We have tried to our best simplify the interpretation of sec 199 A, and explain by citing examples. However, considering the depth and breadth, we cannot explain all. But if you plan properly in 2018 and meet us to discuss how we can help to save taxes will benefit the owners of pass-through entity.
The Sec. 199A deduction, also known as the “Qualified Business Income” deduction The law, however, presents small businesses and individual investors with some tricky-to manage rules and, for high income taxpayers, with more complicated accounting.
The Sec. 199A deduction becomes available as soon as January 1, 2018. Further, the deduction expires after 2025, unless Congress extends it later on. Therefore, this will not be on 2017 tax return.
The Sec. 199A deduction differs from the common “tax shelters” that individuals usually encounter, such the self-employed health insurance deduction or the Individual Retirement Account contribution. Those sorts of deductions often require no upfront planning or preparation. The business owner may only need to pay some amount sometime before the calendar year ends. Or before the tax return due date.
The Sec. 199A deduction works differently—at least for successful business owners.
Some pass-thru entity owners will need to create an S corporation in order make the Sec. 199A deduction work. Some partnerships may need to re-write the partnership agreement in order to maximize the deduction. Some owners of some service businesses will need to find ways to push their taxable income down low enough to use the new deduction. Finally, every high-income taxpayer needs to make sure that the pass-thru entities they receive income from also pay adequate W-2 wages and do good accounting for the entities’ depreciable assets.
Summing up, the Sec. 199A deduction may present a situation where in order to get the really big savings possible, a business owner or real estate investor may want to make operational, legal and accounting changes before the new year or very early in the new year.
In order to understand Sec.199 deductions, first understanding of three key concepts will help CPA better.
Concept 1-Benefits owners of Unincorporated Businesses and S Corporations.
The Sec.199 A deduction benefits the owners of what tax law calls as “pass-through entities.” The list of pass-thru entities targeted by the Sec. 199A deduction includes sole proprietorships, partnerships (including publicly traded partnerships), Subchapter S corporations, real estate investors, trusts and estates, and then some more specialized business structures such as real estate investment trusts (also known as REITs) and qualified cooperatives.
Limited liability companies treated as sole proprietorships, partnerships and Subchapter S corporations qualify, as do real estate investors using a “disregarded” limited liability company to hold their investment.
Concept 2 – Shelters Taxable Ordinary Income
The Sec. 199A deduction shelters taxable income that would otherwise be taxed as ordinary income subject to the highest individual tax rates.
The Sec. 199A deduction doesn’t, therefore, “shelter” income taxed at some lower, discounted tax rate. For example, the Sec. 199A deduction doesn’t reduce the taxes that investors pay on long-term capital gains. Also, the Sec. 199A deduction usually doesn’t “shelter” income that a taxpayer has already “sheltered” with other tax deductions. If you have, say, $100,000 of income from an unincorporated business and you can use other deductions (like interest on a mortgage, state and local taxes and charitable contributions) to shelter half of this income from taxes, the Sec. 199A deduction probably only applies to the remaining half.
Concept 3- Bigger the Benefit, the More Complex the Rules
Though Congress makes the Sec. 199A pretty easy to take for most individuals, the rules get more complicated and more cumbersome as a taxpayer’s income grows.
As a general rule; If you’re single with a taxable income of $157,500 or less or married filing jointly with a taxable income of $315,000 or less, Congress allows you to take the deduction in most situations.
But if your income rises above these levels? Special rules kick in which require you to organize your business affairs in a specific way and which potentially dial down the deduction.
Structure of deduction: How it fits.
The Sec. 199A deduction works like the standard deduction does and like a taxpayer’s total itemized deductions do.
The Sec. 199A deduction, in other words, doesn’t work as an adjustment for “adjusted gross income” like an Individual Retirement Account contribution or a self-employed health insurance deduction. It becomes one of the deductions that move a taxpayer’s adjustment gross income to taxable income.
