One of the most complicated sections of the new tax legislation (The Tax Cuts and Jobs Act) is the new Section 199A deduction. I must admit that when I first read the proposed laws for this section, my mind was spinning. After reading through it multiple times I now have my head wrapped around the mechanics of the deduction.
For those of you who do not know what I am talking about, I will give you some background. The Section 199A deduction (a/k/a Qualified Business Income deduction, or QBI for short), is a major new deduction for certain business owners of Pass-Thru entities starting in 2018. At the current time, the deduction will be made with the owner’s personal taxes as a deduction after Adjusted Gross Income (“AGI”) on the Form 1040. This is important as it will not affect certain deduction phase outs that depend on AGI and nor will affect self-employment taxes.
In simpler terms, the deduction is 20% of QBI for a certain business. But, of course, the final amount you can deduct on your taxes is not that simple! As you might have guessed, there are some complicated rules and regulations that come with this deduction. Due to the complexities, I am going to explain everything in multiple parts. Part I of this analysis will focus who qualifies for the deduction. Please note that the IRS will need to clarify some items in this new reform, so the below is subject to potential change.
Types of Entities That Qualify
The QBI deduction is available only to certain business owners of Pass-Thru entities. Pass-Thru entities include sole proprietorships, real estate investors, disregarded entities, partnerships, S corporations, trusts, and estates [additionally qualified dividends from cooperatives and real estate investment trusts (REITS), and qualified income from publicly traded partnerships (PTPs) qualify as well].
The business owners that may ultimately take the deduction are non-corporate entities (individuals, trusts, and estates). This means that a C Corporation partner of a partnership cannot take the QBI deduction.
A major provision to the QBI deduction that affects all potential qualifying businesses is that the business entity cannot be certain types of service businesses. These types of non-qualifying businesses include the following:
- Services fields of health, law, accounting, consulting, athletics, financials services, brokerage services, actuarial sciences, and performing arts AND
- Any trade or business where the “principal asset is the reputation or skill of one or more of its employees or owners”
As you might be able to see, the second bullet point is the “kicker”. For the time being, the tax bill is leaving this up to interpretation as the IRS has not clarified this section yet. Business owners and their tax accountants will need to do a great deal of analysis and documentation on this one!
The tax bill allows for businesses that otherwise do not qualify for the QBI to participate if the Pass-Thru business owner’s taxable income (“TI”) before the QBI deduction on their 1040 is under certain thresholds. For MFJ filers, a full deduction is allowed if combined TI is below $315,000. The QBI then begins to phaseout between combined TI of $315,000 to $415,000. Anything over $415,000 is fully phased out. For single filers, the TI amounts stated previously are reduced by ½.
As you can see the Section 199A QBI deduction is pretty complicated. If you thought this was convoluted, wait until Part II next week! Of course, if you have any questions about this please feel free to reach out to me directly.