
Married filing joint: zero long-term capital gains tax up to taxable income of $77,200; 15% on such gains when taxable income is $77,200 to $479,000, and 20% on such gains when taxable income exceeds $479,000. In 2017, the 15% tax rate begins at $76,550 and the 20% rate begins at $470,700.
Single returns: zero long-term capital gains tax up to taxable income of $38,600, 15% on such gains when taxable income is $38,600 to $425,800, and 20% on such gains when taxable income exceeds $425,800. In 2017, the 15% tax rate begins at $37,950 and the 20% rate begins at $418,400.
A 25% rate may reach part of the gain on buildings (unrecaptured Section 1250 gain) but not land. ((See Sec. 1(h)(1)(E); 2017 Form 1040 Schedule D, line 19, and page D-12, 13 of the 2017 instructions to Schedule D.)) Tax consequences may be affected by the minimum tax.
If our interpretation prevails, then one might have the sale of business realty where part of the gain is ordinary income under the depreciation recapture rules, part of the gain is subject to the 25% tax, and part of the gain is subject to the usual long-term capital gain treatment, yet all the gain from the sale would be subject to Section 199A. If one argues that gain taxed at the favorable 20% capital gains rate or even the 25% rate that can apply to part of the gain on the sale of a building should not qualify under Section 199A because it is already tax-advantaged, it would apparently lead to treating the depreciation recapture portion of the gain as subject to the 20% of business income deduction, whereas the rest of the income from the same sale of the same asset did not qualify. There’s nothing in the statute or legislative history suggesting one breaks down one transaction into a portion that is subject to Section 199A and a portion that is not.
We believe the better view is that the 20% of business income concept does reach gains on sales of business assets, even the portion that may qualify as long-term capital gain.
Planning point: A possible planning aspect and an issue of interpretation or IRS regulation is whether pre-2018 appreciation is fully subject to the benefits of the new Section 199A, whether or not the asset was even a business asset when the new law was introduced. For example, assume land is used in business and its sale in 2018 results in a $1,000,000 gain but there was no appreciation in 2018. Is the entire $1,000,000 gain subject to the benefits of the new 20% of business income deduction rule, assuming such gain isn’t excluded from being business income for purposes of Section 199A just because it is already beneficially taxed?
We believe post-2017 gain or loss for purposes of Section 199A does not have to distinguish the portion of the gain that may relate to pre-enactment years, which suggests that when justified there may even be an incentive to convert assets from personal to business use. Conspicuous by its absence is any rule in the new law or its legislative history saying we distinguish the portion of “gain” that may relate to appreciation in years prior to enactment of the new statute. Compare Section 1374 which does have such a concept in so far as reaching appreciation relating to a C corporation’s years that is realized in certain periods following conversion to S corporation status. In general, this would be very complex and we would be surprised if the IRS introduces such a concept by way of regulations or rulings.
A detailed discussion of measuring gain/loss on the disposition of business assets is beyond our scope, but the measurement details can be complicated. In measuring gain or loss within a business context, there may arise any number of different issues, including those relating to basis upon converting a declined-in-value asset from personal to business use, or converting an asset whose value has increased from personal to business use via a sole proprietorship or as a contribution to a partnership or S corporation. ((See, e.g., IRS Pub. 551, Basis of Assets, Rev. Dec. 2016, p. 10.))
Taxpayers may be looking at more and more taxable transactions involving property because the 2017 Tax Act amended the like-kind exchange rules to generally provide that after 2017, they apply only to exchanges of realty not held primarily for sale. ((Conf. Rep., p. 396; see p. 72, 73, 394-396; see also p. 223. The new rules focus on exchanges completed after 2017 with exceptions if the disposed of property was disposed of prior to 2017 or the property received was received prior to 2017. Conf. Rep., p. 396, 397.))
To summarize, we believe Section 199A, the 20% of business income deduction rule, reaches business income beginning in 2018 looking to income or gains realized or losses sustained after 2017, and we believe this generally as to ordinary income or tax-advantaged gains. If there were say Section 1231 loss from the sale of equipment or say a business building, such loss would appear to reduce the base for computing the 20% of business income deduction. We also believe that even tax-advantaged gain should qualify as gain subject to the benefits of the 20% of business income deduction because the statute basically focuses on business income realized in the taxable year. ((See generally Conf. Rep., p. 223.)) We believe that, e.g., the entire loss sustained on the sale of a business asset after 2017 reduces the benefits under Section 199A even though all or part of the loss relates to pre-enactment years.
We would caveat that there are complexities and possible issues as to how the IRS will interpret the new statute and the stances it will take in rulings and regulations on these important details.
We noted previously legislative history from the Conference Committee, and portions of it has general anti-abuse message.
“The Secretary is required to provide guidance applying rules similar to the rules of section 179(d)(2) to address acquisitions of property from a related party, as well as in a sale-leaseback or other transaction as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital. Similarly, the Secretary shall provide guidance prescribing rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital.” ((Conf. Rep. p. 223.)
What issues arise within these rules when there are multiple businesses?
