The sweeping changes of the Tax Cuts and Jobs Act (TCJA) that went into effect at the beginning of January 2018 included a 20% pass-through deduction to non-corporate taxpayers with “qualified business income.” What is known as the “pass-through rules,” taxpayers can find them in 26 U.S. Code § 199A – Qualified Business Income (QBI). The purpose of § 199A was to give individuals with qualified business interests a break similar to the 21% income tax bracket enjoyed by C corporations, which are taxed as separate entities. 26 U.S. Code § 199A will expire in 2026 unless extended.
The new law did not define “qualified business income” or answer a lot of other questions, leaving that to the IRS. The IRS, therefore, issued proposed regulations on § 199A last August and just released final regulations (numbering 274 pages) on Friday, January 19th, 2019. The regulations affect individuals, LLCs, partnerships, S corporations, trusts, and estates engaged in domestic trades or businesses. Those affected include many self-employed professionals and independent contractors, but IRC § 199A may be applied to most businesses where the owners have pass-through income.
Fortunately, the final regulations landed just in time for tax season which began January 28. The IRS also released two notices and commentary. It’s time for tax advisors to become intimately familiar with IRC § 199A and the final regulations quickly so they can advise their clients how to take advantage of the new deductions and how to avoid the pitfalls on 2018 tax returns.
The Basics of IRC § 199A
- 199A includes three separate deductions rather than just one:
- A 20% pass-through deduction which is the biggest news
- A deduction for 20% of the taxpayer’s qualified REIT dividends and publicly traded partnership (PTP) income for the year (A REIT is a company that owns, operates or finances income-producing real estate.)
- A deduction for specified agricultural and horticultural cooperatives
After you calculate the 20% earned income deduction, you can add it to the deduction for 20% of your qualified REIT dividends and publicly traded partnership income for the year. Compute the deductions separately, then add them together for an overall limitation that is equal to 20% of the excess of
- Your taxable income for the year over
- The sum of net capital gain
The reason for the overall limitation is to prevent the 20% deduction being taken against income taxed at preferential rates. Should you have a loss from your pass-through businesses, you can still claim your 20% deduction for the total of REIT dividends and publicly traded partnership income and vice versa.
Qualified Business Income (QBI) for Each Trade or Business
Qualified business income for the sake of the 20% pass-through deduction is normal operating income as opposed to investment income or employee wages. It does not include, for example, any items treated as capital gain or loss, dividend income or investment income. These are just some examples. Neither does it include reasonable compensation paid to an S corporation shareholder or guaranteed payments described in 26 U.S. Code § 707(c) paid to a partner for services they provide to the trade or business.
Your trade or business must be recognized under 26 U.S. Code § 162 (Trade or Business Expenses) to qualify for the deduction, but unfortunately § 162 eligibility is not clearly defined by statute. Therefore, your tax advisor will need to look to case law such as COMMISSIONER OF INTERNAL REVENUE, Petitioner v. Robert P. GROETZINGER, where the Supreme Court said, “the taxpayer must be involved in the activity with continuity and regularity. . . . A sporadic activity, a hobby, or an amusement diversion does not qualify.”
Any § 162 trade or business is qualified under § 199A except
- The trade or business of performing services as an employee. This prevents an employee from claiming the 20% deduction on their wage income.
- A specified service trade or business as enumerated.
Qualified Business Income Above and Below $157,500
If you have qualified business income for the year that is less than $160,700 (the adjustment for 2019) or double that for married taxpayers filing jointly, and you have a trade or business as defined under 26 U.S. Code § 162, the deduction is pretty simple.
You can take 20% of your qualified business income, add 20% of qualified REIT dividends and PTP income, calculate the overall limit based on taxable income, and you’re finished. However, if your qualified business income is more than that, things get much more complicated, and you will certainly want to consult with a tax advisor. You may also want to check the steps outlined in our earlier article, The Pass-Through Tax Deduction Explained With Calculation Examples.
Taxable Income Over $210,700
If the taxpayer has taxable income over $210,700 (the adjustment for 2019) or $321,400 for married taxpayers filing jointly, a deduction is not permitted against income earned in a “specified service trade or business.” (Above $160,700 until $210,700 there is a sliding scale.)
Also, if you have taxable income over $210,700, there is a limit on the deduction for income earned in an eligible business, in the amount of the greater of
- 50% of the taxpayer’s share of the W-2 wages concerning the qualified trade or business, or
- 25% of the taxpayer’s share of the W-2 wages concerning the qualified trade or business, plus 2.5% of the taxpayer’s share of the unadjusted basis immediately after acquisition of all qualified property.
What Are the Specified Service Trades or Businesses?
Health care, legal, accounting, professional entertainment, athletes and certain other professionals generally can’t take the § 199A deduction if their income is over $160,700 in 2019 for a single person, but there are exceptions. The final regulations spell out the specified service trades or businesses in great detail, though of course, it’s impossible to list everything that may cause a question.
Triple Net Leases Do Not Usually Qualify for § 199A Deductions
Marketing freelancers and dentists should have no problem meeting this qualification. The big question here revolves around rental real estate. IRS Notice 2019-7 provides a safe harbor for landlords to qualify as a trade or business under § 199A with the exception of triple net leases. A triple net lease refers to a situation where the lessee is not only responsible for paying rent and utilities but is also responsible for paying maintenance, insurance, and real estate taxes. The pass-through deduction is meant for those who are active in their business. To qualify for the pass-through deduction, many landlords will have to become more active and be able to show work hours of at least 250 hours per year and meet other qualifications that they are active in the business. For all intents and purposes, this will probably mean renegotiating leases.
The final regulations provide an exception in that if a business rents to itself, it’s automatically granted Section 162 trade or business status. Also, to claim your rental is a trade or business, you will be required to file Form 1099s and treat mortgage interest as business interest.
Will There Be a Big Jump of Employees to Contractor Status?
One of the immediate and most popular questions, when §199A went into effect, was whether a large number of employees would quit their jobs and then return to their work as independent contractors to take advantage of the 20% deduction. The final regulations addressed this. If you are an employee who quits then returns as an independent contractor providing substantially the same services, you are ineligible for the §199A for three years. It may be possible to overcome the presumption, and if you think there is a valid reason for you to change to contractor status beyond grabbing the § 199A deduction, talk with your tax advisor. The new law may, however, persuade more people to go to work as independent contractors rather than employees initially.
Should I Choose an LLC or Sub-S Business Structure?
Before §199A went into effect, most businesses would want to structure themselves as an S corporation so they could pay the owner and keep remaining income free from employment taxes. But wages are not eligible for the 20% deduction under §199A. Therefore, some professionals and smaller businesses may now want to set themselves up as independent contractors to take advantage of §199A and report income on Schedule C of their personal IRS Form 1040.
Consult with an Experienced Tax Advisor
The final regulations for §199A are voluminous. It may be an excellent time to consult with an experienced tax advisor to be sure you are gaining the full benefit under the new law and minimizing the drawbacks. Your tax advisor can be sure you get every deduction you have coming to you under the final regulations and possibly give you options to restructure your businesses to take full advantage.
Disclaimer: The content on this website is for educational purposes only and does not serve as legal or tax advice. For specific advice regarding your tax situation, contact a licensed tax professional or tax attorney.