New Tax Deduction 199A Will Be Lost For Many In 2018
The Tax Cuts and Jobs Act (TCJA), which was signed into law in December 2017 and began to take effect in 2018, created a new deduction for pass-through business owners. The deduction, called the 199A deduction, can in certain situations provide up to a 20 percent tax deduction on one’s qualified business income. However, planning for and determining the best way to take advantage of the 199A deduction is a very complex process. Any pass-through entities planning to utilize this deduction should have already been in touch with their financial advisors and accountants, but many are still unaware of its existence. Further complicating the matter is that tax experts and other professionals are still waiting for additional guidance and clarity around 199A from the government, without any clear timeline in sight. This could leave many small business owners in the dark when it comes to the new 199A deduction.
So, how does the new 199A deduction work? Owners of pass-through businesses—specifically S corporations, partnerships, and limited liability companies (LLCs) taxed as a pass-through entities—have the ability to take up to a 20 percent deduction of their qualified business income. However, the 199A deduction is both complex and limited. First of all, if the business is a specified service business that is defined as a business in the fields of health, law, [bill removed engineering and architecture for purposes of 199A] accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, the deduction is phased out based on the owner’s income. Specifically, the deduction is phased out for joint filers between the range of $315,000 and $415,000. For single filers, the phase-out range is $157,500 to $207,500. This means that the entire 20 percent deduction is lost for those couples or singles earning income from their pass-through business that exceeds the top end of the range.
For non-specified service businesses, the ranges of $315,000 to $415,000 for joint filers and $157,500 to $207,500 for single filers still play a role; however, instead of phasing out the deduction, they phase in a potential 199A limitation. For non-specified service businesses above the stated thresholds, the deduction becomes limited to the lesser amount derived from one of the two following ways of calculating the deduction:
- the 20 percent qualified business income deduction or
- the greater of either
- 50 percent of the W-2 wages of the business or
- The sum of 25 percent of the W-2 wages of the business and 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.
Sounds simple, right? The reality is that this deduction is far from simple. Tax advisors and professionals are still not entirely clear on what income can be aggregated if you own multiple businesses, what exactly is meant by qualified business income, and how to calculate the exact basis rules on the property in question. According to attorney Christopher Woehrle, “despite the laudable goal of taxing the returns to capital lightly, 199As complexity and uncertainty of its durability may make this section a noble failure.”
The planning points people need to consider are vast. Most of it relates to the individual’s income, business structure, W-2 employees, and property ownership. Because the lack of W-2 wages can limit some business owners from taking the 199A deduction, some business owners might need to take a higher W-2 wage for themselves. Others might need to decrease their W-2 wages, as W-2 wage income won’t qualify for the deduction, just qualified business income. However, this should be done very carefully and only as it relates to the actual reasonableness of wages. The IRS has gone after business owners before for shifting costs in S Corps from W-2 wages to earnings. In other cases, it might make sense for a consultant to be categorized as a W-2 employee.
Choice of entity is such an important decision for business owners. But, with the corporate tax changes and the addition of 199A, some businesses need to consider whether or not they need to make a change. As Andrew Komarow, CFP®, CHFC®, CLU®, RICP®, of Talcott Financial Group, Farmington, CT. points out “many small businesses who were previously S-Corps, especially sole member LLCs who ‘checked’ the box to be S-Corps may want to consider revoking the S Election in order for potentially all income to be considered QBI.” In other cases, some might even want to consider moving from a pass-through to a C Corp or vice versa. However, the rules can be complex for changing entity and the benefits are not always clear to the business owner.
Those with other businesses may need to pay close attention to their unadjusted basis in property in order to maximize their 199A deduction. Essentially, this limit puts many business owners into the real estate business. Some owners might want to consider buying property that they rent or, if they own multiple buildings, it could make sense to shift debt to different properties or re-leverage debt to maximize the unadjusted basis in order to open up a higher deduction amount under 199A.
In other cases, business owners will want to lower their income by finding deductible savings opportunities in IRAs, 401(k)s, and defined-benefit plans. Although the number of defined-benefit plans has been decreasing over the years, they can still play a powerful role in 199A planning. (Click here to read more on defined benefit plans and 199A.) By saving in a tax-deferred account, business owners can decrease their income to get below the phase-out ranges of 199A. Defined-benefit plans are unique in that the maximum deductible contribution can be four or five times higher than that of a 401(k), allowing a business owner to deduct well over $100,000 a year from his or her taxable income. This can help business owners save for retirement and also qualify for the 199A deduction.
For many business owners, decisions need to be made today. Delaying until tax time 2019 will be too late for many, causing business owners to pay thousands more in taxes than they are required to pay under the new law. Furthermore, as Anna K. Pfaehler, CFP®, Director of Financial Planning at HORAN, points out, “the 199A deduction is scheduled to sunset in 2026 so you need to plan for contingencies. If your business make changes to take advantage of the deduction, make sure you also have a strategy to unwind those changes in a few years if need be.”
Remember, this is a new law. No one has ever dealt with it before and there will be a degree of uncertainty around it for several years to come. Work with your financial advisors, a defined benefit plan specialist like Decided DB, and your tax professionals to do the best you can with 199A planning so that you can take full advantage of this new tax deduction.