New section 199A presents owners of passthrough businesses two types of difficulties.
The first set of challenges involves drawing bright lines around inherently hard-to-define concepts. What types of businesses are specified service businesses that perform services in the fields of health, law, consulting, etc., whose benefits will be limited? What is the dividing line between owner-employee wages (subject to payroll tax) and return on capital (qualified for a section 199A deduction)? Most section 199A calculations must be made separately for each trade or business. What exactly is a trade or business? When do we divide business lines into two separate trades or businesses? When do we join business lines into a single trade or business? If two or more trades or businesses have common ownership, how are revenues, costs, deductions, wages, and qualified property allocated and apportioned? Regulations due out in late summer or early autumn should help, but still many passthrough businesses and their owners will face a bewildering array of facts and circumstances determinations.
The second set of challenges relates to mathematics. Once all the above terms are defined and quantified, a potentially long series of calculations must be performed. These calculations are the focus of this article. (Readers may download the Section 199A Spreadsheet to generate their own examples.)
Overview of Section 199A
Owners of passthrough businesses are now potentially entitled to a deduction equal to 20 percent of their combined qualified business activity incomes. Qualifying real estate investment trust dividends and qualifying publicly traded partnership (PTP) income are combined qualified business activity income. Added to that — the focus of most of the attention — is domestic qualified business income (QBI) of each trade or business in which the taxpayer has an ownership stake.
QBI may be limited by the greater of two amounts: 50 percent of the W-2 wages paid, or the sum of 25 percent of those wages and 2.5 percent of the unadjusted basis of specific depreciable tangible property relating to the trade or business. Importantly, these limits must be calculated separately for each trade or business. The trade-or-business limits vary with the individual taxpayer’s taxable income and filing status, and they differ depending on whether the trade or business is a specified service business. Finally, all deductions (after taking into account taxable income phaseouts and wage-property limitations) from each trade or business are combined with REIT and PTP income, which have no income phaseouts or entity-level limitations, and are subject to an overall income limit at the individual level equal to 20 percent of the excess of taxable income over capital gains.
The Basics
Now let’s try to make this a bit more digestible. Probably the best way to start is to compute individual taxable income (not including any section 199A deduction). Here’s the good news. For a single taxpayer with taxable income below $157,500 and for joint returns with income below $315,000, there are no trade-or-business level wage-property limitations. (The $157,500 and $315,000 amounts in this context are called threshold amounts. They coincide with the border between the 24 percent and 32 percent income tax brackets and are indexed for inflation.) There is no other entity-level calculation. And it doesn’t matter whether income is from a specified service business. In this case, the only potential wrinkle is that the total section 199A deduction — equal to the sum of REIT dividends, PTP income, and all passthrough trade or business income — cannot exceed 20 percent of the excess of taxable income over capital gains. (See Panel A of tables 1 and 2.)
Let’s go to the other end of the income scale. If a passthrough business is a specified service business, for a single taxpayer with taxable income above $207,500 (that is, $157,500 plus a phaseout range of $50,000) and for a joint return with income above $415,000 ($315,000 plus a phaseout range of $100,000), there is more good news from a computational standpoint: The deduction for that business is zero. So high-income lawyers, doctors, accountants, and a whole host of other high-skilled professionals are out of luck unless they do some tax planning — for which there are numerous possibilities.
Beyond these cases, nothing is simple. If a passthrough business is not a specified service business, but is a retailer, a farmer, a manufacturer, or an active investor in real estate, high-income owners will be subject to the 50 percent wage or 25 percent wage plus 2.5 percent of property limitation. As matters get more complex, the economics get more interesting. For example, when subject to these limits, the owners may get tax benefits for purchasing depreciable tangible capital and for increasing wages — by expanding employment, raising employee salaries, or paying themselves more wages for compensation paid. (See Panel B of tables 1 and 2 for trade-or-business treatment of filers in excess of threshold amounts plus $50,000 or $100,000.)