We’re going to conclude that the taxpayer needs to plan on capturing information on wages and capital expenditures broken down by each trade or business in any particular year when taxable income exceeds certain levels: $157,500 of taxable income in 2018 for single taxpayers and $315,000 in joint returns. These levels are subject to indexing so they will change each year. Measuring wages and capital expenditures is discussed in more detail in “The Basic Math Gets More Complicated with Higher Levels of Income.” The concept of finding multiple businesses in this context seems focused on applying the wages or wages and capital expenditures rules separately to each trade or business and perhaps also focusing on the separate treatment of certain types of service providers which we discuss later.
The ffocus in finding multiple businesses seems to be the disallowance of the 20% deduction. If a particular activity rises to the level of a separate trade or business and the wages or wages and capital rules as they relate to that particular trade or business do not support a 20% of business income deduction, the result is disallowance (or partial disallowance). Lawyers, CPAs and certain other service providers are not permitted the 20% deduction, or it is scaled back, if their taxable income as defined for this purpose (not just their income from that particular activity) is too high, and the concept of separately identifying the trade or business could seemingly apply for purposes of these rules also.
There is within the statute the concept of carryover of losses. Losses have potential for reducing the base against which the 20% would be applied, and the language here reads: “If the net amount of qualified income, gain, deduction and loss with respect to qualified trades or businesses of the taxpayer for any taxable year is less than zero, such amount shall be treated as a loss from a qualified trade or business in the succeeding year.” ((Sec. 199A(c)’(2). The legislative history of the Senate version, largely followed in conference, shows business A with income of $20,000 and business B with a loss of $50,000, and the $30,000 net loss carried over to the next year when there was $70,000 of income, $20,000 from business A and $50,000 from business B. The $30,000 loss is carried to the second year where it reduces the $70,000 amount. ((Conf. Rep., p. 214.)) The language doesn’t seem to emphasize separate businesses, though the facts could have emphasized the separate income of the two businesses. The second year income of business B which gave rise to the carryover would have absorbed the entire $30,000 but that’s not emphasized. The concept is maximum use of the loss, which as a carryover is only a contingent reduction in the base for computing the 20%. If there is a loss from one business and income from another in the same year, the loss offsets the gain in such year. So the general emphasis is to use the loss with less emphasis on the separate business concept. Yet given the concept of applying the wage or wages and capital calculations to separate businesses, it would seem to require allocating the loss carryover to a particular business. We will see if the regulations follow that concept.
The “if less rule” looks to taxable income and net capital gain income as defined in Section 1(h) times 20%, and this concept wouldn’t require looking at whether there are pockets of income or loss, or whether there are separate businesses. ((Sec. 199A(a)(1)(B).
The basic 20% of business income statute looks to the “combined qualified business income amount of the taxpayer,” and such amount would obviously entail some additions, and apparently there is no isolating of losses in any separate business. To not offset such losses would inflate the 20% of business income deduction, so apparently any separate losses would offset the base for computing the 20% of business income deduction.
Section 199A(b)(1)(A) defines “combined qualified business income amount” as the “sum” of amounts under Section 199A(b)(2) whose heading refers to “each” trade or business and whose purpose is to determine the deductible amount with respect to “each” trade or business. It is here that the deduction computation focuses on the taxpayer’s qualified business income with respect to the qualified trade or business, or the amount as reduced considering the wages or wages and property acquisitions for “the” trade or business. The issues don’t seem stressed in the legislative history but as to using wages versus wages and capital with their differing percentages, It would appear one could annually change approaches as to a business, and use whichever limitation was advantageous for different businesses of the taxpayer in a year.
The conference report discussing the wage or wage and capital limitation refers to “the qualified trade or business…” ((Conf. Rep. , p. 222-224. See also p. 217-218.))
A multitude of different businesses, including a partnership flow-through of business income, is not an issue until one gets to the wage or wage and property acquisitions limitations, which may not even apply. But when they apply, one has to measure those limitations looking to each trade or business.
Under the statute as written, an excess of, say, wages for purposes for one trade or business would not help another trade or business where there is a limitation based on the wages or wages and capital rule.
There is some discussion in the legislative history of consistency in grouping trades or businesses under Section 199A and the passive loss rules. ((See, e.g., Conf. Rep., p. 211 discussing the House provisions. Conference basically followed the Senate version.))
The issue of multiple trades or businesses is even the major focus of Section 13703 within the 2017 Act amending Section 512 related to unrelated business income of charities. The topic of multiple businesses can be important in other tax rules. ((See Conf. Rep. p. 545-548. See “Planning for UBTI Changes,” Dennis Walsh, Planned Giving Design Center, 1/16/18; http://www.pgdc.com/pgdc/planning-ubti-changes. His discussion of what constitutes a separate trade or business for purposes of this new statute includes references to the topic under the unrelated business income rules, the passive loss rules of Section 469 and the hobby loss rules of Section 183.))
