Qualified Business Income (Pass-Through) Deduction Under the Tax Cuts and Jobs Act

Qualified Business Income (Pass-Through) Deduction Under the Tax Cuts and Jobs Act

Few provisions in the recently enacted Tax Cuts and Jobs Act (the Act, PL 115-97, 12/22/2017) are likely to have a greater impact or create more confusion than the new Code Sec. 199A deduction for noncorporate taxpayers for qualified business income (also referred to as the “pass-through deduction”). Put simply, the deduction, effective for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, is generally 20% of a taxpayer’s qualified business income from partnerships, S corporations, or sole proprietorships (i.e., the net amount of items of income, gain, deduction, and loss with respect to the trades or businesses). However, very little about the deduction, with its limitations, phaseouts, thresholds, and special definitions, is simple.

Observation: The term “pass-through deduction” itself is something of a misnomer as the deduction is available not only to pass-through entities such as partnerships, S corporations, and limited liability companies (LLCs), but also to sole proprietorships.

Observation: While some businesses might be tempted to change their form in order to take advantage of the new pass-through deduction, there are many other factors that need to be considered — perhaps, most notably, the newly reduced 21% income tax rate for C corporations. Commentators seem largely split on the relative benefits of pass-through vs. corporate form, and the best choice for any given taxpayer will likely depend on its particular facts and circumstances. Commentators also note that, while perhaps appealing on its face, converting from an employee to an independent contractor to obtain the benefits of the deduction, even if possible, requires some hard choices, such as giving up fringe benefits.

The deduction for noncorporate taxpayers is generally 20% of a taxpayer’s qualified business income from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to the trade or business.

The deduction is taken “below-the-line,” i.e., it reduces taxable income, rather than being taken “above-the-line,” i.e., in determining adjusted gross income (AGI) (Code Sec. 62). However, the deduction can be taken by taxpayers who don’t itemize their deductions (Code Sec. 63(b)(3)) (Code Sec. 63(d)(3)).

The deduction applies only for income tax purposes (Code Sec. 199A(f)(3)); it thus doesn’t apply, for example, for purposes of determining self-employment tax. For purposes of determining Code Sec. 55 alternative minimum taxable income, qualified business income is determined without regard to any adjustments under Code Sec. 56 through Code Sec. 59 (Code Sec. 199A(f)(2)).

The basic deduction

The amount of the deduction is specifically calculated as the sum of:

  • The lesser of
    • (a) the “combined qualified business income” amount of the taxpayer for the tax year (Code Sec. 199A(a)(1)(A)) or
    • (b) the sum of 20% of the excess (if any) of the taxpayer’s taxable income for the tax year (determined without regard to this deduction) over the sum of (i) the taxpayer’s Code Sec. 1(h) net capital gain for the tax year and (ii) the taxpayer’s aggregate amount of the qualified cooperative dividends for the tax year (Code Sec. 199A(a)(1)(B)), plus
  • The lesser of (a) 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year (Code Sec. 199A(a)(2)(A)), or (b) the taxpayer’s taxable income (minus the taxpayer’s net capital gain) for the tax year (Code Sec. 199A(a)(2)(B)).

The total of the amount cannot exceed the taxpayer’s taxable income (minus the taxpayer’s net capital gain) for the tax year (Code Sec. 199A(a)).

Qualified business income defined

The qualified business income for a tax year is the net amount of qualified items of income, gain, deduction, and loss relating to any qualified trade or business of the taxpayer. It doesn’t include any qualified real estate investment trust (REIT) dividends, qualified cooperative dividends or qualified publicly traded partnership income (Code Sec. 199A(c)(1)). Qualified items of income, gain, deduction, and loss are items of income, gain, deduction, and loss to the extent these items are: effectively connected with the conduct of a trade or business within the U.S. under Code Sec. 864(c) (applied by substituting “qualified trade or business” for “nonresident alien individual or a foreign corporation” or for a “foreign corporation” each place it appears), and included or allowed in determining taxable income for the tax year (Code Sec. 199A(c)(3)(A)).

Example: A qualified business has $100 of ordinary income from inventory sales and makes a $25 expenditure that must be capitalized and amortized over five years. The business income is $95 ($100 minus $5 current-year ordinary amortization deduction).*

If the net amount of qualified income, gain, deduction, and loss relating to qualified trade or businesses of the taxpayer for any tax year is less than zero, the amount is carried over as a loss from a qualified trade or business in the succeeding tax year (Code Sec. 199A(c)(2)).

