The Section 199a Deduction: Concepts & Examples

• Publication year: 2019
• Author: By Laura L. Buckley & Ethan B. Shakoori

The Section 199A Deduction: Concepts & Examples

By Laura L. Buckley¹ & Ethan B. Shakoori²

Laura Buckley is a Certified Specialist in Taxation Law. Ms. Buckley represents US and international individuals and businesses with their state and federal taxation matters and business transactions. Ms. Buckley specializes in cost-effective resolution of tax controversies before the Internal Revenue Service, Franchise Tax Board, and State Board of Equalization. Ms. Buckley also represents clients before the Office of Tax Appeals and the United States Tax Court.

Before joining Higgs Fletcher & Mack, Ms. Buckley was an IRS Chief Counsel attorney and a Special Assistant United States Attorney. Ms. Buckley is the Chair-Elect of the Executive Committee for the California Lawyers Association's Taxation Section and is a Past Chair of the San Diego County Bar Association's Tax Section. Ms. Buckley teaches Advanced Business Planning at the University of San Diego School of Law. Ms. Buckley is also an active member of San Diego Downtown Rotary, Club 33.

Ethan B. Shakoori is a law clerk at Higgs Fletcher & Mack LLP where his focus is tax and bankruptcy law. Mr. Shakoori obtained his Bachelor of Arts in Economics with an emphasis in Quantitative Analysis from San Diego State University. Mr. Shakoori obtained his juris doctorate from California Western School of Law where he served as the Executive Lead Articles Editor for California Western Law Review.

I. INTRODUCTION

In the Tax Cuts and Jobs Act of 2017 ("TCJA"), Congress created Internal Revenue Code (IRC) section 199A to address, among other things, concerns regarding increases in business income taxation. TCJA addressed these concerns for taxpayers investing in Subchapter C corporations by reducing the income tax rate on C corporations from 35 to 21 percent and making a similar reduction with respect to the highest ordinary income tax rates for individuals, trusts, and estates from 39.6 to 37 percent.

The legislative history of TCJA reveals that Congress noted that the reduction in the corporate tax rate to 21 percent failed to abate general concerns regarding the income tax rate applicable to business income taxed to individuals, trusts, and estates.³ To create parity between C corporations and pass-through entities (and sole proprietorships), Congress enacted section 199A as individual tax reform, allowing investors in domestic businesses operating as a sole proprietorship, partnership, or S corporation to take a deduction of up to 20 percent of "Qualified Business Income," subject to certain limitations.⁴ This so-called "pass-through deduction" applies to tax years beginning January 1, 2018 and ending December 31, 2025,⁵ and is also available to trusts and estates that invest in certain pass-through entities. Employees and owners of certain service businesses may be out of luck, though.

In determining who can benefit from the section 199A deduction, Congress set guardrails based on, among other things, the type of business generating the income, the taxable income of the taxpayer, and whether the business is employing employees. As discussed in detail below, these guardrails (which for example may require the taxpayer to calculate W-2 wages under section 199A(b)(2)(B)(i) and (ii) and (b)(4)(A), and "unadjusted basis" of "Qualified Property" under section 199A(b)(2)(B)(ii) and (b)(6)), dictate who can benefit from the deduction and by how much.

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This article does not, in any way, provide an all-encompassing guide to the intricate world of section 199A. Rather, it provides a thorough overview of what the authors believe are section 199A's need-to-know concepts, with a focus on real estate activities. There are many important details associated with the different aspects of section 199A that go unmentioned because they are outside this article's scope and purpose. For those who have read section 199A, its attendant Treasury Regulations, and administrative pronouncements, it goes without saying that section 199A is incredibly complicated and will provide ample opportunity for practitioners to interpret and opine.

II. FINAL TREASURY REGULATIONS

On August 8, 2018, just eight months after section 199A was enacted, the Internal Revenue Service ("IRS") published Proposed Treasury Regulations and Notice 2018- 64 (providing guidance on calculating W-2 wages for section 199A purposes).⁶ After trekking through a daunting 104-page Preamble and 80 pages of Proposed Treasury Regulations, 335 comments were submitted to the IRS requesting additional guidance.⁷

On January 18, 2019, amid a government shutdown, the IRS issued 247 pages of Final Treasury Regulations ("Treasury Regulations"),⁸ Revenue Procedure 2019-11,⁹ and Notice 2019- 07¹⁰ to clarify some of the deduction's mechanics.¹¹ Similar to the Notice released with the Proposed Treasury Regulations, Revenue Procedure 2019-11, issued with the Final Treasury Regulations, addressed W-2 wage calculations, and Notice 2019-07 addressed the trade or business safe harbor for Rental Real Estate Enterprises. Both are explained in detail below in Sections V and VI.