Planning point: Early in the process of dealing with these new rules, give thought to what may be construed as a different trade or business. Plan to capture the relevant information, such as wages and capital expenditures by each trade or business beginning in 2018, if the wage or wage and capital limitation may apply. Consider changing the facts in a manner that may avoid multiple businesses. It would seem that finding a single trade or business would be advantageous under the new Section 199A rules.
Planning point: Part of the “math” here involves decisions about whether to have deductions, business or non-business deduction, in a particular year that reduce taxable income to a level such that the wage or wage and capital limitations don’t apply.
Planning point: It is often difficult to project accurately one’s taxable income for the year. The taxpayer may not have any idea of the taxable income that may flow through, say, a new partnership investment. A bonus paid late in the year or unusual income, such as income flowing from an estate of a family member who passes, can all affect taxable income, and higher taxable income can trigger the need to know wages and capital expenditures broken down by each trade or business. So generally plan on capturing the relevant information even if it isn’t clear whether it will be needed.
Planning point: It doesn’t necessarily follow that flow-through income from partnership or S corporation is from a single trade or business for purposes of Section 199A, so these rules may trigger added complexities and accounting analysis with added expense at the entity level. When feasible, changing the facts at the entity level to have only one trade or business may be advantageous from the standpoint of the tax result, while also reducing administration and accounting costs. Tax preparers and others also need to plan from a compliance standpoint considering that, e.g., flow through entities may not only need to report income and expense items by separate trade or business but they also may need to capture flow-through of factors data by separate trade or business , such as wages or wages and property factors. It would appear from the definition of property factors that analysis of distant prior years may be necessary. The entity’s rules about when to toss old records may need to change. Reporting for mutli-tiered partnerships may be more complex and costly.
Each industry may present its own issues as to when activities may constitute a single business or multiple businesses. For example, in the real estate industry, one may see the proliferation of LLCs or limited partnerships for purposes of limiting liability, which sometimes involves the proliferation of partnership returns even when there is only a husband and wife. In general, a husband and wife in a community property state may disregard their LLC for tax purposes and report results directly on the joint return. ((See Rev. Proc. 2002-69, 2002 CB 831.)) Assuming the real estate activities rise to the level of a trade or business, does the proliferation of, say, spousal LLCs and/or the proliferation of partnership returns hurt the prospects of finding a single trade or business for purposes of Section 199A? Would the IRS entertain finding a single trade or business when that would require adding together the results of multiple partnership returns, even if there are just spousal partnerships?
Planning point: In a community property state where the couple may be permitted to disregard filing a partnership return or multiple partnership returns, consider reporting directly on the couple’s Form 1040 to enhance the argument of having a single trade or business for purposes of Section 199A.
Caveat: Consider legal advice since some believe the proliferation of returns and LLCs tends to reduce the scope of potential law suits. Some also believe that when the couple files myriad partnership returns, as a practical matter, the scope of an IRS audit of the couple may encompass fewer properties. ((See “Organizing the Real Estate Client,” J. Michael Pusey, Main Street Practitioner, October2017, National Society of Accountants, p. 8; nsacct.org.))
THE BASIC MATH GETS MORE COMPLICATED WITH HIGHER LEVELS OF TAXABLE INCOME
Our focus here is on the special limitations requiring in some circumstances wages or wages and capital.
When these limitations are fully applicable at higher levels of taxable income, the added limitation basically looks to the higher of (a) 50 % of W-2 wages, or (b) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
There is a 20% of business income rule, which is combined business income net of losses, and it is this rule which involves the wage or wages and capital limitation. We may refer to this as Rule #1.
There is another limit based on 20% of taxable income not counting the Section 199A deduction. This second, very important, often applicable limitation, also contains a reduction for gains under Section 1(h) which appears to encompass long-term capital gains over short-term capital losses plus qualified dividends. We may refer to this as Rule #2.
There is a third rule saying the deduction can never exceed taxable income as reduced by net capital gain. ((Sec. 199A(a), last sentence.)) As discussed above, net capital gain for this purpose appears to be net long-term capital gains in excess of short-term capital losses plus qualified dividends.
There is another limit which introduces computations based on wages and property. This concept applies only for purposes of Rule #1, the basic rule looking to 20% of net business income. When the computation applies the “if less” approach focused on Rule #2 which looks to 20% of taxable income as reduced by long-term capital gains net of short-term capital losses plus qualified dividends, the level of wages or wages and capital improvements doesn’t enter into the computation. The level of taxable income can be important in Rule #1, however, because there is another rule saying the taxpayer can totally or partially disregard the rules requiring wages or wages and capital improvements depending on the level of taxable income.
We later discuss another major limitation focused on certain service providers.
As indicated above, we will at times distinguish the moderate-income taxpayer (whose income isn’t all that small), the middle-income taxpayer, and the higher-income taxpayer. The distinctions focus on taxable income, not gross sales or business income. One of the complications here is that there are some scenarios where one has to capture information on wages or wages and capital broken down by each trade or business.
