Flow-Through Business Owners Line Up For Advice On New 199A Deduction
The 2017 Tax Cuts and Jobs Act (TCJA) introduced Internal Revenue Code Section 199A, which could potentially provide millions of taxpayers with a 20% deduction for qualifying “flow-through” income, known under the statute as qualified business income.
This will include the personal “Schedule C” income for people who have their own businesses, and K-1 income that comes from ownership in S-corporations and partnerships when certain requirements are met. It does not apply to income from a C corporation.
Tens of thousands of taxpayers will be able to change how their businesses, rental activities, and professions are structured to be eligible to take this deduction, and proposed regulations that should help decipher these rules and define avenues of permissible and sometimes frowned upon strategies will be released any day now to be studied by thousands of tax advisors.
It provides owners of flow-through trades or businesses (often called pass-through entities) a significant tax break to rival the new, lower tax rate for C corporations. However, the 21% rate for C corporations is deceptive, because double taxation, state corporation taxes, as well as Net Investment Income tax on higher income individuals can distort the effective tax rate to above 40%.
Likewise, many advisors have touted the 29.6% tax rate on flow-through income, which represents income taxed at 37% individual bracket reduced by the 20% deduction (37% * 20% = 29.6%), but this only applies to income in the highest individual tax bracket, which for single filers is income above $500,000, and for married filers is income above $600,000. Individuals with taxable income in the 24% bracket may have their flow-through income taxed at 19.2% (24% * 20% = 19.2%) for a savings of only 4.8%. The 199A deduction represents a significant opportunity for a great many savvy business owners to save money.
The rules relating to the 20% Section 199A deduction are very complicated in many situations, especially where the individual taxpayer who would receive the deduction is single, and has more than $157,500 of taxable income, or is married with more than $315,000 of taxable income.
When these income levels are exceeded, most business income can still qualify as long as the business pays a certain amount of wages or has a certain amount of depreciable property or has a combination of both. Business owners will consider paying more in wages or acquiring buildings and equipment as a means to help them qualify for the deduction. For a discussion on the amount of wages that need to be paid to avoid these limitations, see Peter J. Reilly’s Forbes article from January on 199A.
Certain trades and businesses in the health, law, accounting, consulting, and several other categories (what the statute calls “Specified Services”) will be limited when their incomes exceed the above thresholds, even if there is payment of significant wages or holding of qualifying property. The deduction on flow-through income from these types of businesses will be entirely lost if the income of the owner exceeds another threshold of $207,500 if the owner is single and $415,000 if the owner is married.
This chart explains how the owner’s taxable income corresponds to the 199A deduction:
The deduction is also limited to 20% of taxable income over net capital gains, which prevents taxpayers from taking huge losses and still getting a deduction. Capital gains and losses, however, are also not included in flow-through income, which takes it out of the equation entirely.
Stay tuned as we cover primary aspects of these regulations in future postings. Soon after the proposed regulations, I will be writing summaries and commentary on them along with tax experts Martin Shenkman, Jonathan Blattmachr and Brandon Ketron for our upcoming book, The Section 199A (and 1202) Handbook, With In-Depth Technical Analysis.
We welcome all questions, comments and suggestions regarding this interesting and powerful tax law provision.
An excellent Forbes article on the new 20% deduction can be found in Tony Nitti’s Tax Geek Tuesday column from December 26, 2017. Forbes’ Ashlea Ebeling explains here how business owners are socking more in retirement plans to snag the 20% break.
You cannot call 1-800-888-199A to get this deduction, but you can call your tax advisor to get in line for an appointment to determine how these rules can best impact your situation. Contact firstname.lastname@example.org receive our free white paper on these rules.