Example: Taxpayer has qualified business income of $20,000 from qualified business A and a qualified business loss of $50,000 from qualified business B in Year 1. Taxpayer is not permitted a Code Sec. 199A deduction for Year 1 and has a carryover qualified business loss of $30,000 to Year 2. In Year 2, Taxpayer has qualified business income of $20,000 from qualified business A and qualified business income of $50,000 from qualified business B. To determine the deduction for Year 2, Taxpayer reduces the 20% deductible amount determined for the qualified business income of $70,000 from qualified businesses A and B by 20% of the $30,000 carryover qualified business loss.*

Exclusions: The following investment items are not taken into account as qualified items of income, gain, deduction, or loss (Code Sec. 199A(c)(3)(B)):

  • Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss;
  • Any dividend, income equivalent to a dividend, or Code Sec. 954(c)(1)(G) payment in lieu of dividends;
  • Any interest income other than interest income that is properly allocable to a trade or business;
  • Any Code Sec. 954(c)(1)(C) commodity transaction gain or loss or Code Sec. 954(c)(1)(D) foreign currency gain or loss (applied by substituting qualified trade or business for controlled foreign corporation);
  • Any item of income, gain, deduction, or loss relating to Code Sec. 954(c)(1)(F) notional principal contracts (determined without regard to the rules coordinating the notional principal contract rules with other categories of foreign personal holding company income and excluding items attributable to notional principal contracts entered into in Code Sec. 1221(a)(7) hedging transactions);
  • Any amount received from an annuity that is not received in connection with the trade or business; and
  • Any item of deduction or loss properly allocable to an amount described in any of the preceding items in this list.
  • In addition, qualified business income doesn’t include: (a) reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered for the trade or business; (b) any Code Sec. 707(c) guaranteed payment paid to a partner for services rendered for the trade or business; and (c) to the extent provided in regs, any Code Sec. 707(a)payment to a partner outside of his partner capacity for services rendered for the trade or business (Code Sec. 199A(c)(4)).

Observation: Under pre-act case law that was not affected by the act, an S corporation shareholder who performs services for the corporation is deemed to have received reasonable compensation from the S corporation for his services, regardless of whether the corporation actually makes a payment to him. Similarly, in the case of a partnership interest received by gift, Code Sec. 704(e) requires that the donor partner receive reasonable compensation from the partnership for his services. Thus, where a business is conducted through a partnership or an S corporation, a portion of its income may have to be treated as compensation (which is not qualified business income). In contrast, in the case of a business conducted by a sole proprietor or a single member LLC that is treated as a disregarded entity, all of the business’s income can be qualified business income.

Qualified business income from Puerto Rico sources: In the case of any taxpayer with qualified business income from sources within Puerto Rico, if all the income is taxable in the U.S. under Code Sec. 1 for the tax year, then the taxpayer’s qualified business income for the tax is determined by treating Puerto Rico as part of the U.S (Code Sec. 199A(f)(1)(C)(i)).

In the case of any taxpayer subject to this rule, the W-2 wages of the taxpayer relating to any qualified trade or business conducted in Puerto Rico are determined without regard to the Code Sec. 3401(a)(8) exclusion for remuneration paid for services in Puerto Rico (Code Sec. 199A(f)(1)(C)(ii)).

Qualified trade or business

A qualified trade or business is any trade or business other than a specified service trade or business or the business of performing services as an employee (Code Sec. 199A(d)(1)).

Observation: It appears that a “trade or business” is defined by reference to Code Sec. 162. In such a case, an activity qualifies as a trade or business if the taxpayer’s primary purpose for engaging in the activity is for income or profit and the taxpayer is involved in the activity with continuity and regularity. Thus, a sporadic activity or a hobby doesn’t qualify as a trade or business.

