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BUSINESS DEDUCTION RULE
The Tax Cuts and Jobs Act of 2017 will bring significant changes to all areas of federal taxation, including the new qualified business income deduction rule contained in the new IRC section 199A. Owners and advisors of pass-through entities—partnerships, S corporations, and sole proprietorships—must familiarize themselves with the environment and evaluate the impact on their business structures and operations.
President Trump signed the Tax Cuts and Jobs Act (TCJA), H.R. 1, into law on December 22, 2017. The law was passed by Congress two days earlier, on December 20, 2017. In general, the effective date of the TCJA is January 1, 2017. Many of the provisions of the TCJA will sunset on January 1, 2027, although some provisions are permanent. While the conference committee resolved the differences between the House and Senate bills—and there were indeed many differences—the Conference Committee selected the final parts of the bill and sent it back or passage.
This article will summarize the TJCA section 11011, which enacted the new IRC section 199A allowing an owner of a pass-through entity to claim a deduction up to 20% of the qualified business income (QBI) of each portion of a qualifying business owned by the taxpayer. This marks the first time in the history of the federal income tax that pass-through business income is taxed at a lower rate than the tax rate that applies to salary, interest, and similar items. With a new maximum marginal income tax rate of 37% for taxpayers other than corporations, this 20% deduction can reduce the federal income tax rate for pass-through entities to as little as 29.4%. In addition to sole proprietors, shareholders in S corporations, and partners in partnerships, the law states that trusts and estates are eligible for the 20% deduction rule. Rules similar to the new IRC section 199A will apply for apportioning between fiduciaries and beneficiaries the W-2 wages and unadjusted basis of qualified property under the limitation.
As for the entire set of business reforms introduced by the TCJA, time will tell whether this hastily drawn tax blueprint will become popular with business entities and their owners. The proposed changes with respect to unincorporated businesses institute a lower tax rate based on the type of business activity that the owners are engaged in, as well as the level of wages that the business entity pays. As a result, while partners and owners of S corporations will see their taxes reduced, forecasting just how much will very much depend upon individual circumstances.
Becoming familiar with changes to the income tax rate to individuals is an important prerequisite to understanding the changes to the pass-through regimes, such as partnerships and S corporations, as well as for determining the tax rates on capital gains. It is also helpful to understand the coming changes made to the individual alternative minimum tax.
Reduction of Individual Income Tax Rates
Under current law, individuals are subject to federal income tax at graduated rates, starting at 10% on taxable income not over $9,235, and climbing to a maximum marginal rate of 39.6% for taxable income over $418,400. In seven tax brackets, the rate of tax increases as taxable income levels climb over higher thresholds. For married couples filing joint returns, the marginal tax rate of 39.6% applies to joint taxable income over $470,700. Estates and trusts, as treated under current law, quickly hit the maximum marginal rate of 39.6% on taxable income over $12,500.
The Conference Committee adopted the seven-bracket approach of the Senate bill and adopted rates ranging from 10% to a maximum of 37%.
With respect to capital gains, for an individual, estate, or trust, the amount of adjusted net capital gain, which otherwise would be taxed at the 10% or 15% rate, is not taxed at all. Adjusted net capital otherwise taxed at rates over 15% but below 39.6% (over $37,950 in taxable income but less than $418,400 in taxable income for single individuals for example) is taxed at a 15% rate. For taxable income levels subject to the maximum individual income tax rate of 39.6%, adjusted long-term capital gain is taxed at a 20% rate. Adjusted net capital gain is increased by the amount of “qualified dividend income,” as defined under IRC section 1(h)(11)(B), which includes dividends received from domestic corporations and qualified foreign corporations. [A special holding period requirement is set forth with respect to qualified dividend income. Moreover, dividends received from a passive foreign investment company, per IRC section 1297, in either the year of the distribution or the preceding taxable year, are not qualified dividends. A dividend is treated as investment income for purposes of IRC section 163(d) (Limitation on invested interest) only where the taxpayer elects to treat the dividend as not eligible for the reduced rates.] A qualified foreign corporation is one that is eligible for benefits under an income tax treaty with the United States that includes an exchange of information provision. For income realized in the form of depreciation subject to recapture under IRC section 1250, the maximum rate of tax is 25%, while capital gains from the sale of a collectible is taxed at a maximum rate of 28%.
