Owners of businesses taxed as pass-through entities may realize a potentially beneficial, albeit complicated, tax benefit with Internal Revenue Code (IRC) Section 199A (§199A), enacted by the Tax Cuts and Jobs Act of 2017.
A pass-through entity is a business entity that does not generally pay income tax at the entity level. Instead the entity’s income, deductions, and other tax attributes pass through to the entity’s shareholders, members, or partners (owners) and are taken into consideration of the owners’ personal income tax returns. Examples of pass-through entities include S corporations, partnerships, and limited liability companies taxed as partnerships.
This new qualified business income (QBI) deduction, also known as the §199A deduction, provides for a 20% deduction for pass-through entities. The deduction is scheduled to automatically expire in December 2025, but we believe with careful planning many business owners can maximize the income tax deduction under §199A.
In our view, the key to planning for §199A is understanding when the application of its provisions are complex — and when they just appear to be. Business entities, business investments, hiring and salary decisions, distribution policies, and retirement planning elections can be structured properly to fully use this deduction.
The analysis begins with QBI, which is the net amount of income, gain, deduction, and loss from any qualified trade or business. QBI is determined separately for each qualified business unless the taxpayer elects to have the aggregation rules apply to multiple businesses.
The taxpayer must be engaged in a trade or business to be eligible for the §199A deduction, and some business activities might not meet that criterion. There are two primary considerations when determining if an activity constitutes a trade or business:
- the continuity, repetition, and extensiveness of activities; and
- the good faith intent of the taxpayer to make a profit or produce income.
The term does not encompass purely personal activities no matter how continuous, extended, or profitable they may be. For example, the rental of real estate through a triple net lease arrangement may not rise to the level of a trade or business for purposes of §199A. Also, income from many business investments may not be part of the trade or business, including capital gains and losses, certain dividends and interest income not properly allocable to a trade or business, or guaranteed payments to a partner for services rendered to a business.
When Section 199A Is Complicated — and When It’s Not
Taxable Income below Threshold Amounts
Section 199A considers the amount of the business owner’s (and spouse’s, if applicable) taxable income. As enacted for 2018, the threshold amount for married taxpayers filing jointly was $315,000 and $157,500 for single and all other taxpayers. These amounts are indexed for inflation in future years. The threshold levels are annually adjusted for inflation for taxable years beginning after December 31, 2018. In 2019, the threshold levels are increased from $315,000 to $321,400 for married taxpayers fling jointly and from $157,500 to $160,725 for single and all other taxpayers. For a taxpayer in 2019 with less than $160,725 of taxable income (single and all other filing statuses) or $321,400 (married filing jointly), the analysis is fairly straightforward — the entire 20% deduction should apply to QBI. For example, if a self-employed, married doctor who files jointly has taxable income of $200,000 per year and the doctor’s spouse earns $75,000 per year in W-2 wages, the 20% deduction should apply to the entire QBI of the self employed doctor. Accordingly, application of §199A is not so complicated if taxable income is below the threshold levels.
Taxable Income above Threshold Levels
Complexity increases significantly when taxable income exceeds the threshold levels, as described below.
For Taxpayers Engaged in an SSTB
The QBI deduction starts phasing out at the threshold levels for business owners engaged in a specified service trade or business (SSTB). For 2018, the deduction is completely eliminated at $207,000/$415,000 of taxable income, indexed for inflation for future years. For 2019, these amounts are increased from $415,000 to $421,400 for married taxpayers filing jointly and from $207,000 to $210,725 for single and all other taxpayers (the phase out/in level, also referred to as the service business test).
Many of the final Treasury regulations concern what qualifies as an SSTB. Most traditional professional service providers are engaged in the practice of an SSTB and generally cannot take advantage of the QBI deduction if taxable income exceeds the phase out/in level. Many taxpayers and their advisors were concerned that virtually any business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners would constitute an SSTB, but the final regulations confirmed this potentially broad language would be narrowly interpreted.
The service business test is a significant planning issue when a taxpayer is between the threshold levels and the phase out/in levels. In our view, this is arguably the range where the analysis reaches maximum complexity.
For Taxpayers not Engaged in an SSTB
For a taxpayer not engaged in an SSTB whose taxable income exceeds the phase out/in level, the deduction is limited to:
- 50% of the taxpayer’s share of W-2 wages with respect to the qualified trade or business; or
- the sum of 25% of the taxpayer’s share of W-2 wages with respect to the qualified trade or business, plus 2.5% of the taxpayer’s share of the unadjusted basis immediately after acquisition of all qualified property.
This is referred to as the wage and asset test, which is phased in between the threshold levels and phase out/in levels.
There is a different application of the phase out/ in levels for taxpayers engaged in an SSTB versus taxpayers not engaged in an SSTB. QBI from an SSTB cannot be deducted if the taxpayer has taxable income over the phase out/in levels. On the other hand, QBI not from an SSTB can continue to be deducted even when taxpayer’s taxable income exceeds the phase out/in levels, subject to the wage and asset test limitations.