The Phaseouts
For taxpayers in the phaseout range — between $157,500 and $207,500 for single filers and between $315,000 and $415,000 for other filers — the deduction for each trade or business that would otherwise be 20 percent of QBI is phased out. The phaseout computations add another layer of complexity to the prior calculations, and they are different for businesses that are specified service businesses and those that aren’t.
For businesses that aren’t specified service businesses, first calculate the deduction without any limitations — that is, 20 percent of QBI. Then calculate the wage-property limitation. The deduction will be a weighted average of these two amounts. To obtain this weighed average, first find the difference between the two. Then multiply that difference by the percentage of taxable income over the phaseout range. So if a couple’s taxable income is $375,000, they are $60,000 over the $315,000 threshold. Given that the phaseout range is $100,000, they are 60 percent into the phaseout range — a phaseout percentage of 60 percent. (Later it will be important to distinguish this from what section 199A calls the “applicable percentage,” which equals 1 minus the phaseout percentage.) Multiply the phaseout percentage by the excess, and finally, subtract that amount from 20 percent of QBI. (See Panel C of tables 1 and 2.) This is easier to understand with a picture, so an example is illustrated in the figure.
For a specified business in the phaseout range, things get even weirder. As explained by Anthony Nitti, a tax partner at WithumSmith+Brown PC, deductions in this case aren’t a simple weighted average of two amounts, but a “double phaseout” of 20 percent of a passthrough business’s QBI. One of the easier ways of determining this amount is to take the phaseout deduction that would have applied if the business was unspecified, as described in the prior paragraph, and multiply that by the applicable fraction. (See Panel D of tables 1 and 2.) An example of this is illustrated in the figure.
If you are wondering about section 199A’s treatment of agricultural cooperatives and farmers who sell to them, that is a chapter entirely to itself, especially since the rules were recently retroactively revised by the Consolidated Appropriations Act, 2018 (P.L. 115-141). Farmers who don’t sell to co-ops are treated like any other unspecified trade or business. Throughout this article, we assume that taxpayers aren’t making any qualified sales to agricultural co-ops. (Prior analysis: Tax Notes, Mar. 26, 2018, p. 1745.)
The following are examples calculated in tables 1 and 2.
Example 1: Laura is an unmarried sole proprietor who owns a flower shop that generates $100,000 of her $120,000 of taxable income. Whether the business is considered a specified service business doesn’t matter. Nor does the wage-property limitation factor into the calculation. Because her income is below the threshold amount, all her passthrough business income qualifies for the 20 percent section 199A deduction. The deduction amount is simply 20 percent of $100,000, or $20,000.
Example 2: Tom and Vivian, a married couple, are independently wealthy farmers whose ownership of an S corporation provides $100,000 of their $500,000 of taxable income. Their subchapter S corporation sells vegetables to local supermarkets, so they compute their deduction like any business that isn’t a specified service business. Because their taxable income is above $415,000, the wage-property limit fully applies. Given the wages paid by their business and the unadjusted basis of its qualified property, that limit will be the greater of (1) 50 percent times $30,000 ($15,000) and (2) the sum of 25 percent times $30,000 and 2.5 percent times $250,000 ($13,750). Their section 199A deduction is $15,000. Tom and Vivian could increase their section 199A deduction by paying themselves wages. In their tax bracket, that is equivalent to a nontaxable wage credit of 18.5 percent — that is, 50 percent of wages times a 37 percent income tax rate. This section 199A benefit would be offset by a payroll tax with a rate of 15.3 percent because they have no other wage income.