A key concept here is “threshold amount,” defined in 2018 as $157,500 except it is $315,000 with a joint return. ((Sec. 199A(e’)(2). These are for 2018 or the taxable year beginning after December 31, 2017.)) The focus is on taxable income being less than the threshold amount; taxable income being prior to the 20% of business income deduction under Sec. 199A. The statutory definition of “threshold amount” incorporates annual cost-of-living adjustments so the amount changes annually.
Planning point: The higher threshold amount with a joint return is in most cases an obvious incentive for a married couple to file a joint return.
The basic math we described in the immediately preceding section prevails if the taxable income prior to the Section 199A deduction is less than the threshold amount – $157,500 for other than joint returns and $315,000 for joint returns.
So amidst all the complexity, the moderate-income taxpayer (or taxpayers if a joint return) basically look to the lesser of 20% of business income, or 20% of taxable income over the sum of net long-term capital gain in excess of short-term capital losses plus qualified dividends.
This rule focuses on a range of income, taxpayers whose taxable income (before the Section 199A deduction) isn’t significantly above the threshold amount. These amounts for 2018 are as follows: (a) for other than joint returns, the threshold amount of $157,500 plus $50,000, or a range from $157,500 to $207,500 of taxable income; or (b) for joint returns, the figure is taxable income of $315,000 plus $100,000, or a range of $315,000 to $415,000 of taxable income.
The $50,000 and $100,000 amounts look not to be subject to cost-of-living adjustments.
Accordingly, the middle-income taxpayer is subject to the rules we discuss here. Our scope is other than joint return taxpayers whose taxable income is between $157,500 and $207,500, and joint return taxpayers whose taxable income is between $315,000 and $415,000.
At this point, we have to introduce another important limitation which applies to other than moderate- income taxpayers. This rule basically says you don’t get the deduction, or don’t get the full deduction, without payment of wages or a combination of wages and capital items.
These rules look at the level of taxable income, not business income; the level of taxable income is indexed and the 2018 amount below will change each year.
(a) If you are a moderate-level taxpayer (our terminology), defined as having taxable income before the Section 199A deduction below $157,500 single or $315,000 on a joint return, you can ignore the rules about having to have wages or wages and qualified property;
(b) If you’re a middle-income taxpayer (our terminology), defined as having taxable income before the Section 199A deduction between $157,500 to $207,500 single (or head of household or married filing separately) or $315,000 to $415,000 on a joint return, then the wage or wage and qualified property rules may phase out your Section 199A deduction to some extent; and
(c) If you’re a high-income taxpayer (our terminology), defined as having taxable income before the Sec. 199A deduction of more than $207,500 single (or head of household or married filing separately) or more than $415,000 joint, then the wage and qualified property rules phase out your Section 199A deduction altogether except to the extent you support it with wages or wages and qualified property.
We observe generally that there appears to be no maximum to the Section 199A deduction, so it could be millions, but the high-income taxpayer would need to justify the deduction with wages or wages and qualified property.
Business income is obviously good for purposes of maximizing the deduction.
On the other hand, higher levels of taxable income bring into play the rules about wages or wages and qualified property, so high taxable income arising from any source can have a detrimental effect under Section 199A unless the taxpayer has wages or wages and qualified property sufficient to support the deduction.
Note also that the statute basically defines the deduction as the lesser of the amounts computed under the general rules looking to 20% of business income but with the rules requiring wages or wages and qualified property, or 20% of taxable income for the year less the sum of net long-term capital gain in excess of short-term capital loss plus qualified dividends. ((Sec. 199A(a).)) So if you have relatively high taxable income from any source and are brought into the portion of the rules that require some level of wages or wages and qualified property to justify the deduction, your deduction under Section 199A can drop to zero if you have no wages or wages and qualified property even if you have relatively small business income.
Planning point: Reducing taxable income can be particularly important given the limitation rules under Section 199A. Deductions with respect to capital expenditures under Section 168(k) and Section 179, which we discuss in some more detail below, may be helpful in controlling taxable income for this purpose of minimizing or doing away with this particular limitation, but they would also reduce the 20% of business income calculation unless, say, the deductions related to realty that for some reason wasn’t considered a trade or business.
Planning point: As one reads Section 199A, there are references to determining the deducible amount with respect to “each trade or business” and measuring wages or wages and qualified property with respect to “the trade or business.” One combines the results of the trades or businesses in finalizing the year’s deduction, but it appears that correctness of the accounting records with respect to “each trade or business” and having wages or wages and qualified property correctly reflected on “the trade or business” are particularly important when there are multiple trades or businesses. In general, the emphasis within the statute that focuses on each trade or business will bring into play more limitations than would be the case if the computation were just based on totals for the year. If one with high taxable income had, for example, significant wages or wages and qualified property flowing through as memo information from a partnership, any “excess” wages or wages and qualified property apparently couldn’t help support the deduction with respect to a sole proprietorship that had little or no wages or wages and qualified property.