Consider this hypothetical example. A owner of an architectural firm with taxable income of $500,000 must fit within the limitations of the wage and asset test in structuring and operating the business when trying to maximize the §199A deduction. On the other hand, a partner in a law firm (an SSTB) earning $500,000 through the practice of law does not qualify for the §199A deduction.
Special rules apply to relevant pass-through entities, publicly traded partnerships, trusts and estates
The final regulations provide reporting rules for upper-tier entities that own other, lower-tier pass through entities. These regulations allow the owners of the upper-tier entities to receive a deduction, if eligible, for QBI passing through from lower- to upper-tier entities.
Upper-tier entities are business entities (such as corporations, partnerships or limited liability companies) or trusts that own other entities (lower-tier entities). For example, if corporation X owns stock of corporation Y, then corporation X is an upper-tier entity with respect to corporation Y; similarly, corporation y is a lower-tier entity with respect to corporation X.
A trust or estate computes its §199A deduction based on QBI, W-2 wages, unadjusted basis immediately after acquisition of qualified property, real estate investment trust (REIT) dividends, and publicly traded partnership income allocated to the trust or estate. An individual beneficiary of a trust or estate considers such items in the same way he or she would if those items had been allocated from a relevant pass-through entity. To the extent a trust or estate allocates QBI to its beneficiaries, it is treated as a relevant pass-through entity; to the extent it retains QBI, it is treated as an individual. After calculating the relative amounts at the entity level, the trust or estate allocates them among the trust or estate and beneficiaries based on their relative percentage allocation of distributable net income. If the trust or estate has no distributable net income for a taxable year, all of these items are allocated to the trust or estate.
For trusts and estates, the threshold amount for 2018 was $157,500, and for future years that amount is indexed for inflation as provided in the final regulations. A trust formed solely to avoid exceeding the threshold amount will not be considered a separate entity.
Planning Ideas for Business Owners
Taxpayers can take several actions to minimize tax and maximize the deduction under §199A. Perhaps the simplest is to reduce an individual’s taxable income. If a taxpayer can reduce taxable income to below the threshold amounts, neither the service business test nor the wage and asset test would apply, allowing the taxpayer to receive the entire benefit of the §199A deduction — even if the taxpayer is engaged in an SSTB.
Of course, most taxpayers would rather not have less income just to receive an increased deduction. Nevertheless, there are planning techniques to help reduce a business owner’s taxable income, including:
- Increase contributions to qualified retirement plans (contributions to qualified plans, up to certain limits, help reduce taxable income).
- Determine that truly unrelated businesses are operated through separate entities independently from one another, especially if the service business test may apply to one business but not another. Take care to avoid the anti-abuse rules that would prevent related businesses from being separated solely for this purpose. For example, a doctor may own an office building, renting half to unrelated tenants and the other half to the medical practice. The portion of the business renting to unrelated tenants (not a SSTB) may be able to benefit from the deduction, whereas the operating medical practice will not.
- In an S corporation where the wage and asset test would otherwise limit the deduction, consider increasing W-2 wage income to employees.
- Review partnership agreements to reduce guaranteed payments to partners in favor of distributive shares.
- Consider whether a conversion from a partnership or sole proprietorship to an S corporation would achieve a larger deduction.
- Think about aggregating activities for the wage and asset test.
Aggregation May Present a Significant Planning Opportunity
Many of the business owners we advise own interests in several operating businesses and real estate entities. The final regulations clarify how business owners can use the aggregation election for purposes of the wage and asset test to increase the §199A deduction.
Elective aggregation can occur when:
- the same person or group of persons owns 50% or more of each trade or business;
- the 50% or more ownership exists for a majority of the taxable year, including the last day of the taxable year;
- the aggregated trades or businesses report items on the same taxable year (either the same fiscal or calendar year); and
- none of the aggregated trades or businesses is an SSTB and two of the following three requirements are satisfied:
- the trades or businesses provide products, property, or services similar or customarily offered together;
- the trades or businesses share facilities or centralized business elements (for example, accounting, personnel, legal); and
- the trades or businesses are operated in coordination or reliance upon one of more businesses in the aggregated group (for example, supply chain dependencies).
When determining the §199A deduction, aggregating businesses to increase the amount of wages could prove beneficial when applying the wage and asset test. For example, assume the taxpayer owns a closely held businesses with many employees and other businesses with a few employees. Depending on the circumstances, aggregation may allow the taxpayer to qualify the business with few employees for the §199A deduction by taking advantage of the wages paid by the business with many employees.
We believe the most effective business plan is one that understands the owner’s personal financial situation and strategic plans for the business while also taking into account the owner’s trust and estate planning and tax- and non-tax-motivated goals. Section 199A could offer potential benefits to business owners, but they should take caution to plan effectively and avoid potential pitfalls. Also, business owners should consult their tax and legal advisors.