| Example 1 | Example 2 | Example 3 | Example 4 |
---|---|---|---|---|
Passthrough business #1: | ||||
Qualified business income (QBI) | $100,000 | $100,000 | $400,000 | $400,000 |
Owner W-2 wages | $0 | $0 | $0 | $0 |
Other W-2 wages | $30,000 | $30,000 | $20,000 | $20,000 |
Total W-2 wages | $30,000 | $30,000 | $20,000 | $20,000 |
Qualified property | $250,000 | $250,000 | $600,000 | $600,000 |
Specified = 1, Unspecified = 0 | 0 | 0 | 0 | 1 |
Individual taxpayer: | ||||
Qualified REIT dividends | $0 | $0 | $0 | $0 |
Publicly traded partnership income | $0 | $0 | $0 | $0 |
QBI (passthrough business #1) | $100,000 | $100,000 | $400,000 | $400,000 |
QBI (passthrough business #2) | $0 | $0 | $0 | $0 |
Capital gains | $0 | $0 | $0 | $0 |
Owner W-2 wages | $0 | $0 | $0 | $0 |
Other income | $0 | $400,000 | $30,000 | $30,000 |
Deductions | $0 | $0 | $75,000 | $75,000 |
Taxable income | $120,000 | $500,000 | $355,000 | $355,000 |
Taxable income less cap gains | $120,000 | $500,000 | $355,000 | $355,000 |
Single = 1, Joint = 2 | 1 | 2 | 2 | 2 |
Threshold | $157,500 | $315,000 | $315,000 | $315,000 |
Range | $50,000 | $100,000 | $100,000 | $100,000 |
Wage-property limitation (business #1) | ||||
50% of wages | $15,000 | $15,000 | $10,000 | $10,000 |
25% wages + 2.5% property | $13,750 | $13,750 | $20,000 | $20,000 |
Greater of two | $15,000 | $15,000 | $20,000 | $20,000 |
Panel A: Below Threshold | ||||
20% of QBI | $20,000 | $24,000 | $80,000 | $80,000 |
Panel B: Above Threshold | ||||
Wage-property limit |
| $15,000 | $20,000 | $20,000 |
20% of QBI |
| $24,000 | $80,000 | $80,000 |
Unspecified deduction is lesser of two |
| $15,000 | $20,000 | $20,000 |
If specified, deduction = 0 |
| $15,000 | $20,000 | $20,000 |
Panel C: Phaseout, Unspecified | ||||
“Excess amount” of QBI |
|
| $60,000 | $60,000 |
Threshold ($157,500 or $315,000) |
|
| $315,000 | $315,000 |
Taxable income - threshold |
|
| $40,000 | $40,000 |
Denominator ($50,000 or $100,000) |
|
| $100,000 | $100,000 |
In-range percentage (= 1 - App%) |
|
| 0% | 40% |
“Amount of reduction” |
|
| $24,000 | $24,000 |
Unspecified deduction |
|
| $56,000 | $56,000 |
Panel D: Phaseout, Specified | ||||
Applicable percentage |
|
|
| 60% |
App% times unspecified phaseout |
|
|
| $33,600 |
Overall income limitation: | ||||
Passthrough #1 deduction | $20,000 | $15,000 | $56,000 | $33,600 |
Passthrough #2 deduction | $0 | $0 | $0 | $0 |
Qualified REIT dividends | $0 | $0 | $0 | $0 |
Publicly traded partnership income | $0 | $0 | $0 | $0 |
Combined QBAI | $20,000 | $15,000 | $56,000 | $33,600 |
20% (TI - CG) limit | $24,000 | $100,000 | $71,000 | $71,000 |
Individual taxpayer 199A deduction | $20,000 | $15,000 | $56,000 | $33,600 |
Unshaded cells calculated from values in shaded cells. Spreadsheet available on request. See text. |
| Example 5 | Example 6 | Example 7 | Example 8 |
---|---|---|---|---|
Passthrough business #1: | ||||
Qualified business income (QBI) | $300,000 | $8,000,000 | $0 | $75,000 |
Owner W-2 wages | $130,000 | $260,000 | $0 | $0 |
Other W-2 wages | $0 | $1,740,000 | $0 | $0 |
Total W-2 wages | $130,000 | $2,000,000 | $0 | $0 |
Qualified property | $600,000 | $9,000,000 | $0 | $0 |
Specified = 1, Unspecified = 0 | 1 | 0 | 0 | 0 |
Individual taxpayer: | ||||
