Section 199A provides a 20% deduction on the amount of Qualified Business Income (referred to as QBI and defined later) from a domestic business operated as a partnership, S-Corporation, sole proprietorship, trust or estate. This deduction is in response to the approximate 20% tax rate cut for C-Corporations and replaces the Domestic Productions Activity Deduction (DPAD).
Section 199A applies to all US (including Puerto Rico) non C-corporation taxpayers and is calculated at the individual taxpayer level. It is limited by each individual taxpayer’s taxable income range and the industry in which they conduct their trade or business. Specified Service Trade or Businesses (referred to as SSTB and defined later) can reduce or eliminate the amount of deduction received. There are several other limitations which are discussed later in detail.
Section 199A puts all taxpayers into one of three categories:
- Those below the taxable income threshold ($157,500 single/$315,000 married filing joint)
- Those above the taxable income threshold and within the phase-in range ($157,500-207,500 single/$315,000-415,000 married filing joint)
- Those above the taxable income threshold and above the phase-in range
Depending on the category an individual taxpayer falls within certain limitations may apply.
How is Qualified Business Income defined?
Per IRC Sec. 199A(c), qualified business income means the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. QBI does not include any qualified REIT dividends or qualified publicly traded partnership income. Qualified items of income, gain, deduction, and loss mean items of income, gain, deduction and loss to the extent such items are effectively connected with the conduct of a trade or business within the United States, and included or allowed in determining taxable income for the taxable year (Sec. 199A(c)(3)(A)).
Simply put, Box 1 or Box 2 from K-1s, Schedule C income, Schedule E rental income (pending further guidance from the IRS), and Schedule F farm income are all included in QBI. Also included are Sec. 751 gain or loss giving rise to ordinary income and Sec. 481 adjustments (if the adjustment arises in taxable years ending after 12/31/17). Previously disallowed losses under Secs. 465, 469, 704(d), and 1366(d) allowed in the taxable year are taken into account for purposes of computing QBI if the losses were disallowed after 12/31/17.
Items of income and deduction that are excluded from QBI include: short-term and long-term capital gains & losses, dividend income, interest income (other than interest income which is properly allocable to a trade or business), wages to shareholders, partner guaranteed payments, and Sec. 1231 gains (unless taxed at ordinary rates).
How is a Specified Service Trade or Business defined?
A Specified Service Trade or Business (SSTB) includes any trade or business involving the performance of services in the fields of:
- Health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services,
- Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or
- Which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.
Based on the definitions in the proposed regulations and pending further guidance form the IRS, certain professions that appear to be SSTBs are not. In general, construction industry activities are not SSTBs.
When do the limitations apply?
The income category of the taxpayer will determine the limitations on the 199A deduction. The three categories of income thresholds are listed above and the deduction can be limited by two major factors:
- W-2 wages and qualified property
- Whether the trade or business is an SSTB
W-2 Wages and Qualified Property Limitation
The deduction is limited to the lesser of 20% of the qualified business income OR the greater of 1) 50% of the W-2 wages relating to the qualified trade or business and 2) the sum of 25% of the W-2 wages and 2.5% of the unadjusted basis of qualified property.
If the taxpayer falls in the first category (under the income threshold of $157,500 single/$315,000 married filing joint), the wage and qualified property limitation do not apply. The limitation is phased in over the income above the threshold for the taxpayers who are in the second category ($157,500-207,500 single/$315,000-415,000 married filing joint). Taxpayers in the third category (above the thresholds) apply the wage and qualified property limitation in full.
Specified Service Trade or Business Exception
As stated above, a SSTB taxpayer may not be able to claim any or the full 199A deduction otherwise allowed based on the income category that applies to the taxpayer. The same categories apply to the SSTB exception in a similar way to the wage and qualified property limitation.
The SSTB exception does not apply to taxpayers in the first category. Therefore, even a SSTB taxpayer below the income threshold can claim the 199A deduction. The deduction amount of an SSTB taxpayer is phased out over the income range for SSTB taxpayers in the second category. For a SSTB taxpayer in the third category, the 199A deduction is prohibited on the corresponding SSTB income.
Because most construction companies will not fall under the SSTB designation, the wages and qualified property limitation will be the most significant consideration in determining the 199A deduction.
How do we apply Section 199A?
The following examples illustrate the application of the 199A deduction in various scenarios.