Passive losses: See generally our previous discussion of “What Qualifies as Business Income for Purposes of the 20% Credit?” In that discussion, we opined that the normal passive loss rules continue to apply and determine the year a loss is deducted, and queried how the wage or wage and qualified property requirements would be applied in a passive activity context. For example, if there are small passive losses carrying to a year in which there is large passive income from the activity, does one consider only wages or wages and qualified property from the business from the current year? In measuring the level of wages or wages and qualified property needed to avoid limitations, does one consider the net income from multiple years but look to the level of wages or wages and qualified property needed to support the positive income of the current year? We noted above that the likely answer is one looks to the wages figure for the year but there may be issues of interpretation and fairness in particular circumstances or special rules for unusual circumstances. ((See Sec. 199A(b)(4)(A).))
The legislative history indicates that if there are net qualified business losses in a particular year (apparently deductible losses, not losses currently subject to the passive loss limitation), they would carry over to offset business income in a later year. ((Conf. Rep. p. 214 discussing Senate amendment. Conference basically followed the Senate version with modifications. Conf. Rep. p. 222.)) There may be issues of how one applies the wages or wages and qualified property rules in that scenario.
We turn to a more detailed look at the wages or wages and qualified property rules that cannot increase the Section 199A deduction but they can reduce it all the way to zero for high taxable income taxpayers.
The moderate-income taxpayer doesn’t have to justify any of the deduction computation by showing wages, or wages and acquisitions of qualified property. But those with taxable income above the threshold amounts have to contend with limitations.
The limitations look to “W-2 wages” with respect to a qualified trade or business, or a combination of “W-2 wages” and “the unadjusted basis immediately after acquisition of all qualified property.” ((Sec. 199A(b).))
W-2 wages do not include amounts “not properly allocable to qualified business income…” ((Sec. 199A(b)(4)(B).)) Nor does it include amounts “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.” ((Sec. 199A(b)(4)(C).))
So the tax benefits here suggest being sure one’s payroll tax reports are not delinquent, or at least not very delinquent.
The added limitation basically looks to the higher of (a) 50 % of W-2 wages, or (b) 25% of W-2 wages plus 2.5% of the unadjusted basis of all qualified property.
Qualified property for this purpose includes as part of the definition tangible property of a character subject to depreciation “which is held by, and available for use in, the qualified trade or business at the close of the taxable year…” ((Sec. 199A(a)(6).)) The 2.5% factor is applied to the unadjusted basis of the property immediately after acquisition. ((Sec. 199A(a)(2).))
The asset component arose in conference and the legislative history in the conference committee report gives as an example a business acquiring an asset in 2020, well after the introduction of the rules in 2018. ((Conf. Rep., p. 222, 223.)) Yet the statute and the legislative history seem clearly worded to encompass “old assets” and not just assets acquired post-enactment. The key tests look to the “tangible property” that is “depreciable,” so, e.g., goodwill and land wouldn’t count. Also, the asset must (a) be “held by, and available for use in” the business at the close of the year, (b) have been used at some point in producing income during the year (so idle assets are a problem), and (c) the “depreciable period” hasn’t ended before year end.
The “depreciable period” concept looks unique to this statute, and it basically says look to 2.5% of the unadjusted basis of the property immediately after acquisition and continue to focus on such undepreciated amount for a period of time. The concept is “gross basis” (our term), not net of depreciation. The time period, the “depreciable period” for this unique purpose is the longer of ten years from when the asset is first placed in service, or the “applicable recovery period” looking to Section 168. So the asset needs to be put to work, not just acquired, and can apparently be considered for a ten year period even if such period exceeds the prescribed depreciation period, or if longer, the applicable recovery period. So an asset with a long life can be counted for more than ten years. As we read this, one could even count a depreciable asset still in use even if it so happened to have been removed from the depreciation schedule because of its short depreciable life.
The legislative history provides:
“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. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property under section 168 (without regard to section 168(g)).” ((Conf. Rep. p. 222.))
These look to be unique rules needed only for this purpose, so there will be special workpapers focused on just this test.
Keep in mind the context is defensive. The 20% of business taxable income deduction isn’t increased regardless of the wages or acquisitions of qualified property.
It would appear that direct ownership vs. related-party leasing arrangements for the assets used in the business could have a significant effect on the computations. On the other hand, it seems difficult to justify conceptually why a business that owns the assets should be that much better off in these computations than a competitor who leases them. Perhaps there will be discussions of such issues by the IRS. ((There is some discussion of the IRS looking at sale-leaseback situations, but the context isn’t clear as to whether, e.g., the focus is on who is the buyer. Conf. Rep., p. 223.))
There might be issues of one spouse’s ownership but husband-wife partnership income, or community property ownership but the business is that of one spouse. It seems unlikely the IRS would press these type of issues to trigger limitations under Section 199A but such issues may well come up in the regulations, rulings, etc.
The 2017 Act is known for making it easier to deduct items that are capital, depreciable by nature, but the language in this limitation provision is focused on depreciable basis immediately after acquisition raises issues. Do decisions to, say, expense an item under Section 179 mean the costs do not qualify for this purpose? What about assets where there is a 100% deduction under the “bonus depreciation” rules of Section 168(k)? Such decisions would not be made until well after year end, but would they be interpreted as reducing basis “immediately after acquisition”? The general context is to be generous and encourage taxpayers to make capital expenditures, but will decisions to maximize deductions affect the capital additions portion of these calculations?