Individuals are currently subject to a 3.8% Additional Medicare Tax under IRC section 1411 on the lesser of their net investment income, including capital gains and dividends, or modified adjusted gross income over a threshold amount of $250,000 (for married couples filing a joint return or a surviving spouse), $125,000 (for a married individual filing a separate return), or $200,000 (for any other individuals).
Conference Committee agreement.
The Conference Committee adopted the seven-bracket approach of the Senate bill and adopted rates ranging from 10% on taxable income not over $9,525 for individuals ($19,050 for married couples filing jointly (MFJ) to a maximum of 37% for taxable income over $500,000 for individuals ($600,000 for MFJ). The Conference Committee bill therefore imposes a marriage penalty on married couples filing jointly. For married individuals filing separately, the 37% threshold is attained at taxable income over $300,000. No tax relief is provided for estates and trusts other than a reduction in the maximum rate to 37%. The conference agreement retains the present-law maximum rates on net capital gains and qualified dividends. The tax bill’s reduction in overall individual rates expires for taxable years starting in 2025, in which event the current rates spring forward for taxable years beginning on or after January 1, 2026.
The individual income tax brackets are subject to adjustment for inflation based on annual changes in the level of the Consumer Price Index for All Urban Consumers [see IRC section 1(f)]. The indexing adjustment rule is permanent and will later apply to present law rates for taxable years beginning after 2025.
Individual Alternative Minimum Tax
The alternative minimum tax (AMT) is imposed on an individual, estate, or trust in the amount by which the tentative minimum tax exceeds the regular income tax for the taxable year. Under present law, the tentative minimum tax is the sum of: 1) 26% of taxable income under $187,800 [$93,900 for married filing separately (MFS)]; and 2) 28% of the remaining excess. The breakpoints are indexed for inflation. The maximum tax rates on net capital gains and dividends used in computing the regular tax are used in computing the tentative tax.
The alternative minimum taxable income (AMTI) represents taxable income adjusted for statutorily prescribed tax preferences and adjustments. Several familiar adjustments include the fact that miscellaneous itemized deductions are not allowed; itemized deductions for state, local, and foreign real property, personal property, sales and income taxes are not allowed; deductions for interest on home equity loans are not allowed; and net operating losses generally cannot reduce the taxpayer’s AMTI by more than 90% of the AMTI.
The exemption amounts for taxable years beginning in 2017 are $84,500 for married couples filing jointly and surviving spouses and $54,300 for individuals. The exemption amount for a trust or estate is $24,100. For taxable years beginning in 2017, the exemption amounts are phased out by an amount equal to 25% of the amount by which the individual’s AMTI exceeds $160,900 (MFJ and surviving spouses) or $80,450 (MFS or an estate or trust), indexed for inflation.
Where an individual is subject to the AMT in a particular year, the amount of tax exceeding the regular tax liability of the taxpayer is allowed as a credit for any subsequent taxable year to the extent the taxpayer’s regular tax liability exceeds the tentative minimum tax liability for such year.
Conference committee agreement.
The individual AMT is retained, adopting the position of the Senate bill, and the conference agreement temporarily increases the exemption amount and the exemption phaseout amounts. However, the phaseout thresholds are significantly increased to $1,000,000 for married individuals filing a joint return and $500,000 for all other taxpayers (other than estates and trusts). The threshold amounts are indexed for inflation. As a result, fewer individuals will be subject to the individual AMT.
The corporate AMT is repealed, following the House bill. The provisions are effective for taxable years beginning after December 31, 2017.
Taxation of Business Income of Individuals, Trusts, and Estates: Deduction for Qualified Business Income
Present Law: Flowthrough taxation of partnerships and S corporations.