Income Above Threshold Amounts – Wage-Intensive Business
| Business other than SSTB | SSTB | |
|---|---|---|
| Partner’s share of QBI | $1,000,000 | $1,000,000 |
| Partner’s share of W-2 wages | $200,000 | $200,000 |
| Partner’s share of unadjusted basis of qualified property | $10,000 | $10,000 |
| 20% of partner’s share of QBI | $200,000 | $200,000 |
| Deduction: Apply 50% of W-2 wage limit | $100,000 | $0 |
Income Above Threshold Amounts – Capital-Intensive Business
| Business other than SSTB | SSTB | |
|---|---|---|
| Partner’s share of QBI | $1,000,000 | $1,000,000 |
| Partner’s share of W-2 wages | $50,000 | $50,000 |
| Partner’s share of unadjusted basis of qualified property | $1,000,000 | $1,000,000 |
| 20% of partner’s share of QBI | $200,000 | $200,000 |
| Deduction: Apply 25% of W-2/2.5% unadjusted basis limit | $37,500 | $0 |
Where do we go from here?
Because the regulations related to 199A are only proposed, we continue to have questions regarding specific applications to each taxpayer. However, as we approach year end, we need to consider how each of the following will impact the 199A deduction of taxpayers.
Wage Limitation
Wages play a major role in the calculation of the 199A deduction. Below are three scenarios.
| A | B | C | |
|---|---|---|---|
| Wages (including owners) | $400,000 | $200,000 | $300,000 |
| Taxable income | $600,000 | $800,000 | $700,000 |
| 20% of QBI | $120,000 | $160,000 | $140,000 |
| 50% of wages | $200,000 | $100,000 | $150,000 |
| 199A deduction | $120,000 | $100,000 | $140,000 |
In Scenario A (most construction companies) – the deduction is limited to 20% of QBI. Therefore reducing owner’s wages and increasing QBI will increase the deduction. Consider paying quarterly estimates instead of a bonus to pay safe harbor amounts. If the owner reduces his wages by $100,000, and takes a distribution instead, the deduction is increased by $20,000. Please remember to watch reasonable compensation.
In Scenario B (possible for construction management and A&E firms) – the deduction is limited to 50% of the wages. Therefore increasing owner’s wages will increase the deduction. As with any planning technique, consider the cost of increasing payroll expenses versus the benefit of increasing the 199A deduction.
In Scenario C – this is close to the optimum wage to QBI percentage, 50% of wages approximates 20% of the QBI. Another area relating to wages are leased employees, if you have a developer who maintains a separate partnership for all projects but uses one entity for payroll, the payroll can be allocated to the end users of the payroll, thus increase the 199A deductions. Subcontracting is very common in the construction industry and subcontractor fees do not qualify as wages. If your company heavily relies on subcontracting you may want to consider who you can include on payroll to maximize your 199A deduction.
Property Limitations
Another limit of the deduction is 2.5% of unadjusted basis on qualifying property plus 25% of wages. Property no longer qualifies after 10 years from the original placed in service date or the last day of last full year in the applicable recovery period determined under section 168. If this factors into the 199A deduction, it should factor into property replacement decisions.
Aggregation Rules
A taxpayer can potentially choose to aggregate businesses for the deduction if the taxpayer operates multiple businesses in coordination with each other, shares resources, and are commonly controlled. How a taxpayer groups or doesn’t group businesses for purposes of applying the passive activity loss rules doesn’t affect how the taxpayer can aggregate or not aggregate businesses for purposes of applying the QBI deduction rules. After a taxpayer chooses to aggregate two or more businesses for QBI deduction purposes, he or she must continue to aggregate the businesses in all subsequent tax years.
Other Considerations
If the business income does not qualify for the 199A deduction consider additional wages to reduce the income to an amount under the threshold and look at other deductions such as bonus depreciation, Section 179 depreciation, and retirement or SEP contributions. Conversely, some taxpayers may need to reduce the amount of deductions to optimize their 199A deduction. Consider extending the 2018 tax return as the IRS is continually releasing clarifications and some technical corrections are expected. In summary, Section 199A can provide a tax benefit but how to best derive that benefit can be vastly different taxpayer by taxpayer. It is highly recommended you consult the CICPAC group and your tax advisor to discuss any planning needs.
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