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Tax Deduction for Solos & Pass-through Businesses

Tax Deduction for Solos & Pass-through Businesses

The tax treatment of businesses was front and center when Congress tackled tax reform last year. Tax rates for individual taxpayers remained comparatively higher even as the new tax law permanently lowered the tax rate for corporations to 21%. That would have been problematic for sole proprietors and owners of pass-through businesses, so Congress provided a workaround: A deduction of up to 20% to bring the rate lower. That deduction, called the Section 199A deduction, raised a number of questions. The Internal Revenue Service (IRS) has finally issued proposed regulations for Section 199A intended to address some of those issues.

However, there is both good news and bad news. The bad news is that there are 184 pages of proposed regulations, and the good news is that everything you need to know is fully discussed below.

When does the new deduction take effect?

  • The new deduction is available for tax years beginning after December 31, 2017. Eligible taxpayers can claim the deduction on their 2018 federal income tax return (the one you will file in 2019).

Who is eligible for the deduction?

  • Sole proprietors and business owners with pass-through businesses, and certain trusts and estates are eligible for the deduction.

What is a pass-through business?

  • Pass-through businesses are those businesses that do not pay corporate income tax at the income tax but instead pass income and expenses through to the owners. The owners then report their share of income and expenses on their own tax returns and pay any resulting tax at their individual income tax rates. Pass-through businesses include limited liability companies (LLCs), sole proprietorships, partnerships, trusts and S corporations.

Are there exceptions?

  • There are two exceptions:
  1. Specified service trade or business (SSTB):

It is a business that involves the performance of services in the fields of health, law, consulting, athletics, financial services, or brokerage services.  It also includes a business where the performance of services consists of investing and investment management trading or dealing in securities, partnership interests, or commodities. This exception only applies if a taxpayer’s taxable income exceeds $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers

  1. Performing services as an employee.

Are there any income limits? 

  • The deduction is available to taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers. These limits are referred to as threshold amounts. If you are above the threshold amounts, you are subject to limitations and exceptions which are determined by your occupation (SSTBs, as noted above) and a wage and capital limit.

What does the deduction actually do? In other words, what am I deducting in the first place?

  • The deduction reduces the amount of taxable income attributable to your business.

Where will I report the deduction?

  • There is a space for the deduction on the new 1040 draft at line 9:

 

What is QBI and why does it matter?

  • QBI stands for qualified business income and it is the net amount of income, gain, deduction and loss from a qualified trade or business. Items included in taxable income are counted, while items like capital gains and losses, certain dividends and interest income are excluded. QBI is determined based on a per business, not a per taxpayer, basis. It is used to figure deduction.

How do I figure QBI if I have multiple businesses?

  • If you have multiple businesses, you need to calculate the QBI for each business and total the amounts. If you have a negative QBI after netting the amounts, you can carry that amount forward to the next tax year.

Okay, I think I got it. Now, how do I figure the deduction?

  • The deduction is generally equal to the lesser of:
  • 20% of your qualified business income (QBI), plus 20% of your qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income; OR
  • 20% of taxable income minus net capital gains.

That sounds complicated. If I just own a business and I’m below the threshold amount, is there an easier way to figure my deduction?

  • If your taxable income is below the threshold amount, the deductible amount for each of your businesses is simply 20% of your QBI with respect to each business. For example, if your income is $50,000 and your QBI is $40,000, then your deduction is $8,000, or 20% of your QBI. You are under the threshold amount, so no need to do any more math.

If I am over the threshold amount, what do I need to know?

  • If you are over the threshold amount, your deduction may be limited based on:
  • Whether your business is an SSTB;
  • W-2 wages paid by the business; and
  • Unadjusted basis immediately after acquisition (UBIA) of certain property used by the business.

These limitations are phased in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500 (and will be adjusted for inflation in subsequent years). A phase-in range means that the benefit decreases as income increases.

If I am over the threshold amount, and my business is an SSTB, what do I need to know?

