For tax years that begin after Dec. 31, 2017 and before Jan. 1, 2026, noncorporate taxpayers that meet certain requirements may claim an income tax deduction under Code Sec. 199A of 20% of their “qualified business income” (QBI) from a partnership, S corporation, or sole proprietorship. Code Sec. 199A allows noncorporate taxpayers to deduct 20% of their “qualified business income” (QBI) from a partnership, S corporation, or sole proprietorship, as well as 20% of aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. The deduction can’t exceed 20% of the excess of the taxpayer’s taxable income over his net capital gain for the tax year. (Code Sec. 199A(a)(2))
Here are some planning ideas for taxpayers who may be able to qualify for the deduction.
Specified service trades or businesses. Specified service trades or businesses (SSTBs), e.g., businesses that involve performance of services in the fields of health, law, consulting, athletics, financial services and brokerage services, don’t fully qualify unless the taxpayer’s taxable income is equal to or below the threshold amount—$157,500 ($315,000 for married individuals filing jointly), indexed for inflation for tax years that begin after 2018—and don’t qualify at all if the taxpayer’s taxable income is above $207,500 ($415,000 for married individuals filing jointly). For 2019, the threshold ranges are $160,700 to $210,700 for singles and head of households, $160,725 to $210,725 for married taxpayers filing separately, and $321,400 to $421,400 for joint filers. (Code Sec. 199A(d), Code Sec. 199A(e)(2))
As a result, taxpayers who are in those businesses need to make estimates of their 2018 taxable income and 2019 taxable income, and consider shifts of taxable income if those estimates indicate that either year’s taxable income is likely to be near the applicable threshold range. For instance, a single self-employed lawyer who anticipates having taxable income of $100,000 for 2018 and $200,000 for 2019 will be able to increase his or her 2019 QBI deduction by shifting taxable income from 2019 to 2018 and/or shifting deductible expenses from 2018 to 2019.
Taxpayers in SSTBs whose taxable income is too high to qualify for the new deduction should consider incorporating and/or changing/expanding their business model so that they are not SSTBs.
And, in certain cases, married couples may benefit from filing separately to avoid the SSTB limit.
Illustration: James and Jenny are married and have always filed a joint return. James is a W-2 employee and makes a $400,000 salary. Jenny is a sole-proprietor CPA (an SSTB) who has a 2018 net business profit of $165,000. Each has $20,000 of itemized deductions. Together, James’s and Jenny’s taxable income is well over the $415,000 upper limit of the phase-out for the QBI deduction for joint filers. Thus, James and Jenny are unable to claim any amount of QBI deduction for Jenny’s otherwise-eligible business income on a joint return. However, if they file separately, Jenny’s taxable income is under the $157,500 threshold, so she is entitled to a $29,000 QBI deduction (20% x [$165,000 – $20,000]). (Her deduction is limited by the taxable income limitation in Code Sec. 199A(a)(2).)
Caution: Note, however, that there are several disadvantages of filing separately, so merely creating a QBI deduction, where none was available when filing jointly, may not lower the couple’s taxes. It is necessary to compare the couple’s total tax liability under both the filing separately and filing jointly scenarios.
Taxpayers who are subject to the W-2 wages limitation. Except as provided below, the QBI deduction cannot exceed the greater of:
(1) 50% of the W-2 wages with respect to the qualified trade or business (W-2 wage limit), or
(2) the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” (Code Sec. 199A(b)(2)) Qualified property is certain tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year.
The above limit does not apply for taxpayers with taxable income below the threshold amount. The application of the limit is phased in for individuals with taxable income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals). (Code Sec. 199A(b)(3))
The trade or business of the performance of employment services is not a qualified trade or business for purposes of the QBI deduction. (Code Sec. 199A(d)(1)(B)) As a result, an S corporation owner who qualifies for the QBI deduction, and for whom the W-2 wages limitation does not limit his deduction, will increase his QBI deduction by minimizing the amount of wages the S corporation pays him. However, where the W-2 wages limitation does limit his deduction, he may be able to increase his QBI deduction by increasing the amount of wages the S corporation pays him.