The Sec. 199A Formula
In a nutshell, the Sec. 199A “pass-thru entity” tax cut gives the owners of pass-thru businesses like sole proprietors, partnerships, S corporations and then real estate investors a deduction equal to 20% of qualified business income. (Sec. 199A(a) and Sec. 199A(b).)
For example, if each of the following “pass-thru” taxpayers earns $10,000 of qualified business income, each potentially gets a $2000 tax deduction, calculated as 20% of $10,000: • a sole proprietor making $10,000, • a partner earning $10,000 from a partnership, • an S corporation shareholder earning $10,000 from an interest in an S corporation, • a rental property investor earning $10,000 from a real estate investment
No limit exists though some restrictions and special requirements kick in when a taxpayer’s income rises. Accordingly, someone who earns $100,000 may receive a $20,000 deduction. Someone who earns $1,000,000 may receive a $200,000. Some who receives $10,000,000 may receive a $2,000,000 deduction and so on.
Estimating the tax saving from the Deduction
IMPORTANT TO NOTE: The tax savings a taxpayer enjoys depending on the top tax rate the taxpayer pays. But they add up.
You calculate the tax savings a taxpayer receives by first multiplying the taxpayer’s pass-thru income by 20% to get the Sec. 199A deduction amount, and by then multiplying this deduction by the taxpayer’s marginal, or “top,” tax rate.
The new tax law, for example, includes seven tax rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The tax savings per $10,000 of pass-thru income (so a $2,000 Sec. 199A deduction) varies as shown below depending on those rates.
|TAX RATE||Dollar Tax Savings on a $10,000 Pass-Thru Income|
Someone who pays the 10% tax rate saves about $200 in tax for every $10,000 of pass-thru income shown on the tax return, for example.
Someone who pays the 37% tax rate saves about $740 for every $10,000 of pass-thru income shown on the tax return.
In short, the Sec. 199A deduction saves owners of pass-thru entities significant tax. And under the new law, even the smallest established business may save as much with this tax deduction as a taxpayer might save from a generous pension contribution or from a home mortgage.
IMPORTANT TO NOTE: Further, the more qualified business income a taxpayer earns and the higher the tax rate he or she pays, the greater the tax savings.
The deduction formula, however, includes some special rules which may disqualify some businesses and which may limit the deduction amount based on the W-2 wages the taxpayer pays and based on the depreciable property the taxpayer uses.
Specified Service Trade or Business Disqualification
A taxpayer potentially loses the ability to take or fully take the Sec. 199A deduction if taxable income rises too high and the pass-thru entity earns its income in a specified service business.
If a single taxpayer’s income exceeds $157,500 or if a married taxpayer’s income exceeds $315,000, and if the taxpayer or taxpayers earn their qualified business income in a traditional “white-collar” service business or as a performer or an athlete, the taxpayer or taxpayers lose some or all of the deduction.
Example #1: ANKUR kADAKIA earns $100,000 in a CPA firm he operates as a sole proprietorship. His taxable income equals $100,000. He can use the Sec. 199A deduction, and the deduction equals $20,000.
Example #2: SEJAL SHAH earns $500,000 as surgeon working as a partner in a surgical center and her family’s taxable income equals $500,000. She cannot use the Sec. 199A deduction.
Taxable Income Limitation
As mentioned earlier, the Sec. 199A formula generally doesn’t shelter income a taxpayer has already sheltered in some other way such as through adjustments for adjusted gross income or by using the standard deduction.
The Sec. 199A deduction formula usually applies the 20 percent deduction both to the qualified business income from the taxpayer’s unincorporated businesses and then again to the taxable income adjusted for any net capital gains but without adjustment for the Sec. 199A deduction. The taxpayer then receives a deduction equal to the smaller value.
Note: Net capital gain equals the amount of net long-term capital gain less the net short-term capital loss realized by the taxpayer. (Sec. 199A tweaks the taxable income for net capital gains by referring to Sec. 1(h). In effect, this tweak means the Sec. 199A deduction doesn’t reduce taxes on capital gains—though the law accomplishes this purpose indirectly.)