  • Again, the phase-in applies which means that your benefit decreases over the threshold amount. However, if your business is an SSTB and you exceed the threshold amount plus the phase-in range ($415,000 for joint filers and $207,500 for all other taxpayers), then you lose the deduction completely. In that case, the old pass-through rules apply which means that you pay tax using your individual tax rate.

If I am over the threshold amount, but my business is not an SSTB, what do I need to know?

  • Your deduction is not subject to a cut-off, but may still be limited by the amount of W-2 wages paid by your business and UBIA.

Aren’t W-2 wages just what is reported on a normal W-2?

  • Yes and no. Only W-2 wages that are properly allocable to QBI can be used to figure the deduction. The IRS has announced three ways to figure those wages:
  1. Unmodified box method:
  • This method is the lesser of the total entries in box 1 of all forms W-2 filed with the Social Security Administration (SSA) by you with respect to your employees OR the total entries in box 5 of all forms W-2 filed with SSA by you with respect to your employees.
  1. Modified box 1 method:
  • To use this method, total the amounts of all forms W-2 filed with the SSA by you with respect to your employees. Next, subtract any amounts included in box 1 of forms W-2 that are not wages for federal income tax withholding purposes. Now, add to that the total amounts reported in box 12 of forms W-2 with respect to your employees that are properly coded D, E, F, G, and S.
  • Tracking wages method:
  • To use this method, total the amounts of wages subject to federal income tax withholding that are paid to your employees and that are reported on forms W-2 that you filed with SSA for the calendar year, and add the amounts reported in box 12 of forms W-2 with respect to your employees that are properly coded D, E, F, G, and S.

 

Do I figure W-2 wages for all businesses at the same time?

  • The W-2 wage limitation in section 199A applies separately for each trade or business. If W-2 wages are allocable to more than one trade or business, you have to figure the applicable share for each business.

So once I have the W-2 numbers, what happens next?

  • If you are over the threshold amount, the wage and capital limit applies. That limit is the greater of 50% of W-2 wages or the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis (UBIA), immediately after acquisition, of all qualified property.

Okay, but pass-through entities do not always issue a form W-2. What about net earnings from self-employment and net investment income (dividends, for example)?

  • The proposed regulations provide that the section 199A deduction does not reduce net earnings from self-employment under section 1402 or net investment income under section 1411.

 

What about UBIA?

  • Basis, at its most simple, is the cost paid for an asset plus adjustments. The unadjusted basis immediately after acquisition (UBIA) of qualified property used in your sole proprietorship should not be all that complicated. However, figuring basis for property in a partnership, such as an LLC, can be complicated at the best of times. Section 199A does not make any of this simpler, but here are the general rules:
  • For purchased or produced qualified property, the UBIA generally will be its cost under section 1012 as of the date the property is placed in service.
  • For property contributed to a partnership in a section 721 transaction and immediately placed in service, the UBIA generally will be its basis under section 723.
  • For property contributed to an S corporation in a section 351 transaction and immediately placed in service, the UBIA generally will be its basis under section 362.
  • For inherited property immediately placed in service by the heir, the UBIA generally will be its fair market value at the time of the decedent’s death under section 1014.

Some special rules apply, including a reduction in basis for non-business use of property, and a restriction on property acquired and disposed of near the end of the taxable year without having been used in a trade or business for at least 45 days. Remember that the UBIA rules only apply to taxpayers over the threshold amount.

This feels like it is a loophole after loophole waiting to happen. What does the IRS think?

  • Loophole has such ugly meaning. It is true that there will be attempts to take advantage of the rules – some legitimately so (that is why we pay tax professionals) and some not so legitimate. The proposed regulations do establish anti-abuse rules and hint that more might be on the way.

Wait, you did not even get into like-kind exchanges, 1231 losses, and aggregation rules. Is that all?

No. There is more to come. Keep in mind that the proposed regulations are 184 pages and the guidance on W-2 wages constitutes an additional 14 pages – plus FAQs, to boot. This article is meant to provide you with an overview. If you have special circumstances, including ownership in a REIT or if you are a member of a co-op, that can complicate things. Those topics are a little beyond the scope of this article. Finally, remember that these are proposed regulations.



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