Among the issues here is that the language of Section 179(a)(1) says the cost is treated “as an expense not chargeable to a capital account.” So do you have unadjusted basis for purposes of Section 199A if expenditures are treated as an expense? Yet the regulations would indicate there is basis, and presumably basis immediately after acquisition, because they provide basis has to be reduced by the Section 179 expense. ((Regs. 1.179-1(f).))
We are hopeful that the IRS will quickly address and concur with our belief that to accelerate the deductions for capital expenditures under either Sections 179 or 168(k) doesn’t rule out having “unadjusted basis immediately after acquisition” for purposes of avoiding cut-back of benefits under Section 199A.
We caveat that the decision to accelerate expense here will normally relate to a business asset such that the increased business deduction will likely reduce the Section 199A deduction which turns on 20% of business income, or 20% of taxable income as adjusted under the “if less rule.”
We caveat doing the projected math in both 2017 and 2018. Consider maximizing the deductions for capital expenditures in 2017 rather than 2018 when the deduction may reduce the benefits under new Section 199A.
The language focused on the unadjusted basis for extended periods suggests that current capital expenditures can have a positive effect for extended periods; i.e., the language doesn’t just focus on the capital expenditures of a particular year.
Allocations of lump-sum purchase price among assets may affect these calculations.
The available-for-use-at-the-end-of-the-year language could possibly bring into question how one treats equipment out for extraordinary or even ordinary repairs, or the complexities of such a rule in such circumstances as hurricanes and floods. It seems unlikely that storms and floods would be a problem if the assets remain serviceable.
The middle-income taxpayer (our terminology) has to contend with the added limitation but subject to some special calculations. The limitation is a factor but it is not fully implemented.
Step 1: If when one takes the higher of (a) 50% of wages, or (b) the sum of 25% of wages and 2.5% of qualified property, such amount is higher than the 20% of business income limitation, the details we discuss in Step 2 wouldn’t apply. ((Sec. 199A(b)(3)(B).)) The limitation isn’t a factor because it is satisfied.
Step 2: If you didn’t avoid this added limitation in Step 1, one deals with computing the amount of reduction. One computes an “excess amount” which is the amount 20% of qualified business income exceeds the greater of (a) 50% of wages, or (b) the sum of 25% of wages plus 2.5% of the basis of qualified property. ((Sec. 199A(b)(3)(B)(iii).)) The reduction is the result of multiplying this amount by the ratio of (c) taxable income (computed without the Section 199A deduction) minus the threshold amount, to (d) $50,000 or $100,000 if a joint return.
For example, assume 50% of wages is $25,000 and such amount is greater than the sum of 25% of wages and 2.5% of qualified property, a single taxpayer with taxable income (before the Section 199A deduction) of $167,500 and qualified business income of $200,000. The 2018 threshold amount for a single taxpayer is $157,500. Taxable income before the Section 199A deduction exceeds the threshold amount by $10,000. The “excess amount” is the amount by which the normal 20% of business income figure, or $40,000 (20% of $200,000) exceeds the amount allowable under the rules looking to wages and/or wages and capital additions, or $25,000. The “excess amount” is $15,000. The reduction in the deduction is a percentage of the excess amount; such percentage looks to the ratio of the $10,000 amount to $50,000, or 20%. Accordingly, the reduction is 20% of $15,000, or $3,000. Accordingly, the taxpayer deducts $37,000.
The basic logic is if the taxpayer’s taxable income is below $157,500, the normal 20% of business income rule would apply, or 20% of $200,000, or $40,000. If the taxpayer’s taxable income were as high as $207,500, the taxpayer’s deduction would be limited to the lesser amount looking to the limitation based on wages of $25,000; i.e., the wage or wage/capital addition limitation rule would be fully operational. The rule progresses from imposing no limitation under the wage/capital additions rule if taxable income is $157,500 to fully implementing the wage/capital increase rule at a taxable income level of $207,500. In our example, the taxable income is “20% of the way” toward full implementation of the limitation, so the limitation is implemented to the extent of 20%. Keep in mind “taxable income” for this purpose is before the Section 199A deduction.
General note: Unlike some statutory provisions that emphasize increased levels of an activity over a base, the Section 199A rules basically deal with wages and qualified property looking to the amounts without asking whether they increased over some base year or years. We have in mind the R&D credit rules that often look to increases over base periods. There will be special tax records and computations under Section 199A but in general, they may not require major “studies” to make the tax calculations.
For 2018, these are single taxpayers (or heads of household and married separate filings) with more than $207,500 of taxable income, or taxpayers filing jointly with more than $415,000 of taxable income.
These taxpayers basically deduct the lesser of (a) 20% of qualified business income, or (b) the higher of 50% of wages or the sum of 25% of wages and 2.5% of qualified property.