Example #3: PB earns $100,000 in a sole proprietorship but with $30,000 of deductions his taxable income equals $70,000. He can use the Sec. 199A deduction, and the deduction equals $14,000, calculated as .2 times $70,000. The formula uses the $70,000 of taxable income rather than the $100,000 of qualified business income because other deductions already shelter that other $30,000 of the income.
Example #4: Gaurav earns $425,000 as partner in a large professional services firm. His family’s taxable income equals $315,000 because of other tax deductions. She and her husband Gaurav file a married joint tax return. She can use the Sec. 199A deduction—even though she earns her qualified business income in a specified service business—because her taxable income fails to cross that $315,000 threshold for a married taxpayer. The Sec. 199A formula calculates a $63,000 deduction for Rachna using the math .2 times $315,000.
Example #5: Ankit earns $200,000 as a sole proprietor consultant and also recognizes $100,000 of long-term capital gains. Because his personal deductions total $150,000, his taxable income equals $150,000 and his taxable income adjusted for the net capital gains equals $50,000. He can use the Sec. 199A deduction, but the deduction equals $10,000. The Sec. 199A formula calculates one deduction as $40,000 using the math .2 times $200,000 (the qualified business income). But the Sec. 199A formula also calculates a second deduction as $10,000 using the math .2 times $50,000 (the $150,000 of taxable income less the $100,000 of long-term capital gain). That lower number becomes the actual Sec. 199A deduction.
The W-2 Wages and Depreciable Property Limitations
For high income individuals and families, the law may add other requirements in order for a taxpayer to enjoy the Sec. 199A deduction.
Specifically, if a single taxpayer’s taxable income exceeds $157,500 or a married taxpayer’s income on a jointly filed return exceeds $315,000, the Sec. 199A deduction formula looks at the W-2 wages paid to employees of and also at the depreciable property held by the pass-thru entity.
These W-2 wages include the actual W-2 wages paid by the employer, of course, and also include amounts paid on behalf of an employer in a “common paymaster” arrangement. Further, to count, these W-2 wages generally need to be reported to Social Security Administration on or before the 60th day after the due date (including extensions) of the W-2 and W-3 tax returns filed with the Social Security administration.
NOTE: The W-2 language in the Sec. 199A statute nearly perfectly matches language of the Sec. 199 “Income Attributable to Domestic Production Activities” law. Further, like Sec. 199, Sec. 199A instructs the Internal Revenue Service to write rules for situations where a short year, a change in ownership during the year, or a funny year end mean an employer doesn’t actually itself issue W-2s because another employer does. If you want more detail on how Sec. 199A probably works in these sorts of special case situations before the Sec. 199A regulations appear, therefore, you may want to peruse the Sec. 199 Regulations to get a good sense of how the new Section’s Regulations may look.
In addition, the Sec. 199A formula may look at the original cost (before depreciation) of depreciable property used in the business as long as the property isn’t more than ten years old or past its last full year of depreciation (whichever comes later).
For these high-income taxpayers, in some cases, the taxpayer’s Sec. 199A deduction gets limited to either 50 percent of the W-2 wages paid by the entity. Or the taxpayer’s Sec 199A deduction gets limited to 25 percent of the W-2 wages paid by the entity plus 2.5 percent times the qualified property’s original cost. REF Sec. 199A(b)(2)(B)(ii)
Example 6 Yellari enjoys a $1,000,000 taxable income (so way into the territory where the W-2 wages and depreciable property matter) and she operates a flour mill using rented equipment which means she owns no depreciable property. She earns $100,000 of qualified business income with the flour mill. And she should tentatively get a $20,000 Sec. 199A deduction… but only if her flour mill pays at least $40,000 in W-2 wages. Her flour mill pays $100,000 in wages—far more than required. She gets to use the $20,000 deduction.