III. QUALIFIED BUSINESS INCOME

The section 199A deduction only applies to certain income, namely Qualified Business Income ("QBI"), which is the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business.¹² Qualified items of income, gain, deduction, and loss are those that are (1) effectively connected with the conduct of a domestic trade or business, and (2) included or allowed in the taxpayer's taxable income of the current year. However, the following categories of items are not qualified items included in QBI for section 199A purposes:¹³

(1) short- and long-term capital gain and loss;
(2) dividends and dividend equivalents as described in IRC section 954(c)(1)(G);
(3) interest income;
(4) gain or loss from commodity transactions;
(5) any gain, deduction, or loss accounted for in determining the net income from notional principal contracts as described in IRC section 954(c)(1)(F);
(6) amounts received from an annuity unless received in connection with a trade or business;
(7) any deduction or loss allocated to an amount described in the above six categories;
(8) reasonable compensation received by a shareholder in a S corporation; and
(9) payments to a partner as described in IRC section 707(a), or guaranteed payments to a partner as described in IRC section 707(c), for services provided to a trade or business, regardless of whether the partner is an individual or a Relevant Passthrough Entity ("RPE").

If the total QBI amount is negative, that negative amount will be carried forward to the subsequent tax year and treated as a separate trade or business for section 199A purposes.¹⁴ This carry forward does not preclude the loss from being deducted pursuant to other IRC provisions.¹⁵

IV. SPECIFIED THRESHOLD AMOUNT

In enacting section 199A, Congress chose to set certain limitations or guardrails that may apply to reduce or eliminate the deduction if a taxpayer's taxable income exceeds specified thresholds. Thus, while the section 199A deduction is taken at the owner level based on items generated by the pass-through entity (or sole proprietorship) conducting the Qualified Trade or Business ("QTB"), the amount of the deduction, and whether it is even available is determined, among other things, upon the taxable income of the owner. Section 199A categorizes taxpayers into three categories: those below the so-called "Specified Threshold Amount," those within the phase-in range, and, finally, those above the threshold and phase-in-range.¹⁶ Each category is subject to different rules governing how the section 199A deduction is calculated.

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For the 2018 tax year, the Specified Threshold Amount was $157,000 of taxable income for single filers and trusts and estates, and $315,000 for married couples filing joint returns.¹⁷ For 2019, the threshold increased to $160,700 and $321,400 respectively.¹⁸

A. Below the Threshold

Taxpayers whose taxable income is below the threshold may take the section 199A deduction in an amount equal to the lesser of:

(1) the sum of 20 percent of total QBI, 20 percent of all qualified real estate investment trust ("REIT") dividends, and 20 percent of all qualified publicly traded partnership ("PTP") income, which will also be referred to as the "combined QBI;" or
(2) 20 percent of the taxpayer's taxable income less net capital gain.¹⁹

Thus, taxpayers below the threshold are subject to a limitation on their deduction equal to 20% of the taxpayer's ordinary income.

The W-2 basis, Unadjusted Basis Immediately after Acquisition ("UBIA"), and Specified Service Trade or Business ("SSTB") limitations discussed in detail below in sections V and VI are not applicable to taxpayers below the threshold.²⁰

Below is an example of how the deduction works for below-the-threshold taxpayers:

A, an unmarried individual, owns and operates a computer repair shop as a sole proprietorship. The business generates $100,000 in net taxable income from operations in 2018. A has no capital gains or losses. After allowable deductions not relating to the business, A's total taxable income for 2018 is $81,000. The QBI from the business is $100,000, the net amount of its qualified items of income, gain, deduction, and loss. A's section 199A deduction for 2018 is equal to $16,200, the lesser of 20% of A's QBI from the business ($100,000 × 20% = $20,000) and 20% of A's total taxable income for the taxable year ($81,000 × 20% = $16,200).²¹

B. Within the Phase-In Range

Taxpayers with taxable income up to $50,000 over the Specified Threshold Amount ($100,000 for joint filers), are within the phase-in range. In contrast to the threshold amounts, the phase-in range is not adjusted annually for inflation.²²

These taxpayers are subject to the W-2, UBIA, and SSTB limitations, but with phase-in rules.

For example, to determine the amount of SSTB QBI, W-2 wages, and...