Accordingly, such a taxpayer could have zero deduction if no wages and no qualified property. But if such taxpayers have significant wages and qualified property, it is these non-corporate taxpayers whose Section 199A deduction could be a million or more.
As indicated in the preceding section’s example, if we assume the single taxpayer’s taxable income before the Section 199A deduction was $207,500 or more, the Section 199A deduction would be $25,000 rather than $37,000.
Let’s assume joint return taxpayers with very high business income, $787,500, and no other deductions beside the standard deduction. Let’s assume no wages and no qualified property. The “if less” limitation is relatively high but the rule is the normal 20% of business income rule if less, which in this case has to consider the wage or wage and capital limitation. Their Section 199A deduction is zero because they’re high-income taxpayers (our terminology) and are required to have wage and/or qualified property components to justify the deduction.
After all the talk of restricting charitable donations, the 2017 tax bill actually increased the limit from 50% of adjusted gross income to 60% of adjusted gross income. After 2017, the enhanced charitable deduction limit is generally 60% of adjusted gross income. Let’s assume the joint return taxpayer with $787,500 of business income and adjusted gross income also has a charitable donation of 60% of $787,500 or $472,500. The return would not likely be this simple. For example, it would often include such deductions as 50% of self-employment tax. But at the risk of over-simplification, we assume only business income $787,500 and a charitable deduction of $472,500 (which exceeds the standard deduction), or taxable income of $315,000 before any Section 199A deduction. The taxpayers have now moved into the moderate-income category where wages and/or qualified property are not required to justify the 20% of business income deduction. Their deduction would not be 20% of business income, but the lesser 20% of taxable income, or $63,000, which is a major improvement over the zero deduction they would have under the high-income taxpayer calculations assuming no wages or qualified property.
So we see in this scenario that charitable donations (and other deductions) not only save tax in a normal fashion as deductions in their own right, they also yield a worthwhile increase in the Section 199A deduction by moving the taxpayer out of the higher levels of taxable income where the rules about wages or wages and capital can severely limit if not eliminate the deduction.
These rules emphasize “doing the math.”
The charitable deduction is limited to a percentage of adjusted gross income, so the fact that the Section 199A benefit is a deduction in arriving at taxable income but not adjusted gross income can at times have the effect of enhancing our results.
SPECIAL RULES APPLYING TO CERTAIN SERVICE PROVIDERS
There are certain types of service income scenarios where the income may be phased out with higher levels of taxable income.
Architects and engineers were excepted, but many professions are denied access to the 20% of business income rule or attain limited access to it under rules naming: health, law, accounting, actuarial science, performing arts, 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. ((Sec. 199A’s incorporating with exceptions Sec. 1202(e’)(3)(A).)) While “financial services” are referenced in one area of the list, there is also listed work where the trade or business consists of investing and investment management, trading or dealing in securities, etc.
Following is the legislative history mentioning architects and engineers: “The definition is modified to exclude engineering and architecture services, and to take into account the reputation or skill of owners.” Does the rule looking to the reputation and skill of the owners apply to architects and engineers, although the latter are expressly mentioned in the 2017 legislative history? We believe an affirmative answer is required, else you’ve got an exception benefitting only that group.
Interpreting the language and scope of this provision seems problematic. ((For private letter rulings on the language here, see PLRs 201436001, 9/5/14; PLR 201717010, 4/28/17; and re entity classification nuances, see PLRs 201603010-201603014, 1/15/16.))
The type of service work listed in the preceding paragraph is subject to “maybe” being included in the list of qualified business income depending on the level of taxable income. The general rule is that with high business income, given supporting wages and qualified property, there appears to be no limit on the deduction. But there are certain types of service businesses, not all service businesses, where higher levels of taxable income phase one out of the benefit of the 20% of business income deduction regardless of having wages or wages and capital.
The work of doctors, lawyers, CPAs, performing artists, etc. is of a nature that it could be referred to as the maybe-20%-of-business-income deduction list. This type of net income qualifies if taxable income is not too high. It begins to phase out at a certain level, but then is ineligible for the 20% deduction altogether when the taxable income (not just business or professional net income) exceeds certain amounts. These amounts are indexed for inflation but with the beginning year of 2018, these “threshold amounts,” the beginning point of these computations, is $157,500 or $315,000 in the case of joint returns. These amounts, if higher, are subject to possible further adjustment, reduction to the point of eliminating any deduction for high earners in designated lines of personal service.
Basically, the middle-income math for a “specified service provider” in 2018 works in this fashion. The key factor in the scale-back (or elimination) for higher level income for a specified service provider is taxable income before the Section 199A deduction.
One takes the “threshold amount” – $157,500 of taxable income not counting the 20% of business income deduction, or $315,000 for joint returns – plus $50,000 for other than joint returns and $100,000 for joint returns. One computes the “applicable percentage” defined as 100% reduced by the percentage equal to the ratio of taxable income (without the 20% of business income deduction) in excess of the threshold amount bears to $50,000 assuming a single return. We’ll assume Schedule C of legal fee net income of $200,000 and taxable income of $167,500. Taxable income is more than $157,500 but it is also below the phase out altogether level being less than $157,500 plus $50,000, or $207,500. So 100% is reduced by the percentage equal to the ratio of $10,000 to $50,000, or 20%. Accordingly, the 80% “applicable percentage” is applied in making all the normal computations; i.e., 80% of Schedule C income would be $160,000.