Example 7 Anju also enjoys a $1,000,000 taxable income and she also operates a flour mill which earns $100,000 of qualified business income. She should tentatively get a $20,000 Sec. 199A deduction… but her flour mill pays only $30,000 in W-2 wages. On its own, without considering depreciable property, that $30,000 of W-2 wages only supports $15,000 of Sec. 199A deduction because 50% of $30,000 equals $15,000. However, Anju owns the equipment used in her flour mill. Its original cost equaled $400,000 three years ago. The $400,000 of equipment supports $10,000 of Sec. 199A deduction because $400,000 times 2.5 percent equals $10,000. The Sec. 199A deduction formula therefore limits the Sec. 199A deduction to $17,500, or 25% of the $30,000 of W-2 wages plus 2.5% times the depreciable property.
The W-2 Wages and Depreciable Property Limitation Phase-in
When a taxpayer’s income exceeds the threshold amounts ($157,500 for a single taxpayer or $315,000 for a married taxpayer), the W-2 wages and depreciable property requirement phases in as a single taxpayer’s taxable income rises from $157,500 to $207,500 and as a married taxpayer’s taxable income rises from $315,000 to $415,000.
At and below the $157,500 and $315,000 thresholds, just to make this clear, the taxpayer doesn’t need W-2 wages or depreciable property to take the Sec. 199A deduction.
Above the top of the range ($207,500 or $415,000), the Sec. 199A deduction limits the taxpayer’s deduction to either 50% of the W-2 wages paid (directly or indirectly) by the taxpayer or to 25% of the W-2 wages paid plus 2.5% times the depreciable property (ignoring accumulated depreciation).
I read Sec. 199A(b)(6) to say that taxpayers using depreciable property in their calculations include property in those calculations for at least ten years—even if the property is only 3 or 5 or 7 year property. Further, property with a recovery period of greater than ten years gets included as long as the property produces a full year of depreciation.
Within the bands 157,500 to $207,500 and $315,000 to $415,000, a little formula calculates how much of the Sec. 199A deduction a taxpayer takes. Essentially the formula calculates two Sec. 199A deductions. One Sec. 199A deduction equals 20% of the qualified business income and one Sec. 199A deduction equals the amount limited by W-2 wages and depreciable property. The formula then takes a sliding scale approach to setting the actual Sec. 199A deduction that appears on the tax return somewhere between these two amounts.
Example 8 Sangita Sheth, a single entrepreneur, enjoys taxable income equal to $182,500—basically from a rented farm which earns $182,500 of qualified business income. (She does get some deductions but corporate bond interest, coincidentally, perfectly matches her deductions.) And another coincidence: $182,500 sits exactly half way through, or $ 25,000 into, the phase-out band that runs from $157,500 to $207,500. She should tentatively get a $36,500 Sec. 199A deduction calculated as .2 times $182,500… but her farm only pays $30,000 in W-2 wages. The phase-out formula therefore calculates the Sec. 199A deduction she would be entitled to if the deduction gets based on wages as $15,000, calculated as .5 times $30,000. The formula then looks at her taxable income of $182,500, sees that this amount rests half way between $157,500 and $207,500, and then sets the final Sec. 199A deduction amount to the point that’s half way between the $15,000 “W-2 wages” based value and the $36,500 “20% of qualified business income” value, which is $25,75.
Effectively Connected with United States Requirements
Sec. 199A says qualified business income needs to be effectively connected with “the conduct of a trade or business within the United States.”
The “within the United States” requirement means a taxpayer only gets to take the 20 percent deduction on business income earned “inside” the United States and on rental income from property located “inside” the United States.
The taxpayer also only gets to count as W-2 wages, wages for those businesses or real estate located “inside” the United States. And if depreciable property figures into the calculation, that property must be located “inside” the United States.
Entrepreneurs and investors who own a pass-thru entity operating both “inside” and “outside” the United States need to break down the entity’s income, W-2 wages and depreciable property into the “inside” and “outside” portions and then use only the “inside” portion in their calculations.