Partnerships are not subject to federal income tax. The exception is that a publicly traded partnership, whose ownership interests are traded on an established securities market or are readily tradeable on a secondary type market, is generally taxed as a corporation [IRC section 7704(a), (b)]. Corporate treatment is still avoided by a publicly traded partnership if it is predominately holding and managing “passive” assets whereby 90% or more of its gross income constitutes “qualifying income” for this purpose [IRC section 7704(c)(2)]. Individual items of taxable income or loss, as well as “bottom-line” income or loss under IRC section 702(a)(8), are passed through to partners based on a daily prorated portion of each such partner’s/member’s (for a limited liability company) share of such partnership items. Losses are deductible to the extent of a partner’s basis in the partnership interest, with an excess loss carried forward indefinitely in accordance with IRC section 704(d). Other limitations apply with respect to the current deductibility of losses [e.g., IRC sections 465 (at-risk rules), 469 (passive-activity loss rules), 163(d) (investment interest limitation)]. A partner’s tax basis, as adjusted, in a partnership interest generally equals the sum of: 1) the partner’s capital contributions to the partnership based on cost or “book” principles; 2) the partner’s distributive share of partnership income; plus 3) the partner’s share of partnership liabilities determined in accordance with Section 752; less: 1) the partner’s distributive share of losses and certain other nondeductible expenses; 2) any reduction in share of such partner’s liabilities which are treated as constructive distributions; and 3) any actual distributions to the partner.
The law permits partners to allocate items of income, gain, loss, deduction, and credit among the partners—i.e., special allocations—provided such allocations have substantial economic effect [IRC section 704(b)(2) and corresponding regulations]. An allocation has substantial economic effect to the extent that the partner receiving the allocation receives a corresponding economic benefit or cost, so that it affects such partner’s capital account, which is then used in determining the manner in which the assets of the partners are to be distributed in liquidation. There are, of course, other regulations regarding testing allocations, some of which require items of gain or loss to be allocated to certain partners [IRC sections 704(c), 743(b)].
When a partner sells a partnership interest to a third party, the transaction is generally treated by the transferor as a capital gain under IRC section 741. Ordinary income is realized, however, to the extent the amount is attributable to the selling partner’s distributive share of unrealized receivables and items subject to recapture [IRC section 751(a)].
The federal income taxation of S corporations and their shareholders resembles the taxation of partnerships and its partners. It was designed for such purpose when enacted into law in 1958. Over the years, the S corporation has been the subject of various ownership limitation reforms that have greatly expanded its use as a preferred business entity for privately owned companies. An S corporation may not have more than 100 shareholders and may issue only a single class of stock. Only individuals (other than nonresident aliens), certain tax-exempt organizations, and certain trusts and estates are permitted shareholders. As a pass-through entity, an S corporation’s items of income, deduction, loss, and credit generally pass through to its shareholders on a daily proportionate basis based on stock ownership, including shares of nonvoting stock. [Otherwise, an S corporation must only issue a single class of stock per IRC section 1361(b)(1)(D).] As with partners in a partnership, each S corporation’s shareholder reports taxable income or loss on his individual return based on the tax items reflected on Form K-1. Losses may be deducted to the extent of a shareholder’s stock basis, which is not adjusted for entity-level obligations as is required under IRC section 752 for partnerships. Any excess losses may be carried forward [IRC section 366(d)]. The at-risk rules, passive activity loss rules, and investment interest limitations also apply to shareholders in an S corporation. A shareholder’s stock basis is increased for capital contributions and the pass-through of income items reflected on Form K-1. Stock basis is further adjusted for distributions and losses.
S corporations that have converted from C corporation status are subject to a corporate level tax on their recognized built-in gains under IRC section 1374, subject to applicable rules and limitations, for the five succeeding years after the effective date of the conversion and an annual corporate level tax on excess passive investment income under section 1375, which requires that the S corporation have undistributed C year accumulated earnings and profits as well as “excess passive investment income” [IRC section 375(b)(1)].
A shareholder selling shares of S corporation stock to a third party generally will report any resulting gain or loss as capital gain or loss, based on the amount realized less the shareholder’s basis as adjusted through the date of closing. There is no “look-through” recharacterization rule under Subchapter S as there is in IRC section 751 for partnerships [Treasury Regulations section 1.1366-1(b)(1)].