Qualified REIT dividends | $0 | $0 | $50,000 | $0 |
Publicly traded partnership income | $0 | $0 | $20,000 | $0 |
QBI (passthrough business #1) | $300,000 | $8,000,000 | $0 | $75,000 |
QBI (passthrough business #2) | $0 | $0 | $0 | $25,000 |
Capital gains | $0 | $0 | $0 | $0 |
Owner W-2 wages | $130,000 | $260,000 | $0 | $0 |
Other income | $0 | $740,000 | $55,000 | $0 |
Deductions | $0 | $0 | $25,000 | $25,000 |
Taxable income | $430,000 | $9,000,000 | $100,000 | $75,000 |
Taxable income less capital gains | $430,000 | $9,000,000 | $100,000 | $75,000 |
Single = 1, Joint = 2 | 2 | 2 | 2 | 2 |
Threshold | $315,000 | $315,000 | $315,000 | $315,000 |
Range | $100,000 | $100,000 | $100,000 | $100,000 |
Wage-property limitation (business #1) | ||||
50% of wages | $65,000 | $1,000,000 | $0 | $0 |
25% wages + 2.5% property | $47,500 | $725,000 | $0 | $0 |
Greater of two | $65,000 | $1,000,000 | $0 | $0 |
Panel A: Below Threshold | ||||
20% of QBI | $60,000 | $1,600,000 | $0 | $15,000 |
Panel B: Above Threshold | ||||
Wage-property limit | $65,000 | $1,000,000 |
|
|
20% of QBI | $60,000 | $1,600,000 |
|
|
Unspecified deduction is lesser of 2 | $60,000 | $1,000,000 |
|
|
If specified, deduction = 0 | $0 | $1,000,000 |
|
|
Panel C: Phaseout, Unspecified | ||||
“Excess amount” of QBI |
|
|
|
|
Threshold ($157,500 or $315,000) |
|
|
|
|
Taxable income - threshold |
|
|
|
|
Denominator ($50,000 or $100,000) |
|
|
|
|
In-range percentage [= 1 - App%] |
|
|
|
|
“Amount of reduction” |
|
|
|
|
Unspecified deduction |
|
|
|
|
Panel D: Phaseout, Specified | ||||
Applicable percentage |
|
|
|
|
App% times unspecified phaseout |
|
|
|
|
Passthrough# 1 199A deduction | ||||
Overall income limitation: | ||||
Passthrough #1 deduction | $0 | $1,000,000 | $0 | $15,000 |
Passthrough #2 deduction | $0 | $0 | $0 | $5,000 |
Qualified REIT dividends | $0 | $0 | $50,000 | $0 |
Publicly traded partnership income | $0 | $0 | $20,000 | $0 |
Combined QBAI | $0 | $1,000,000 | $70,000 | $20,000 |
20% (TI - CG) limit | $86,000 | $1,800,000 | $20,000 | $15,000 |
Individual taxpayer 199A deduction | $0 | $1,000,000 | $20,000 | $15,000 |
Unshaded cells calculated from values in shaded cells. Spreadsheet available on request. See text. |
Example 3: Nina and Richard, a married couple, own and manage a 30-year-old rental property that now is in a high-rent district and generates $400,000 of QBI. They aren’t in a specified service business. They have $30,000 of interest income and $75,000 of deductions, leaving them with taxable income of $355,000. Because they are in the phaseout range, they must do some special calculations. Their deduction if there were no wage-property limitation would be 20 percent of $400,000, or $80,000. Their wage-property limitation is the greater of (1) 50 percent of $20,000 ($10,000) and (2) the sum of 25 percent of $20,000 of wages and 2.5 percent of the $600,000 of unadjusted basis of their qualified property ($20,000). The excess of 20 percent of QBI over the wage-property limitation is $60,000. Their $355,000 of taxable income gives them a phase-in percentage of 40 percent. That percentage of $60,000 is $24,000. That $24,000 is then subtracted from $80,000 to obtain a deduction of $56,000. This is illustrated in the figure.
