The Tax Cuts and Jobs Act introduced Code Section 199A, a groundbreaking provision offering a 20% deduction for qualifying businesses. However, this deduction is not a one-size-fits-all solution, and not every business is eligible. This article delves into the nuances of this innovative provision to provide a comprehensive understanding.
Overview of Code Section 199A
Effective for tax years starting after 2017, the deduction is applicable to individuals, estates, and trusts with qualified business income originating from S-corporations, partnerships, or sole proprietorships. While the deduction is generally based on net business income, it is applied against taxable income, ensuring that both standard deduction and itemized deduction filers can benefit.
Understanding Qualified Business Income
Qualified Business Income encompasses typical income, deductions, and gains or losses from a U.S. trade or business. Notably, dividends, interest, long-term and short-term capital gains and losses are not considered in the calculation.
Overall Limitations on the Deduction
The deduction is limited to the lesser of the combined qualified business income or 20% of the excess of taxable income over net capital gain and the total of qualified cooperative dividends. If there are no cooperative dividends, the deduction is the lesser of the combined qualified business income or 20% of taxable income over capital gains.
Calculation of Combined Qualified Business Income
The deductible amount for each business, plus 20% of the aggregate amount of qualified Real Estate Investment Trust (REIT) dividends and qualified publicly traded partnership income, determines the combined qualified business income.
Determining the Deductible Amount for Each Business
This calculation involves selecting the lesser of 20% of the net Qualified Business Income or the greater of 50% of W-2 wages for the business or 25% of W-2 wages plus 2.5% of the unadjusted basis of Qualified Property immediately after acquisition. The wage and property limitation is subject to phase-in ranges based on taxable income thresholds.
Phase-In Range for Wage and Property Limitation
The wage and property limit applies when taxable income exceeds $315,000 for married filing jointly (MFJ) and $157,500 for other filers. Below these thresholds, the deductible amount is a straightforward 20% of qualified business income. When taxable income surpasses $415,000 for MFJ and $207,500 for others, the limitation is fully applied. In the taxable income range of $315,000-$415,000 for MFJ and $157,500-$207,500 for others, the limitation is gradually phased in.
- Illustrative Example
- Consider Dennis and Susan, a married couple with $500,000 of taxable income. Dennis's business has a net income of $600,000, wages paid amounting to $100,000, and equipment with a basis of $400,000. After the calculation, the deductible amount is determined as the lesser of $50,000 or $100,000, resulting in a $50,000 deduction.
Qualified Trade or Business (QTB)
Primarily, only a Qualified Trade or Business (QTB) qualifies for the deduction, excluding Specified Service Trade or Business (SSTB). SSTBs include professions such as health, law, accounting, and others listed in the article. Notably, engineers and architects were last-minute exclusions from the SSTB definition.
Specified Service Trade or Business (SSTB)
While SSTBs are generally excluded, there is a phase-out range based on taxable income: $315,000-$415,000 for MFJ and $157,500-$207,500 for other taxpayers. The deduction is allowed in full when taxable income is below $315,000 for MFJ and $157,500 for others. Conversely, it is disallowed when taxable income exceeds $415,000 for MFJ and $207,500 for others, with a gradual phase-out within the intermediate ranges.
This article serves as a comprehensive introduction to Code Section 199A, addressing key aspects such as planning strategies, entity choices, phase-out calculations, reasonable compensation, and the definition of a service business. Further insights into these matters will be explored in upcoming Vishal webcasts and On-Demand learning courses.