Where a business is operated as a sole proprietorship, including a single member LLC, the items of income, loss, deduction or credit are reported by the owner on a Schedule C to Form 1040. Such income or loss may alternatively be shown on Schedule E (rental real estate and royalties) or Schedule F (farming income or loss). A single-member LLC is disregarded for federal income tax purposes unless its owner files an election on Form 8832 to be treated as a C corporation [Treasury Regulations section §301.7701-3(b)(1)(ii)]. The sale of the owner’s interest in the business is treated as the sale of each individual asset based on a fair market value allocation [see Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945)].
The Senate version, which was enacted into law, allows a noncorporate taxpayer a deduction for QBI for taxable years beginning after December 31, 2017, and sunsets after 10 taxable years.
Provisions for Owners of Pass-through Entities
Both the House and Senate bills prescribed lower tax rates for partnership income, but adopted different models—wholesale tax rate cuts (House) versus a more limited deduction in computing taxable income (Senate). The House bill provided a maximum 25% rate for qualifying pass-through business income. The Senate bill adopted a rule permitting a deduction for 23% percent of qualifying business income to arrive at a lower, variable individual rate (new IRC section 199A). It was easily seen that the tax deduction approach in the Senate version would generate far less tax savings for “passive” investors in qualified businesses conducted by a partnership, S corporation, or sole proprietor, than the House version. As mentioned above, Congress adopted the Senate version but lowered the deduction percentage to 20% of QBI subject to special limitations and applicable rules.
New IRC section 199A.
The Senate version, which was enacted into law, allows a noncorporate taxpayer a deduction for QBI for taxable years beginning after December 31, 2017, and sunsets after 10 taxable years. Under the new IRC section 199A, a taxpayer other than a corporation is entitled to deduct 1) the lesser of A) the combined QBI of the taxpayer or B) an amount equal to 20% of the excess, if any, of the taxable income of the taxpayer for the taxable year, in excess of the sum of any net capital gain, plus the aggregate amount of qualified cooperative dividends; plus 2) the lesser of A) 20% of the aggregate amount of qualified cooperative dividends or B) taxable income reduced by net capital gains, as defined by the law. The amount determined may not exceed taxable income as reduced by net capital gain and is subject to other applicable rules and limitations.
Combined QBI is defined in IRC section 199A(b) as an amount equal to the sum of the QBI amounts for each QBI plus 20% of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income of the taxpayer for the taxable year. The determination of the deductible amount for each QBI is the lesser of (1) 20% of the taxpayer’s QBI as to each such qualified trade or business, or (2) the greater of 50% of the W-2 wages with respect to each QBI or the sum of 25% of W-2 wages with respect to each QBI plus 2.5% of the unadjusted basis immediately after the acquisition of all qualified property. If the taxpayer’s taxable income is below a specified threshold amount, the deductible amount for each qualified trade or business is generally equal to 20% of the QBI for each qualified trade or business. Partners in partnerships and shareholders of an S corporation take into account their pro rata share of the tax items of each QBI generated by the pass-through entity.
Every partnership, S corporation, and sole proprietor-ship should immediately assess and project the various tax impacts of the TCJA on their federal and state tax liabilities.
The definition of qualified business income or loss set forth in the new IRC section 199A(c) includes, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss, to the extent such items are effectively connected with the conduct of a trade or business within the United States (within the meaning of IRC section 864(c), replacing nonresident or foreign corporation as defined terms) and are included or allowed in determining taxable income for the taxable year.
Items not taken into account in computing QBI income or loss include (but are not limited to) the following:
capital gains and losses
dividends or deemed dividends
interest income other than interest income allocable to the trade or business
certain items of foreign base company income, i.e., certain net gains from commodities transactions, foreign currency gains and income from notional principal contracts, as well as any item of deduction or loss properly allocable to such excluded items; see IRC sections 954 (c)(1)(D), (E) and (F).
