Proposed Section 199A regulations (REG-107892-18) released on August 8, 2018 further clarify the calculation of the 20% of qualified business income (QBI) deduction allowable for individuals reporting QBI on their personal tax return.  The deduction is intended to reduce the amount of taxable income attributable to the business.  It is only intended for entities/individuals involved in a domestic trade or business (as defined under IRC Section 162).  

Section 199A was enacted in response to the reduced tax rate for US C Corporations offered by the Tax Cuts & Jobs Act (TCJA).  Being that TCJA lowered the US corporate tax rates for tax years after 2017 from 35% to 21%, Congress enacted Section 199A to affect a tax rate decrease for pass-through business entities.  Pass through entities are businesses that do not pay tax on the Company level and instead pass all business net earnings to the individual owners.  The owners report and pay taxes on their share of the business earnings on their individual income tax returns.  Pass through entities include S-corporations, partnerships, sole proprietorships and limited, liability companies (LLC’s).    

For purposes of the 20% deduction, QBI is simply the net income generated from a qualified business.  Items such as capital gains and losses, certain dividends and interest income are excluded from QBI calculations.  It must be noted that employee wages or guaranteed payments received from the business are not considered QBI and are not eligible for the 20% deduction.  

Only one limit applies to the 20% of QBI deduction for individual taxpayers, whose 2018 taxable income falls below $157,500 for individual filers and $315,000 for married filing jointly filers.  That is, the 20% of QBI deduction cannot exceed 20% of the excess of taxable income over net capital gains.    

There are two additional, potential limitations to the 20% deduction, once a person’s income reaches over $157,500 for individual filers and $315,000 for married filing jointly filers.  

Firstly, if the business is considered an SSTB, specified service trade or business, the deduction is subject to a cut-off threshold.  The deduction begins to phase out at $157,500 for single filers and $315,000 for married filing jointly filers and is completely phased out for single taxpayers at $207,500 of income and joint filers with taxable income of $415,000.  An SSTB, is “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.”  Service providers in the fields of health, law, consulting, accounting, athletics, financial services or broker services will meet the definition of an SSTB.  Simply put, if your business is considered to be an SSTB and you have taxable income of more than $207,500 as a single filer or more than $415,000 of income as a joint filer, you are ineligible for the Section 199 deduction.

Secondly, the 20% deduction is limited by the greater of 50% of W-2 wages reported by the business or the sum of 25% of W-2 wages plus 2.5% of the unadjusted bases (UBIA) of qualified property immediately after acquisition.  There are various methods that can be used to calculate the sum of W-2 wages of the business but these calculations are out of the scope of this article.  It must be noted, that W-2 wages includes only wages included on Forms W-2 filed with the Social Security Administration (SSA); net income from a sole proprietorship reported on Schedule C, would not be considered W-2 wages.  UBIA, simply put, is the cost paid for a depreciable asset used in the production of qualified business income.  The property must be in the possession of the business, available for business use as of the end of the year and the depreciable period must not have ended.  Once again, there are various regulations and limitations enacted for computing UBIA that are out of the scope of this article.  This limitation is also phased in beginning at $157,500 for single filers and $315,000 for married filing jointly filers and is completely phased out for single taxpayers at $207,500 of income and joint filers with taxable income of $415,000.  Meaning, for single filers with taxable income of more than $207,500 and joint filers with taxable income in excess of $415,000, the Section 199A deduction is fully subject to the W-2/UBIA limitations.

Taxpayers with multiple businesses, may be able to elect to aggregate their businesses for purposes of calculating the W-2/UBIA limitation.  The businesses must have at least 50% common ownership, the same tax year, none of the businesses can be considered an SSTB, and the businesses must be related (provide services or products that are usually provided together; share facilities; or operate in coordination with each other).

It also should be noted that trusts and estates are eligible to utilize the Section 199 deduction.  There are many anti-avoidance rules in the proposed regulations to avoid set-ups whose primary purpose is avoidance of income tax.  Such as formation of multiple trusts in order to keep income amounts below the SSTB and W-2/UBTI limitation thresholds.