Illustration: An S corporation that is not an SSTB earned $1 million, principally by exploiting its intangible assets, after paying a reasonable salary of $200,000 to its sole owner and sole employee. The W-2 wage limitation would limit the pass-through deduction to $100,000, or 50% of the wages. However, if the owner increased her wages to $300,000 and thus decreased the corporate earnings to $900,000, the pass-through deduction, still subject to the wage limitation, would increase to $150,000. As a result, the owner would decrease her taxable income by $50,000 at the price of a minor increase in payroll taxes.
And, as indirectly illustrated by the above illustration, partnerships and sole proprietorships with numbers similar to those in that illustration can benefit by converting to S corporation status. That is, a partnership or sole proprietorship cannot pay its owner(s) a salary and thus cannot take advantage of the technique used in the above illustration. Converting the partnership or sole proprietorship to an S corporation opens up the above technique.
Businesses that are subject to the W-2 wage limitation can also benefit by hiring employees instead of independent contractors.
Illustration. A sole proprietor who is not an SSTB earns $500,000 of QBI. Her business has no W-2 employees and no qualified property; her QBI is determined after paying $100,000 to several independent contractors. She is over the phase-out limit, so her Code Sec. 199A deduction is zero because of the 50% W-2 wage limit. If, however, she hired employees to replace the independent contractors, her deduction would be $50,000 (50% of $100,000). (Note that, as a result of making this change, she would have additional payroll costs, and it might not sit well with the independent contractors if she wanted to hire the same people as employees—any of those people who themselves took QBI deductions will lose those deductions to the extent that their income converts to employment income.)
Note that wages, for purposes of all of the above planning ideas, includes most forms of contributions to pension and 401(k) plans and employer provided health insurance and many other employee benefits. (Notice 2018-64, Sec. 4, 2018-35 IRB 347)
Considerations for owners of rental real estate. Taxpayers whose taxable income is above the threshold amount and who wish to invest in real estate should consider doing so by investment in a REIT.
The Code Sec. 199A deduction for qualified REIT dividends (together with qualified PTP income) is not constrained by the abovementioned income-based QBI deduction limitations (the wages or wage-and-property tests). Thus, for high-income taxpayers, REITs will, in most cases, provide a higher deduction than would be obtained via direct-owned real estate.
And, there is another significant advantage to holding real estate via a REIT as opposed to owning it directly. The QBI deduction is only available with respect to a trade or business. Depending on the level of activity of the direct owner of rental real estate, such ownership may or may not constitute a trade or business. By contrast, even a passive investment in a REIT will be fully eligible for the Code Sec. 199A deduction, regardless of the investor’s individual level of activity and engagement in the business.
And taxpayers, e.g., owners of rental real estate, whose taxable income is above the threshold amount generally will benefit from increasing the amount of their “qualified property” that is subject to the “2.5% of adjusted basis” rule described under “Taxpayers who are subject to the W-2 wages limitation,” above.
In order to be considered for purposes of the 2.5% test, the property must be owned as of the end of the tax year. Therefore, real estate investors who are considering selling property may benefit from delaying the sale of that property until the start of their next tax year. On the other hand, persons may wish to purchase property, e.g., real estate, before the end of this tax year.
Caution: Proposed regs include an anti-abuse rule that must be considered in this context. Under the regs, property wouldn’t be qualified property if it’s acquired within 60 days of the end of the tax year and disposed of within 120 days without having been used in a trade or business for at least 45 days before disposition, unless the taxpayer demonstrates that acquisition and disposition had a principal purpose other than increasing the pass-through deduction. (Prop Reg § 1.199A-2(c)(1)(iv); Prop Reg § 1.199A-2(d)(1))
References: For the deduction for pass-through income, see FTC 2d/FIN ¶ L-4305 et seq.; United States Tax Reporter ¶ 199A4 et seq.