Example 4: All the facts are the same except this time the couple is John and Jane, who are married physicians and who unwisely report all their sole proprietorship income on Schedule C. This is a specified passthrough business. Their section 199A deduction is their applicable fraction of 60 percent multiplied by what their deduction would have been ($56,000) if they did not have a specified business (as calculated in Example 3). Their section 199A deduction is $33,600. Again, this is illustrated in the figure.
Example 5: Sam and Sue are physicians who practice together and report their business income on Form 1120S. The corporation generates $300,000 of profit. Their practice alone is housed in a building owned by the corporation. They pay themselves reasonable compensation of $130,000. Other taxable income is offset by deductions, so their net taxable income is $430,000, which is above $415,000. Because they own a specified business, they are not entitled to any section 199A deduction. If they spin off ownership of their building into a separate S corporation and the IRS considers their real estate activities a separate (unspecified) trade or business, that business can charge rent to the medical practice. Their total income wouldn’t change, but the rental business, assuming it pays no wages, would generate a section 199A deduction equal to 2.5 percent of the unadjusted basis of $600,000, or $15,000.
Example 6: Katrin and Peter, a married couple, own a subchapter S corporation that is a capital-intensive manufacturer of specialized high-tech devices. This unspecified business generates $8 million of profit. The corporation pays each of them reasonable compensation of $130,000. Including other income of $740,000, their total taxable income is $9 million. The business pays total wages of $2 million and has qualified depreciable property with unadjusted basis of $9 million. Their wage limitation of $1 million reduces their section 199A deduction, which could be as large as $1.6 million, to $200,000. Increasing their combined reasonable compensation — say, by $200,000 — would increase their section 199A deduction by $100,000 and save them $37,000 of income taxes. Because they both are already above the Social Security payroll tax wage cap of $128,700, their marginal payroll tax rate is only 3.8 percent of $200,000, which is partially deductible. Their income tax cut of $37,000 is offset by a payroll tax increase of only $7,600. Notice that this is contrary to the tendency of S corporation owners to reduce their reasonable compensation.
Example 7: Ted and Alice aren’t sole proprietors or partners of a partnership, nor are they owners of a subchapter S corporation. But they’re investors in REITs and PTPs. Their $70,000 of income from these sources is qualified business activity income potentially eligible for a section 199A deduction. There is no wage-property limitation on this income, nor are their taxable income phaseouts. But with other taxable income of only $30,000, they are subject to the overall limit of 20 percent of taxable income less capital gains. In their case, this is 20 percent of $100,000, or $20,000. They could probably make a profit by selling their REIT and PTP ownership shares to taxpayers who are in a higher income bracket and not subject to the overall taxable income limitation. Note that if their taxable income (less capital gains) was $1 million instead of $100,000, they would be entitled to a deduction of $70,000 instead of $20,000.
Example 8: Ted and Alice totally rearrange their affairs. They invest in two small passthrough businesses that generate $75,000 and $25,000 of profit. (The latter calculation is not shown in Table 2 but is in the spreadsheet.) With itemized deductions of $25,000, they have taxable income of only $75,000. If Ted and Alice take part-time jobs that yield them $25,000, that extra income would in effect be eligible for the section 199A deduction because it raises their overall taxable income limitation.
Conclusion
Section 199A provides generous tax relief, but it can also be a great headache for tax practitioners and their clients with passthrough income. This article deals with only a slice of the issues the deduction raises. As noted initially, it doesn’t explore the thorny definitional issues and potential for profit shifting, or touch on the possibility of employees becoming passthrough businesses. Nor does it examine the difficult choice-of-entity decisions that must be reevaluated in light of not only the new section 199A deduction, but also the new 21 percent corporate tax rate.