Specified service trade or business: A specified service trade or business is:

  • (A) Any trade or business involving the performance of services described in Code Sec. 1202(e)(3) (A) other than engineering or architecture or which would be so described if the term “employee owners” were substituted for “employees” in that section
  • Services excluded from the definition of qualified trade or business include health (i.e., medical services by physicians, nurses, dentists, and other similar healthcare professionals, but not services not directly related to healthcare, such as the operation of spas and health clubs), law, accounting,
  • actuarial science, performing arts (but not services by persons other than performing artists, such as promoters or broadcasters), consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees (Joint Explanatory Statement of the Committee of Conference)
  • Any trade or business which involves performance of services that consist of investing and investment management, trading, or dealing in securities described in Code Sec. 475(c)(2), partnership interests, or commodities described in Code Sec. 475(e)(2) (Code Sec. 199A(d)(2))

Threshold exception to exclusion of specified service trade or business: If for any tax year, the taxable income of any taxpayer is less than $157,500 ($315,000 in the case of a joint return), the exclusion for specified service trades or businesses does not apply, and the deduction is available to the taxpayer for that year.

If for any tax year, the taxable income of any taxpayer is less than the sum of the $157,500 ($315,000 in the case of a joint return) threshold amount, plus $50,000 ($100,000 in the case of a joint return), a phaseout rule applies to specified service trades or businesses (Code Sec. 199A(d)(3)(A)(i)).

For tax years beginning after 2018, the above $ amounts are adjusted for inflation and subject to a rounding convention (Code Sec. 199A(e)(2)(B)).

Observation: The effect of the phaseout is to reduce the 20% deduction rate by 1% for each $2,500 ($5,000 in the case of a joint return) that taxable income exceeds $157,500 as adjusted for inflation for post-2018 years ($315,000 in the case of a joint return).

Example: A is a lawyer who files a joint 2018 return. He and his wife have taxable income from his law practice of $365,000 and no other income. Since A is a lawyer, the 20% rate will be reduced to 10%, i.e., 20% x 1/2. [1/2 = $50,000 (taxable income of $365,000 minus the threshold amount of $315,000) divided by $100,000.]

Observation: Thus, no deduction is allowed to a specified service trade or business where 2018 taxable income is $207,500 ($415,000 in the case of a joint return) and greater.

Combined qualified business income

A taxpayer’s combined qualified business income amount for a tax year is equal to: the sum of the deductible amounts determined for each qualified trade or business carried on by the taxpayer (Code Sec. 199A(b)(1)(A)) plus 20% of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnership income of the taxpayer for the tax year (Code Sec. 199A(b)(1)(B)).

A qualified REIT dividend is any dividend from a real estate investment trust received during the tax year that is not a Code Sec. 857(b)(3) capital gain dividend (Code Sec. 199A(e)(3)(A)) and is not Code Sec. 1(h)(11) qualified dividend income (Code Sec. 199A(e)(3)(B)).

Qualified publicly traded partnership income for any qualified trade or business of the taxpayer is the sum of:

  • the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction and loss (determined after excluding reasonable compensation, guaranteed payments and other payments for services) from a Code Sec. 7704 publicly traded partnership that is not treated as a corporation for tax purposes (Code Sec. 199A(e)(5)(A)); and
  • any gain recognized by the taxpayer upon the disposition of its interest in such a partnership to the extent that the gain is treated as amount realized from a sale or exchange of property other than a capital asset under Code Sec. 751(a) (Code Sec. 199A(e)(5)(B)).

Wage/qualified property limitation on the deduction

Unless the taxpayer is below a threshold amount (see below), the deductible amount for a qualified trade or business is limited, i.e., it is the lesser of:

  • 20% of the taxpayer’s qualified business income from the qualified trade or business (Code Sec. 199A(b)(2)(A)) or
  • The greater of (I) 50% of the W-2 wages relating to the qualified trade or business or (II) the sum of (i) 25% of the W-2 wages relating to the qualified trade or business and (ii) 2.5% percent of the unadjusted basis immediately after acquisition of all qualified property (Code Sec. 199A(b)(2)(B)).

Observation: Generally, unadjusted basis means the basis of property for determining gain on a sale (i.e., generally cost, including borrowed funds and the remaining basis of any assets traded-in in a nontaxable exchange) without regard to any adjustments for depreciation allowable, but reduced by: (a) the amount of amortization taken on the property; (b) any Code Sec. 179 expense deduction claimed for the property; and (c) any special depreciation allowance taken on the property. Presumably, as the basis is determined “immediately after acquisition,” the (a) through (c) reductions don’t apply.

Example: A taxpayer who is subject to the limit does business as a sole proprietorship conducting a widgetmaking business. The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of (a) 50% of W-2 wages or $0 and (b) the sum of 25% of W-2 wages ($0) plus 2.5% of the unadjusted basis of the machine immediately after its acquisition: $100,000 x .025 = $2,500. Thus, the amount of the limitation on the taxpayer’s deduction is $2,500 (Joint Explanatory Statement of the Committee of Conference).