There may also be an adjustment downward as to the factors – wages and qualified property. ((Sec. 199A(d)(3)(A)(ii).))
If one is in the ineligible group of service providers, the phase-out is complete and the 20% of business income deduction with respect to such service income drops to zero when taxable income before the Section 199A deduction exceeds, in 2018, $207,500, or $415,000 in joint returns.
Planning point: Given the concept that the benefits of the 20% deduction are phased out in certain circumstances based on higher levels of taxable income and corporations are not eligible for this benefit, does one consider incorporating certain service activities (or portions of an activity; e.g., based on geography, risk, etc.) to shift income away from the Form 1040 to gain access to the 20% deduction for certain income in the Form 1040? What guidelines will the IRS regulations pose in such circumstances?
For example, one may get into clear reflection of income or business purpose issues in such circumstances. ((See, e.g., Sec. 482.)) Keep in mind that the higher levels of income here are taxable income, not just service income. One needs such service income out of corporate solution; i.e., in the Form 1040, if the goal is to access the 20% of business income deduction, but at the same time, highly taxable non-business income items may shift the service provider into levels of taxable income that preclude the Section 199A deduction, which may suggest, e.g., gifts of assets producing high levels of taxable income to other family members, or incorporation of investments, which raises such issues as avoiding the personal holding company tax. ((Sec. 542.))
The planning under the new rules promises to be interesting; i.e., multi-faceted and complicated.
Planning point: The scale-back focuses on taxable income which may encourage, e.g., charitable contributions.
SOME GENERAL PLANNING OBSERVATIONS
There are limitations under these rules that can flow from higher levels of taxable income before the 20% of business income deduction and as adjusted for certain items. The level of wages or wages and capital is one such limitation except when taxable income is at reduced levels. The taxpayer may have to determine the business income of each separate trade or business, which could present a significant administrative and practical problem, and deal with pockets of limitations except when there are lower levels of taxable income. The rule that denies the benefit of the 20% of business income deduction to certain categories of service providers, such as lawyers and CPAs, goes away at lesser levels of taxable income.
Non-business deductions can sometimes do “double duty” – reduce taxable income and help the taxpayer avoid the limitations in the previous paragraph while at the same time not reducing the base for computing the 20% of business income deduction. Deductions related to realty may or may not be considered related to a trade or business for purposes of Section 199A depending on the facts and how the rules are interpreted.
Business deductions may similarly help avoid limitations but reduce he base for computing the 20% of business income deduction, while helping reduce the self-employment tax.
Among the possibilities for larger business deductions is a decision to maximize write offs of depreciable asset acquisitions under Section 179 and the “bonus depreciation” rules of Section 168(k). Capital additions may be a favorable factor at higher taxable income levels which require certain levels of wages or wages and capital. These rules under Section 199A look to the basis in equipment immediately after the acquisition. We are hopeful that the IRS will quickly conclude that maximizing deductions under Sections 179 and 168(k) doesn’t reduce the “unadjusted basis” for purposes of avoiding reductions of benefits under the 20% of business income rules. We encourage “doing the math” in 2017 and 2018 with respect to whether or when to maximize deductions under Sections 179 and 168(k) considering that such business deductions in 2017 won’t reduce income in 2018 which may qualify for the 20% deduction.
Planning with respect to large gains on sales of business assets may encompass not only preferential rate treatment but incremental benefits under the 20% of business income rules. Planning with respect to such gains may be problematic in that the “if less” income limitation includes an adjustment for gains but there may nevertheless be planning possibilities with larger sales of business assets.
Buyer and seller issues in significant business transition transactions will include looking at the Section 199A issues for both parties.
Planning with respect to investments generally should consider the 20% of business income aspects. For example, the benefit of such deduction can arise from flow-through income from an active business in which the individual isn’t active whereas interest income doesn’t qualify. While “qualified dividends” are subject to beneficial tax treatment, they appear to not increase the “if less rule” looking to taxable income as reduced by the sum of net long-term capital gains net of short-term capital losses plus qualified dividends. So for purposes of that computation, one may prefer interest income, if that limitation is close to being a factor.
Planning possibilities with respect to this new provision are surprisingly complex, in part because the statute at times focuses generally on taxable income (with adjustments) which introduces such a broad range of possibilities. The planning with respect to this new provision is particularly interactive with planning in connection with such options as maximizing depreciation or expensing capital improvements. The planning of non-business income and deductions can also have a major impact on the Section 199A deduction.
The information contained herein is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230, as the content of this document is issued for general informational purposes only, is intended to enhance the reader’s knowledge on the matters addressed therein, and is not intended to be applied to any specific reader’s particular set of facts. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. Applicability of the information to specific situations should be determined through consultation with your tax adviser.