The qualified business income tax deduction: Section 199A
Under the 2017 Tax Cuts and Jobs Act, newly devised Section 199A of the Internal Revenue Code establishes a qualified business income deduction for certain pass-through entities and disregarded entities. Partnerships, S corporations, estates and trusts are eligible to take advantage of the deduction. For individuals, the deduction is available whether they elect to itemize deductions or claim the standard deduction on their tax returns.
The initial deduction formula provides that the amount allowed as deduction under Section 199A for any taxable year is (1) the lesser of the taxpayer’s qualified business income for the year or (2) 20 percent of the excess of the taxpayer’s taxable income for the year, over the taxpayer’s net capital gains for the year.
While seemingly straightforward, the initial formula requires a taxpayer to understand what qualifies as qualified business income. Qualified business income or combined qualified business income is defined as the deductible amount determined under IRC Section 199A(b)(2) for each qualified trade or business carried on by the taxpayer.
The deductible amount for a qualified trade or business, as defined under Section 199A(b)(2), is (1) the lesser of 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business or (2) the greater of 50 percent of the W-2 wages with respect to the qualified trade or business or the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2 1/2 percent of the unadjusted basis immediately after acquisition, or UBIA, of all qualified property.
If the above wasn’t complicated enough, further limitations are placed on a taxpayer’s eligibility to utilize the deduction if the business falls within the parameters of a specified service trade or business, or SSTB. The business may be excluded from utilizing the deduction depending on where the taxpayer falls in relation to the threshold amount, which we’ll discussed later. Businesses falling under the umbrella of an SSTB include those in fields such as legal, health, accounting, athletics and more.
The threshold amount, mentioned above, is $160,700 of taxable income for 2019 for an individual or $321,400 for a taxpayer filing a joint return. Depending on where a taxpayer’s taxable income falls in relation to the threshold amount, the taxpayer may fall subject to the W-2 wages and UBIA limitations.
There are six basic scenarios under which a taxpayer may fall, three involving a taxpayer engaged in a qualified trade or business and three involving a taxpayer engaged in the business of an SSTB. If a taxpayer is engaged in a qualified trade or business and has taxable income for the year that is less than the threshold amount, the taxpayer’s deduction amount will be determined under alternative two of our initial deduction formula and will, therefore, be 20 percent of the qualified business income. Under the same circumstances, a taxpayer engaged in an SSTB will have the deduction determined in the same manner. The deduction will be 20 percent of their qualified business income.
A taxpayer engaged in a qualified trade or business who has taxable income above the threshold amount plus $50,000, or $100,000 if filing a joint return, is subject to the W-2 and UBIA limitations discussed above. Depending on the wages or qualified property, the deduction may be severely limited. For a taxpayer engaged in an SSTB and falling under the same circumstances, the taxpayer is excluded entirely from utilizing the deduction.
Finally, a taxpayer engaged in a qualified trade or business who has taxable income above the threshold but below the threshold plus $50,000, or $100,000 for those filing a joint return, will be subject to the wages and qualified property limitations but with a variation to the calculation. The variation is a reduction by what is known as the excess amount. For a taxpayer engaged in an SSTB under the same circumstances, the formula is complicated even further. In addition to the reduction for the excess amount, there is a further reduction in the potential deduction amount for what is known as the applicable percentage.
If you have questions regarding the qualified business income deduction, the deduction’s benefits and pitfalls or utilization of the deduction when developing your business structure, contact Woods Fuller. As the law is currently stated, the Section 199A qualified business income deduction is slated to sunset at the beginning of 2026, meaning that taxpayers may be able to utilize the deduction for only five more years.