W-2 wages: A person’s W-2 wages for a tax year is the total of the wages described in Code Sec. 6051(a)(3) and the Code Sec. 6051(a)(8) elective deferrals paid by the person for employment of employees during the calendar year ending during the tax year, but only for amounts properly allocable to qualified business income. In addition, amounts that are not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such returns are excluded (Code Sec. 199A(b)(4)). IRS is directed to issue regs regarding how wages and adjusted basis of qualified property are determined in cases of a short tax year or where the taxpayer acquires or disposes of the major portion of a trade or business or the major portion of a separate unit of a trade or business during the tax year (Code Sec. 199A(b)(5)).

Qualified property: Qualified property relating to a qualified trade or business for a tax year is tangible property of a character subject to a Code Sec. 167 depreciation allowance that is: (a) held by, and available for use in, the qualified trade or business at the close of the tax year; (b) used at any point during the tax year in the production of qualified business income; and (c) the depreciable period for which has not ended before the close of the tax year (Code Sec. 199A(b)(6)(A)).

The depreciable period for qualified property of a taxpayer is the period beginning on the date the property was first placed in service by the taxpayer and ending on the later of (i) the date that is 10 years after that date, or (ii) the last day of the last full year in the applicable recovery period that would apply to the property under Code Sec. 168 (i.e., the Modified Accelerated Cost Recovery System (MACRS)), without regard to the Code Sec. 168(g) alternative depreciation system (Code Sec. 199A(b) (6)(B)).

Observation: The term “depreciation period” should not be confused with “recovery period” (3-year, 5-year, 7-year, 10-year, 15-year and 20-year, etc.). For example, the unadjusted basis of 5-year recovery period would be taken into account as qualified property from the year placed in service and for nine years after that (i.e., 10 tax years beginning with the year placed in service) assuming it was used in a qualified business for each of those years. Where the recovery period is longer than 10 years (e.g., for 39-year recovery property), the property would be taken into account for the longer recovery period.

Threshold amount exception to wage/qualified property limitation

The wage/property limitation doesn’t apply for taxpayers below the threshold amount (Code Sec. 199A(b)(3)(A)) of $157,500 ($315,000 in the case of a joint return) (Code Sec. 199A(e)(2)(A)). For tax years beginning after 2018, this amount is adjusted for inflation and subject to a rounding convention (Code Sec. 199A(e)(2)(B)).

Observation: Because of the threshold amounts, certain married taxpayers may find it beneficial to file separate returns.

Example: Husband (H) has a qualified business which produces $150,000 of qualified business income. Wife (W) is employed and her taxable income is $200,000. If H and W file a joint return, their $350,000 joint income will exceed their $315,000 threshold amount and they will be subject to the limitation. In contrast, if H files a separate return, his $150,000 taxable income will be below the $157,500 threshold amount, and he will not be subject to the limitation. If (i) the taxable income of a taxpayer for any tax year exceeds the threshold amount, by less than $50,000 ($100,000 in the case of a joint return) and (ii) the amount in item (2) at “Wage/property limitation…” on page 6 (determined without regard to this rule) is less than 20% of the taxpayer’s qualified business income from the qualified trade or business, then that item (2) limitation will not apply. Instead, the 20% of the taxpayer’s qualified business income from the qualified trade or business amount will be reduced by (a) 20% of the taxpayer’s qualified business income from the qualified trade or business (determined without regard to this rule) minus (b) the amount in item (2), at “Wage/property limitation…” on page 6 (determined without regard to this rule) (the excess amount) multiplied by (I) the amount by which the taxpayer’s taxable income for the tax year exceeds the threshold amount and divided by (II) $50,000 ($100,000 in the case of a joint return) (Code Sec. 199A(b)(3)(B)).

Observation: In other words, where a taxpayer’s taxable income exceeds the threshold amount, but exceeds it by less than $50,000 ($100,000 in the case of a joint return), and the amount at (1) under “Wage/property limitation…” on page 6 exceeds the amount at (2) there, the deduction will be an amount that is in between the amount at (1) and the amount at (2).

