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99A Deductions

by Jonathan Benjamin, CPA

The Tax Cuts and Jobs Act (TCJA), effective for 2018, enacted several favorable tax provisions for both businesses and individuals.  In January 2019, the IRS released regulations that clarified ambiguities in the new law and modified the proposed regulations in several key areas.  The new IRC Sec. 199A deduction available to owners of partnerships, S-corporations, sole proprietorships, and certain rental properties could provide significant tax savings.

Taxable income from these entities passes through and is taxed on Form 1040 at the owners’ standard tax rates.  Beginning in 2018, the TCJA established a Section 199A deduction for this type of pass through income and is subject to certain limitations, exceptions, and phase-ins and phase-outs.

The Section 199A deduction is generally 20% of Qualified Business Income(QBI).  QBI is generally net income with some exceptions.  A few common items not included in QBI include capital gains, dividend income, or interest income, as well as any deduction related to these items.  Further, QBI does not include W-2 compensation or guaranteed payments paid to the taxpayer for services on behalf of the trade or business.

Conversely, sole proprietorships have no adjustment to QBI for reasonable compensation paid for the value of the owner’s services.  However, pursuant to the final regulations, self-employed individuals must reduce QBI by 50% of self-employment tax, the self-employed health insurance deduction, and qualified retirement plan contributions.

To claim the full Section 199A deduction the taxpayer must be in a qualified trade or business.  This is broadly defined as any business other than the business of performing services as an employee or a specified service trade or business (SSTB).  A SSTB is generally any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners, although some exclusions apply.  These restrictions prevent claiming a Section 199A deduction against wage income or personal service income.

Rental property owners are subject to ambiguity in determining whether their rental income qualifies as trade or business income.  There are various requirements as well as uncertainties in this area, and each situation will need to be evaluated accordingly.  The IRS has provided safe harbors if certain requirements are met.  These generally require separate books and records be maintained for the rental activity and a certain number of hours spent on rental services each year.  Additional rules apply for self-rentals, triple net leases, and vacation homes.

The QBI deduction is also subject to certain restrictions when taxable income exceeds various thresholds.

For taxpayers with income in excess of these thresholds, the QBI deduction is limited to:

Cost basis of qualified property is generally the original basis of property with certain limitations based on the life of the property.  Qualified property is all tangible property subject to depreciation owned by the business on the last day of the year.  Variations apply to like-kind exchanges, involuntary conversions, and the purchase of partnership interests.

If these thresholds are not met, there is a reduced deduction.  Further, a second limitation may reduce the deduction to 20% of the taxpayer’s taxable income less the sum of net capital gains.

Taxpayers with SSTB income are subject to phase-out of the deduction based on the same thresholds above.  The deduction is completely eliminated if over the upper limit.  These taxpayers are still subject to the 20% of taxable income less capital gains limitation.

This provision involves many complexities that have not been addressed in this article.  However, the Section 199A deduction will provide a significant tax benefit to many taxpayers with qualified business income.  Please contact us if we can assist with any questions you may have related to your particular situation or for planning opportunities to ensure you are getting the best use of this new deduction.