Finally, a few words about trades or businesses operating in Puerto Rico… First, if a pass-thru entity operates in Puerto Rico, generates qualified business income, and pays income taxes on that income, then the trade or business “counts” as operating within the United States and the taxpayer may use the Sec. 199A deduction. Second, the trade or business gets to include as W-2 wage amounts that aren’t really W-2 wages because they’re paid in Puerto Rico. – Sec. 199A (f)(C) and Sec. 3401(a)(8)
DEFINITION OF QUALIFIED BUSINESS INCOME
Taxpayers apply the Sec. 199A deduction to what the new tax law labels “qualified business income,” Qualified REIT dividends, qualified cooperative income and dividends, and qualified publicly traded partnership income. Sec. 199A shelters all of this income in roughly the same way—the one exception being qualified cooperative dividends.
The Detailed Rules about What Counts and Doesn’t Count
A taxpayer’s qualified business income includes “the net amount of qualified items of income, gain, deduction and loss with respect to any qualified trade or business of the taxpayer. Ref Sec. 199A(c)(1) This definition sweeps up almost everything a business owner or real estate investor naturally considers her or his business or investment income. Ref Sec. 199A(c)(3).
Further, the definition includes not just a business’s or rental property’s bottom line operating income but also the gains and losses on dispositions of assets used in the business if tax law treats those gains as ordinary income or ordinary losses.
IMP NOTE: However, the qualified business income excludes short-term and long-term capital gains, interest income (unless earned in the actual trade or business), and C corporation dividend income. Ref Sec. 199A(c)(3)(B
And then one other wrinkle: If the qualified business income from all of the trades or businesses of the taxpayer for any taxable year actually shows up as a loss, no Sec. 199A deduction gets calculated for that year (which makes sense) and the loss carries forward to the next year’s qualified business income calculations (which seems fair). Ref Sec. 199A(c)(2 How these detailed rules apply to specific pass-thru entities varies, however, so let’s step through the different types of entities:
Sole Proprietors Running Active Trades or Businesses
Tax law treats an individual running an unincorporated active trade or business as a sole proprietorship. Tax law may also treat an individual who owns a “single member” limited liability company running an active trade or business as a sole proprietorship unless the LLC makes an election to be treated as a corporation. In either of these cases, this sole proprietor reports her or his income and deductions on a Schedule C tax form. And that Schedule C’s bottom line profit number should equal the proprietorship’s qualified business income.
Example #9: Jatin Gandhi, a single taxpayer, earns $100,000 in a sole proprietorship (which constitutes his qualified business income) and enjoys $120,000 in taxable income (due to other investments in large corporations). His Sec. 199A deduction equals $20,000, calculated as .2 times $100,000. Deductions which a taxpayer uses to calculate adjusted gross income (such as self-employed health insurance and pension contributions) as well as itemized deductions which a taxpayer uses to calculate taxable income (such as mortgage interest and charitable contributions) don’t appear to directly affect the qualified business income. But because the deductions do affect taxable income, they may change the Sec. 199A deduction.
Ref: The language of Sec. 199A to say that items of deduction directly connected to the qualified trade or business—like pension contributions and self-employed health insurance deductions supported by the sole proprietor’s or partner’s earnings—also count in the qualified business income number. But I now think the Sec. 199A approach will match that used by Sec. 199 for calculating the qualified domestic production activities deduction which means these items will not count directly—though they will impact indirectly because they determine taxable income.
Example #10: Vaishali’s tax return includes $100,000 in sole proprietorship profits, $24,000 of bank account interest and the $24,000 standard deduction. Her return also includes a $10,000 SEP-IRA contribution and a $10,000 self-employed health insurance deduction. Her qualified business income equals $100,000 but the combination of other income and deductions on the return drop her taxable income to $80,000. In this case, her Sec.199A deduction equals $16,000 calculated as .2 times $80,000.
Example #11: Louisa earns $100,000 in a sole proprietorship and shows $200,000 in taxable income before accounting for the depreciation on new equipment used in the business. If her sole proprietorship adds $50,000 of depreciation to its tax return, that deduction reduces qualified business income to $50,000 and taxable income to $150,000. In this situation, the Sec. 199A deduction equals $10,000 calculated as .2 times $50,000.
