Understanding the new Sec. 199A business income deduction.

• Author: Nitti, Tony

With the enactment of legislation known as the Tax Cuts and Jobs Act (the Act) (1) on Dec. 22, 2017, a new provision of the Internal Revenue Code was born: Sec. 199A, which permits owners of sole proprietorships, S corporations, or partnerships to deduct up to 20% of the income earned by the business. The motivation for the new deduction is clear: to allow these business owners to keep pace with the significant corporate tax cut also provided by the Act.

Income earned by a C corporation is subject to double taxation: first at the entity level, and then a second time at the shareholder level when the corporation distributes its income as a dividend. Part of the Act reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%. While the Act retained the top rate on dividend income of 20%, (2) the dramatic decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%. (3)

In contrast to C corporations, income earned by a sole proprietorship, S corporation, or partnership is subject to only a single level of tax. There is generally no tax at the entity level; instead, owners of these businesses report their share of the business's income directly on their tax return and pay the corresponding tax at ordinary rates. The Act reduced the top rate on ordinary income of individuals from 39.6% to 37%, and Sec. 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%. (4)

Thus, after the passage of the Act, owners of sole proprietorships, S corporations, and partnerships retained a similarly sizable federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law. (5)

While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear. The provision is rife with limitations, exceptions to limitations, phase-ins and phaseouts, and critical but poorly defined terms of art. As a result, Sec. 199A has created ample controversy since its enactment, with many tax advisers anticipating that until further guidance is issued, the uncertainty surrounding the provision will lead to coundess disputes between taxpayers and the IRS. Adding concern is that, despite the ambiguity inherent in Sec. 199A, Congress saw fit to lower the threshold at which any taxpayer claiming the deduction can be subject to a substantial-understatement penalty.

This article examines the various computational and definitional elements of claiming the Sec. 199A deduction. It then discusses the primary areas of concern and confusion among tax advisers, highlighting areas where additional guidance is most desperately needed, as well as planning opportunities in the absence of such guidance.

Sec. 199A in general

Effective for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, (6) a taxpayer other than a corporation is entitled to a deduction equal to 20% of the taxpayer's "qualified business income" earned in a "qualified trade or business." (7) The deduction is limited, however, to the greater of:

* 50% of the W-2 wages with respect to the qualified trade or business; (8) or

* The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. (9)

The deductible amount of qualified business income for each of the taxpayer's qualified trades or businesses is determined separately and added together. The sum of these amounts is then subject to a second limitation equal to the excess of:

* The taxable income for the year, over

* The sum of net capital gain (as defined in Sec. 1(h)) plus the aggregate amount of the qualified cooperative dividends for the tax year. (10)

The purpose of this overall limitation is to ensure that the 20% deduction is not taken against income that is taxed at preferential rates.

Example 1: In 2018, A, a married taxpayer, has $100,000 of qualified business income, $100,000 of long-term capital gain, and $30,000 of deductions, resulting in taxable income of $ 170,000.A's Sec. 199A deduction is limited to the lesser of $20,000 (20% of $100,000) or $14,000 (20% of $70,000, the excess of taxable income of $170,000 over net capital gain of $100,000).

Taxpayers entitled to claim the deduction

The Sec. 199A deduction is available to any taxpayer "other than a corporation." (11) This includes:

* Individual owners of sole proprietorships, rental properties, S corporations, or partnerships; and

* An S corporation, partnership, or trust that owns an interest in a passthrough entity.

With regard to the latter group, future regulations will provide guidance on how to determine the deduction in the case of tiered entities. (12)

The statute is unclear regarding the determination of the deduction in 2018 for a fiscal-year qualified business. A version of the Act passed by the House of Representatives, which would have generally imposed a top rate of 25% on qualified business income, made clear that taxpayers would be entitled to only a proportional benefit of the reduced rate related to fiscal-year businesses with a tax year that included Dec. 31, 2017. (13)

The conference committee report to the Act, however, states only that the final version of Sec. 199A is effective "for tax years beginning after Dec. 31, 2017," without differentiating between the tax year of the taxpayer claiming the deduction and the tax year of the business generating the qualified business income. (14) Because Sec. 199A is written from the perspective of the taxpayer claiming the deduction--and because the final Act does not contain the specific language governing fiscal-year businesses found in the House bill--it is reasonable to conclude that a calendar-year owner of a fiscal-year business is entitled to claim the full deduction on his or her 2018 tax return, despite the fact that a portion of the income earned by the fiscal-year business was earned prior to 2018.

Example 2: A, an individual, is a shareholder in an S corporation with a fiscal year end of June 30. On A's 2018 Form 1040, U.S. Individual Income Tax Return, A may claim the Sec. 199A deduction for the qualified business income earned by the S corporation for its tax year beginning July 1, 2017, and ended June 30, 2018. Qualified trade or business

A taxpayer must be engaged in a "qualified trade or business" to claim the Sec. 199A deduction. Sec. 199A defines a qualified trade or business by exclusion; every trade or business is qualified, other than:

* The trade or business of performing services as an employee; (15) and

* A specified service trade or business. (16)

The first prohibition prevents an employee from claiming a 20% deduction against his or her wage income.

Example 3: A is an employee, but not an owner, of a qualified business. A receives a salary of $100,000 in 2018. A is not permitted a Sec. 199A deduction against the wage income because A is not engaged in a qualified business. Specified service business

This second category of disqualified businesses serves the same purpose as the first--to prevent the conversion of personal service income into qualified business income. This latter category, however, takes aim at business owners, rather than employees, prohibiting the owner of a "specified service trade or business" from claiming a Sec. 199A deduction related to the business.

Sec. 199A(d)(2) defines a specified service trade or business by reference to Sec. 1202(e)(3)(A), which includes among the businesses ineligible for the benefits of that section:

any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees. Sec. 199A modifies this definition in two ways: first, by removing engineering and architecture from the list of prohibited specified services businesses (17) before then amending the final sentence to reference the reputation or skill of one or more of its "employees or owners" rather than merely its "employees." (18) Sec. 199A(d)(2)(B) then adds to the list of specified service businesses any business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. (19) However, see the discussion below of the taxpayer income threshold exception to the denial of the deduction for a specified service trade or business.

Qualified business income

Once a taxpayer has established that he or she is engaged in a qualified trade or business, the taxpayer must determine the "qualified business income" for each separate qualified trade or business.

Qualified business income is defined as the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business (20) that are effectively connected with the conduct of a business within the United States. (21) Qualified business income does not include, however, certain investment-related income, including: (22)

* Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss;

* Dividend income, income equivalent to a dividend, or payment in lieu of a dividend described in Sec. 954(c)(1)(G);

* Any interest income other than interest income properly allocable to a trade or business;

* Net gain from foreign currency transactions and commodities transactions;

* Income from notional principal contracts, other than items attributable to notional principal contracts entered into as hedging transactions;

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