Partnerships and S corporations

The qualified business income deduction for noncorporate taxpayers is applied to partnerships and S corporations at the partner or shareholder level (Code Sec. 199A(f)(1)(A)(i)). Thus, each partner or shareholder must take into account his allocable share of each qualified item of income, gain, deduction, and loss (Code Sec. 199A(f)(1)(A)(ii)), and is treated as having W-2 wages equal to his allocable share of the W-2 wages of the partnership or S corporation for the tax year (as determined under IRS regs) (Code Sec. 199A(f)(1)(A)(iii)). A partner’s or shareholder’s allocable share of W-2 wages is determined in the same manner as the partner’s or shareholder’s allocable share of wage expenses, and a partner’s or shareholder’s allocable share of the unadjusted basis of qualified property immediately after acquisition of qualified property is determined in the same manner as the partner’s or shareholder’s allocable share of depreciation. In the case of an S corporation, an allocable share is the shareholder’s pro rata share of an item (Code Sec. 199A(f)(1)(A)).

Observation: As the income threshold limitation for determining whether a taxpayer can take the business income deduction is determined at the partner or S shareholder level, some partners and shareholders may be eligible to take the deduction while others in the same partnership or S corporation may not. Further, the threshold amounts are determined by looking at taxable income, which means that all of an individual’s income, not just qualified business income, is taken into account for the threshold.

Observation: It would appear that partnerships have the flexibility to cause specific partners to be allocated W-2 wages and unadjusted basis, by making special allocations of wage expenses and depreciation deductions.

Rules similar to the pre-act former Code Sec. 199(d)(1)(B)(i) apply to apportion W-2 wages and unadjusted basis immediately after the acquisition of qualified property among trusts, estates, and beneficiaries for purposes of the deduction (Code Sec. 199A(f)(1)(B)).

Specified agricultural or horticultural property: For any tax year of a specified agricultural or horticultural cooperative beginning after Dec. 31, 2017, a deduction is allowed to the extent of the lesser of:

  • 20% of the excess (if any) of (i) the gross income of the specified agricultural or horticultural cooperative (Code Sec. 199A(g)(1)(A)(i)) over the qualified cooperative dividends of the taxpayer paid during the tax year for the tax year (Code Sec. 199A(g)(1)(A)(ii)), or
  • the greater of (a) 50% of the W-2 wages of the cooperative relating to the qualified trade or business (Code Sec. 199A(g)(1)(B)(i)) or (b) the sum of (i) 25% of the W-2 wages relating to the qualified trade or business and (ii) 2.5% of the unadjusted basis immediately after acquisition of all qualified property of the cooperative (Code Sec. 199A(g)(1)(B)(ii)).

However, the total amount cannot exceed the specified agricultural or horticultural cooperative’s taxable income for the tax year (Code Sec. 199A(g)(2)).

A specified agricultural or horticultural cooperative is an organization subject to part I of subchapter T (Code Sec. 1381 through Code Sec. 1383) that is engaged in: (1) manufacturing, producing, growing, or extracting, in whole or significant part, any agricultural or horticultural product; (2) marketing agricultural or horticultural products that its patrons have manufactured, produced, grown, or extracted; or (3) providing supplies, equipment, or services to farmers or to organizations described in items (1) or (2) (Code Sec. 199A(g)(3)).

Penalty for substantial understatements

Taxpayers are subject to a 20% accuracy-related penalty for an underpayment of tax attributable to negligence or a substantial understatement of income (Code Sec. 6662(d)). An understatement is generally considered “substantial” for this purpose if it exceeds the lesser of (1) 10% of the tax required to be shown on the return, or (2) $5,000. However, for a taxpayer claiming the Code Sec. 199A deduction, the accuracy penalty for substantial understatements of income tax applies if the amount of the understatement is 5% (instead of the usual 10%) (Code Sec. 6662(d)(1)(C)).

Regulations to be issued

IRS is directed to prescribe regs that are necessary to carry out the purposes of the deduction (Code Sec. 199A(f)(4)).

IRS is also directed (i) to apply rules similar to Code Sec. 179(d)(2) to prevent the manipulation of the depreciable period of qualified property using transactions between related parties and (ii) to prescribe rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions (Code Sec. 199A(h)). This guidance may also apply to sale-leaseback transactions (Joint Explanatory Statement of the Committee of Conference).

Effective date

These provisions apply for tax years beginning after Dec. 31, 2017 (Act §11011(e)) and before Jan. 1, 2026 (Code Sec. 199A(i)).

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