Analysis of above example: A nitpick point for tax practitioners… Adding $50,000 of depreciation to a tax return that already shows $100,000 of qualified business income and $200,000 of taxable income actually changes the taxable income by less than $50,000. The additional depreciation reduces not just the taxable income but also the self-employment earnings. The reduction in self-employment earning then reduces the self- employment taxes. The reduction in self-employment taxes, in turn, reduces the self-employment tax deduction used to calculate the self-employment tax deduction.
Sec. 1231 Gains and losses on asset dispositions also impact the qualified business income if treated as ordinary income and ordinary losses. Losses reduce the qualified business income. Gains increase the qualified business income.
Note: Just a quick clarification for taxpayers reading this material. Sec. 1231 gains and losses stem from the sale or exchange of assets used in a trade or business or for the production of income (such as rental property). In general, a Sec. 1231 loss gets treated as an ordinary loss.
And Sec. 1231 gains get treated partially as ordinary gains and partially as capital gains. Ref: Sec 1231(a)(3)
Example #12: Andrew enjoys a taxable income equal to $150,000 largely through earning $100,000 from a sole proprietorship but that’s before accounting for a $50,000 loss on the sale of equipment used in the business. After accounting for the $50,000 loss, his taxable income equals $100,000, his qualified business income equals $50,000 and the Sec. 199A deduction equals $10,000, calculated as .2 times $50,000.
Example #13: Renu Antil earns $100,000 from a sole proprietorship before accounting for a $50,000 gain on the sale of equipment used in the business due to depreciation being recaptured. Her other taxable income and deductions, oddly, perfectly offset each other, so her taxable income doesn’t limit the Sec. 199A deduction. After accounting for the $50,000 gain, her qualified business income equals $150,000 and the Sec. 199A deduction equals $30,000, calculated as .2 times $150,000.
A remark about Example #13… Any portion of a Sec. 1231 gain that gets treated like capital gains probably does not count toward qualified business income but this gain does get subtracted from the taxable income amount used to limit the Sec. 199A deduction. This makes sense considering that this part of the gain already receives favorable tax treatment.
Real Estate Investors
Real estate investors treat the net rental income shown on the Schedule E tax form as qualified business income. These investors also net rental losses against income, including passive suspended losses.
Example #14: Murthy, a real estate investor, holds three rental properties. One property generates $10,000 of rental income. Another property generates $20,000 of net rental income. A third property loses $5,000. The qualified business income equals $25,000 calculated as $10,000+$20,000-$5,000. The Sec. 199A deduction equals $5,000 calculated as .2 times $25,000.
If a real estate investor accumulates passive suspended losses and then “unlocks” previously suspended losses by recognizing passive income, the previously suspended losses plug into the Sec. 199A deduction formula and reduce and may even eliminate qualified business income.
Example #15: Gokuldas, another a real estate investor, also holds three rental properties. One property generates $10,000 of rental income. Another property generates $20,000 of net rental income. A third property loses $5,000. Gokuldas has accumulated $25,000 of passive suspended losses in prior years which “unlock” for the current year’s tax return. The qualified business income equals $0 calculated as $10,000+$20,000-$5,000- $25,000. The Sec. 199A deduction also equals zero.
Regarding gain on the sale of real estate investments, I read the law to say that a gain which stems from past depreciation counts as qualified business income and that the gain that flows from pure “appreciation” in the value doesn’t count toward the qualified business income and does get subtracted from the taxable income. This treatment would mean the Sec. 199A deduction doesn’t shelter income taxed at a lower-than- ordinary tax rate.
And this quick clarification: While some tax practitioners believe (for good reason) that rental property investors only get the Sec. 199A deduction if their real estate activities rise to the level of a trade or business through something like material participation, (The Sec. 469 material participation rules appear here.) I don’t at this point think that’s the case. I may be wrong. But when I read both the House and Senate bills, the conference report, and then look at the actual law (and see the way REIT dividends and qualified publicly traded partnerships are treated), I see Congress rather freely providing this tax benefit regardless of a taxpayer’s material participation.