In addition, QBI specifically does not include 1) reasonable compensation paid to the taxpayer by a QBI for services rendered with respect to the trade or business, 2) any guaranteed payment described in IRC Section 707(c) paid to a partner for services rendered to the trade or business, and 3) any payment described in IRC section 707(a) for services rendered to the trade or business, to the extent provided in regulations. For W-2 employee shareholders in an S corporation, for example, the compensation received by the employee shareholder, assuming such compensation meets the requirements for deductibility under IRC section 162, will not qualify for the 20% deduction. In the partnership area, distributions in the form of advances under the regulations to IRC section 731 will not be treated as compensation received by the partner for services.
Under the new IRC section 199A(d), a qualified trade or business means any trade or business other than: a specified service trade or business or a trade or business of performing services as an employee. A specified trade or business is one described in IRC section 1202(e)(3)(A), other than engineering or architecture—that is, any trade or business involving the performance of services in the fields of health, law, 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 one or more of its employees. A specified service trade or business also includes services relating to investing and investment management, trading or dealing in securities [as per IRC section 475(c)(2)] and partnership interests or commodities [as defined in IRC section 475(e)(2)]. There is a limited exception provided to the specified service trade or business limitation if the taxable income of any taxpayer is less than $50,000 ($100,000 in case of a joint return; see IRC section 199A(d)(3).
If the net amount of QBI from all qualified trades or business of a taxpayer represents a loss, such loss is permitted to be carried forward in accordance with the new IRC section 199A(c)(2), but the deduction allowed in a subsequent year is reduced (but not below zero) by 20% of any carryover qualified business loss.
Example. Taxpayer has QBI of $20x from qualified business A and QBI of ($50x) from qualified business B in 2018. Taxpayer has no QBI in 2018 and the QBI (loss) of ($30x) is carried over into 2019. In 2019, taxpayer has QBI of $20x from qualified business A and $50x of QBI from qualified business B. In determining the carryover loss deduction for 2019, the conference committee report states that the taxpayer can only reduce the QBI of $70x by only 20% (23% before final revision) of the ($30x) carryover qualified business loss.
Under the new IRC section 199A, as mentioned above, qualified business items must be effectively connected with the conduct of a trade or business within the United States [IRC section 864(c)]. Therefore, if a domestic partnership or S corporation has foreign source income, unless the regulations permit certain items to be deemed effectively connected with a U.S. trade or business, then such income (or loss) falls outside of the scope of IRC section 199A. It will be interesting to see if the applicable regulations will cross-reference the regulations under IRC section 864 or will adopt separate and new applicable rules and conventions.
Tentative deductible amount for a qualified trade or business.
As previously stated above, when computing taxable income under the new law, each qualified trade or business is allowed to deduct up to the lesser of: 1) 20% of the QBI with respect to such trade or business; or 2) the greater of 50% of the W-2 wages with respect to such qualified trade or business, or the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
There are modifications that may limit the amount of the IRC section 199A deduction [see IRC section 199A(b)(3)]. As a starting point, the law provides that the wage-offset limitation in IRC section 199A(b)(1)(B) (the “wage limitation amount”) does not apply for any taxpayer whose taxable income for the year does not exceed the “threshold amount.” The threshold amount for this purpose is defined in IRC section 199A(d)(2) as $157,500 ($315,000 in the case of a joint return), further subject to a cost of living adjustment. The wage limit phases in for a taxpayer with taxable income of $50,000–$100,000 in excess of the threshold amount (or $207,500–$415,000 for a joint return) as adjusted by a prescribed cost of living adjustment factor. If the wage limitation amount is less than 20% of the taxpayer’s QBI with respect to a particular qualified trade or business, the taxpayer’s deductible amount is 20% of QBI reduced by the same proportion of the difference between the 20% QBI and the wage limitation amount, as the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return). If the taxpayer’s taxable income is greater than the aggregate phasein amount, then the wage limitation amount determined under either the 50% wage amount or the 25% wage amount plus 2.5% adjusted basis computation in new IRC section 199A(b)(2)(B) is fully operative. Therefore, the wage base limitation may, in many instances, limit the amount allowable as a deduction under IRC section 199A, particularly with respect to high-income individuals or partners if the applicable trade or business is not labor intensive.