Preface: The tax reform passed in 2017 changed taxes in many ways. One change that excites tax preparers is the Section 199A Qualified Business Income Deduction. This section gives taxpayers a “free” deduction by allowing them to honestly deduct an expense that cost them zero dollars. Section 199A allows for a 20% deduction starting in 2018, and taxpayers may want to start thinking about it now.
New Tax Law Per The 199A Qualified Business Income Deduction
Credit: Jacob M Dietz, CPA
The 199A Qualified Business Income Deduction provides a very helpful tax deduction to many businesses, including manufacturing and construction. The new tax deduction has numerous complexities and more details will follow.
The well advised will start the conversations early with their tax accountant about the 199A Qualified Business Income Deduction and the tax benefit implications to business, since it can substantially reduce tax liabilities in certain instances.
Brief Overview The Section 199A Qualified Business Income deduction is not available to C Corporations, and some of the details of the calculation have not been released yet. The 199A section provides a threshold ($157,500 for taxpayers filing single and $315,000 for married taxpayers filing jointly with their spouse) above which there is a phaseout of the deduction for service businesses. For nonservice businesses, this threshold triggers the need for additional calculations involving W-2 wages paid and unadjusted basis in property. Although there are many more details to this section, this bird’s eye overview provides a starting point for planning.
Income Threshold First, will your personal income be under the $157,500 if filing single or $315,000 if married filing jointly threshold? If so, then you don’t need to worry about a service business classification or your paid W-2 wages and unadjusted basis in property. If your income will exceed the threshold, then you may want to consider if there are ways to defer some of that income, such as by accelerating depreciation or using the installment method to report a large sale. If your personal income looks like it will still exceed the threshold after considering income deferral options, then consider if you are a service business.
Service Business What happens if your personal income will exceed the threshold when your business is a service business? A phaseout will begin for the deduction. The phaseout could eliminate your deduction completely. How do you know if you operate a service business? The Internal Revenue Code clearly defines certain activities as service businesses, such as an accounting firm. Other businesses, however, may fall under the classification of a service business if the business is “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” It is unclear how aggressively the IRS will classify businesses with the service designation, but more details may come later.
Other Businesses What about businesses that do not fall under the service business classification? These businesses, as they reach the threshold, may avoid the phaseout IF the deduction does not exceed either
- 50% of qualified W-2 wages
- Or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.
- Reasonable Compensation Reasonable compensation and guaranteed payments are excluded from the calculation of the deduction. Carefully consider what constitutes reasonable compensation and guaranteed payments if your business is taxed as a partnership. Consider consulting with a tax advisor early in 2018 regarding your guaranteed payments.
- W-2 Wages and Unadjusted Basis A nonservice business above the phaseout threshold may still take the deduction if it has enough W-2 wages and/or unadjusted basis in qualified property. A nonservice business could make some projections to predict if it has enough W-2 wages or unadjusted basis to still take advantage of the deduction if the owner is above the threshold.
The 199A Qualified Business Income Deduction provides a very helpful deduction to many businesses. It has many complexities and more details will follow, but start the conversation with your accountant soon about the 199A Qualified Business Income Deduction and the relevance to your business tax planning.
This article is general in nature, and does not contain legal advice. Please contact your accountant to see what applies in your specific situation.