Partners in Investment Partnerships
A partner in a partnership investing in real estate calculates her or his qualified business income as his or her proportional share of the partnership’s qualified business income, which in turn gets calculated using the same principles described for taxpayers directly investing in real estate.
If the partnership earns interest income (such as on bank accounts) or qualified dividends or capital gains on traditional investments (such as from holding shares in publicly held companies), that income does not count as qualified business income.
Routing income or deductions through a pass-thru entity does not change the character of the income or deductions.
The Sec. 199A deduction does apply to publicly traded partnership interests.
Partners in Partnerships Conducting Active Trades or Businesses
Partners in partnerships conducting active trades or businesses calculate their qualified business income as their proportional share of the partnership’s qualified business income, which gets calculated using the same basic accounting principles as described for sole proprietors operating active trades or businesses.
A partnership’s guaranteed payments to partners count not only as a deduction on the partnership tax return but they reduce the qualified business income. Ref Sec. 199A(c)(4)
Example #16: Chirag and Arjav partner in a venture. Each receives $80,000 in guaranteed payments and another additional $100,000 as their share of the partnership profit. Each partner, therefore, calculates the qualified business income as $100,000 and calculates a $20,000 Sec. 199A deduction.
Reminder: If the partnership earns interest income (such as on bank accounts) or qualified dividends or capital gains on traditional investments (such as from holding shares in large corporations), that income does not count as qualified business income.
Subchapter S Shareholders
Subchapter S shareholders calculate the qualified business income they receive from an interest in a Subchapter S corporation in the same basic way that a sole proprietor does—except that rather than reporting the entire business’s income as their qualified business income, they report only their percentage share. IMPORTANT: Subchapter S corporation shareholders do not include shareholder-employee wages in the qualified business income. Ref Sec. 199A(c)(4)(A)
Example #17: Amit Jain, a single taxpayer, owns ten percent of Tyler Corporation and also works in the corporation as an employee. Tyler Corporation earns $1,000,000 of income from its active trade or business, which means John’s ten percent share of the $1,000,000 equals $100,000. John also earns $80,000 in W-2 wages. His Sec. 199A deduction equals $20,000, calculated as .2 times the $100,000 share of Subchapter corporation profits. The W-2 wages he earns don’t count toward qualified business income.
The accounting for gains and losses on dispositions of Sec. 1231 assets used in the Subchapter S Corporation’s active trade or business should work just like the accounting for a sole proprietorship, as described earlier. (That means these ordinary gains and losses count toward the qualified business income).
Finally, as with partners and partnerships, if the Subchapter corporation earns interest income (such as on bank accounts) or qualified dividends or capital gains on traditional investments (such as from holding shares in large corporations), that income would not count as qualified business income. Investment income doesn’t “morph” into qualified business income simply by being routed through a pass-thru entity.
Trusts and Estates
The Sec. 199A deduction for trusts and estates works in the same manner as it does for a partnership. Ref: Sec. 199A(f)(1)(B
REIT Dividends and Qualified Cooperative Dividends
The Sec. 199A deduction applies to two other pass-thru entities: real estate investment trusts (often referred to as REITs) and qualified cooperatives. Ref: Sec. 199A(g)
The basic rules work like this: Qualified dividends from REITs and Sec. 1388 qualified cooperative “patronage dividends” (and similar items) count as qualified business income eligible for the Sec. 199A deduction. Ref: Sec. 199A(b)(1)(B), Sec. 199A(e)(3), Sec. 199A(e)(4) Capital gain dividends and C corporation “qualified dividends” do not count. Even if they flow through from something like a REIT.
But one wrinkle worth mentioning regarding qualified cooperative dividends. Qualified cooperative dividends, uniquely as compared to other types of qualified business income, don’t get limited by the taxable income in the same way as other types of qualified business income.
For example, normally, a taxpayer calculates the Sec. 199A deduction as the lesser of either 20% of the qualified business income or 20% of the taxable income.
Example #18: Chkor, a single taxpayer, earns $100,000 in a sole proprietor and due to deductions reports $80,000 of taxable income. His Sec. 199A deduction 20% of his $80,000 of taxable income (or $16,000) and not 20% of his $100,000 of qualified business income (or $20,000).
The Sec. 199A deduction formula works differently for qualified cooperative dividends, however. The deduction equals the lesser of either 20% of the qualified cooperative dividends or $100% of the taxable income.
Example #19: Arun, also a single taxpayer, earns $100,000 in qualified cooperative dividends and due to deductions reports $80,000 of taxable income. His Sec. 199A deduction 20% of his $100,000 of qualified cooperative dividends, or $20,000. Even though his taxable income equals a lesser amount, $80,000.
W-2 Wages and Depreciable Property Limitations and Partnership and Subchapter S
If a taxpayer owns an interest in a partnership or Subchapter S corporation and the pass-thru entity’s W-2 wages and depreciable property plug into the Sec. 199A deduction (because the taxpayer’s income rises over $157,500 if single or over $315,000 if married), a partner or shareholder gets “credit” for her or his proportional share of the W-2 wages paid by and the depreciable property held by the partnership or Subchapter S corporation.
The entity tax return should give “credit” for W-2 wages to partners and shareholders based on how much of the wages implicitly appear in their distributive shares. The entity tax return should give “credit” for depreciable property to partners and shareholders based on much of the depreciation on the property appears in their distributive shares.
Example #20: Because he enjoys a high income as a partner in large farm, Kaushik needs to limit his Sec. 199A deduction to 50% of the W-2 wages he indirectly “pays” by holding ten percent of a partnership. If the partnership pays in total $500,000 in W-2 wages, Kaushik gets “credit” for $50,000 of the W-2 wages, calculated as .1 times $500,000.
His Sec. 199A deduction, because it’s limited to 50% of those wages, equals $25,000 calculatedAs 05 times $50000.
2018 Tax Brackets for Individuals at a Glance
|Rate||Individual||Married Filing Jointly|
|10%||Up to $9,525||Up to $19,050|
|12%||$9,526 to $38,700||$19,051 to $77,400|
|22%||$48,701 to $82,500||$77,401 to $165,000|
|24%||$82,501 to $157,500||$165,001 to $315,000|
|32%||$157,501 to $200,000||$315,001 to $400,000|
|$35%||$200,001 to %500,000||$400,001 to $600,000|
|37%||Over $500,000||Over $600,000|
In general, the new tax rate structure means lower brackets for most filers, with the top rate dropping to 37% from 39.6%. The 10% bracket now extends to almost $10,000 for individuals and $19,000 for joint filers, which doubles the amount of income taxed at the lowest rate.
Several other changes have been applied to standard deductions (doubled), exemptions (eliminated), child tax credits (increased), mortgage interest (capped at $750,000), AMT and other deductions and credits.
Individual tax cuts: In the end, GOP leaders settled on a seven-rate structure, the same as exists now, with lower rates and revised bracket amounts. Ultimately, the top rate was cut from its current level of 39.6% to 37%, as opposed to the 38.5% rate that appeared in the Senate Bill.
Standard deduction and personal exemptions: Along with the individual rate cuts, the standard deduction is effectively doubled to $12,000 for single filers and $24,000 for joint filers. Personal exemptions are completely eliminated.
|Filing Status||No Children||One Child||Two Children||Three+ Children|
|Single or Head of Household
Income at Max Credit
Phaseout Ends (Credit Equals Zero)
|Married Filing Jointly
Income at Max Credit
Phaseout Ends (Credit Equals Zero)
Please contact Satish Shah for any questions you have. These are just highlights of changes in the 2018 tax law and SHOULD NOT be considered as tax advice. The content on this page is not all-inclusive for changes in the tax law as of Dec. 22, 2017.
Proprietary of Shah Associates, CPA, P.A. (Satish P. Shah, CPA)