The New Business Pass-Through Deduction: Are You Eligible?

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1 January 18, 2018 The New Business Pass-Through Deduction: Are You Eligible? Signed into law on December 22, 2017, the tax reform act of 2017 (the Act) heralded the largest change to the United States tax law system since Among the changes individual owners of pass-through businesses (e.g., partnerships and S corporations) should note, the Act adds a new, complex deduction with respect to qualifying business income from passthrough businesses. Though details of this deduction must be fleshed out with guidance from Treasury and the IRS, what follows is a high-level overview of the new Section 199A deduction. Executive Summary In general, this complex new deduction is (a) 20% of the lesser of a taxpayer s qualified business income or taxable income (excluding net capital gain and cooperative dividends), plus (b) the lesser of 20% of cooperative dividends or taxable income (excluding net capital gain). The amount of the deduction may be modified based on any qualified REIT dividends and publicly-traded partnership income. If a taxpayer s income exceeds applicable income limits ($157,500 (single) or $315,000 (married) subject to phase-in), a limitation on the amount of the deduction applies based on the amount of W-2 wages paid by the qualifying business and on whether the business is a specified service business. For partnerships and S corporations, each partner/s shareholder takes his/her allocable share of each item of the partnership/s corporation qualified business income, deduction and expense and his/her allocable share of the partnership/s corporation W-2 wages (for purposes of applying the W-2 wages limitation). Eligible owners of pass-through entities with qualifying business income are entitled to the deduction whether or not the eligible owners itemize their deductions. The deduction is also allowed for beneficiaries of trusts and estates and certain agricultural or horticultural cooperatives. Example H and W file a joint return on which they report taxable income of $200,000 ($0 capital gains or REIT or cooperative dividends). H has a sole proprietorship qualified trade or business that is not a specified service business (qualified business A). H s qualified business income from

2 qualified business A is $150,000, 20% of which is $30,000. H and W s taxable income is below the $315,000 threshold amount for a joint return; therefore, the W-2 wages limitation does not apply to qualified business A. H s deductible amount for qualified business A is $30,000, the lesser of: (1) $30,000 (the combined qualified business income amount for the year determined below), or (2) $40,000 (20% of the taxable income ($200,000) over any net capital gain and qualified cooperative dividends ($0)). The combined qualified business income amount is $30,000, the sum of: (a) $30,000 (the deductible amount determined for the qualified business), plus (b) $0 (20% of the taxpayer s qualified REIT dividends and qualified publicly traded partnership income ($0)). The deductible amount for the qualified business is $30,000 (20% of the qualified business income ($150,000). No W-2 wages limitation applies. W has a sole proprietorship qualified trade or business that is not a specified service business (qualified business B). W s allocable share of qualified business income is a loss of $40,000, 20% of which is $8,000. As a loss, there is no Section 199A deduction amount for qualified business B, and W s $8,000 share of the qualified business B loss reduces H s and W s combined Section 199A deduction amount to $22,000 ($30,000 - $8,000). Analysis What is the deduction? Subject to certain trade and income limitations, the new Section 199A provides eligible taxpayers with a deduction equal to the sum of; (a) the lesser of: (1) the taxpayer s combined qualified business income amount for the year, or (2) 20% of the taxpayer s taxable income over any net capital gain and qualified cooperative dividends, (b) plus the lesser of:

3 (1) 20% of qualified cooperative dividends, or (2) taxable income reduced by net capital gain. Note: The 199A deduction amount cannot exceed the taxpayer s taxable income (reduced by net capital gain) for the tax year. What is the Combined Qualified Business Income Amount? The combined qualified business income amount is the sum of: (a) the sum of the deductible amounts determined for each qualified business carried on by the taxpayer for the year, plus (b) 20% of the taxpayer s qualified REIT dividends and qualified publicly traded partnership income for the year. What is the Deductible Amount for each Qualified Business? The deductible amount for each qualified business is the lesser of: (a) 20% of the taxpayer's qualified business income with respect to each qualified business, or (b) for taxpayers whose taxable income exceeds applicable thresholds, the greater of: (1) 50% of the W-2 wages with respect to the qualified business, or (2) the sum of 25% of such W-2 wages, plus 2.5% of the unadjusted basis of all qualified property used in the qualified business. The W-2 wages limitation is phased-in if the taxpayer s taxable income is between $157,500 and $207,500 (single) or between $315,000 and $415,000 (married) (based on how much taxable income exceeds the applicable phase-in floor amount). If the taxpayer s taxable income exceeds the applicable phase-in ceiling amount, then the W-2 wages limitation fully applies to the taxpayer. W-2 wages are total wages paid and properly reported in payroll returns filed with the Social Security Administration that are allocable to the qualified business during the year and properly included as a business expense deduction in determining qualified business income of the qualified business.

4 What is qualified property? Qualified property is tangible property subject to depreciation held and used to produce qualified business income at the end of the tax year, and for which the 199A depreciable period has not ended by the end of the tax year. The 199A depreciable period begins on the date the property is first placed in service by the taxpayer and ends on the on the latter of (1) the 10-year anniversary of the placed in service date, or (2) the last date of the last full year of the of the property s recovery period under IRC Section 168 (without regard to Section 168(g)). This nuance is significant for real estate owners and owners of capital intensive companies. What is a Qualified Business and what is Qualified Business Income? Qualified business income is the net amount of all domestic United States (and, in certain cases, Puerto Rico) business income, gain, deduction, expenses and loss for each qualified business for the year, excluding qualified REIT or cooperative dividends, or qualified public traded partnership income. Qualified business income also does not include dividends, investment interest income, capital gains and losses, currency gains and the like (other than such gains or losses with respect to stock, currency or other investments held for sale to customers in the ordinary course of business). Qualified business income is determined annually for each qualified trade or business of the owner and is based on items of income, deduction and expense to the extent such items are included or allowed in determining taxable income for such year. In addition, qualified business income does not include compensation paid to the taxpayer, or guaranteed payments paid to the taxpayer, for services rendered to the qualified business. If the net amount of qualified business income for a year is a loss, the net loss is carried forward to reduce net qualified business income determined for the next year. Qualified business income is subject to a phased-in limitation for certain specified service businesses (discussed below). A qualified business is any business other the business of being an employee or specified service businesses. What are Specified Service Businesses? Specified service businesses include most service providers such as doctors, dentists, accountants, financial and investment consultants and brokerage service providers, attorneys, artists, athletes and any business where the principal asset is the reputation or skill of one or more employees (architects and engineers are excluded). A specified service business, however, will still qualify as a qualified business if the taxpayer s taxable income is less than the applicable income floor amount for the W-2 wages limitation noted above ($157,500 (single) or $315,000 (married)), subject to application of a percentage

5 phase-in (applicable percentage) of the limitation for income above the applicable income floor amount but below the applicable income ceiling amount. Where the taxpayer s income from a specified service business exceeds the applicable income ceiling amount ($207,500 (single) or $415,000 (married)), the 199A deduction will not be available with respect to such specified service business income. How does the determination of qualified business income apply to pass-through entities? The deduction is taken by individual owners of businesses organized as one of the following: sole proprietorships, S corporations, and partnerships (including LLCs, LLPs, etc., that are taxed as a partnership). For partnerships and S corporations, each partner/s shareholder takes their allocable share of each item of the partnership/s corporation qualified business income, deduction, expense, and their allocable share of the partnership/s corporation W-2 wages (for purposes of applying the W-2 wages limitation). Eligible owners of pass-through entities with qualifying business income are entitled to the deduction whether or not the eligible owners itemize their deductions. The deduction is also allowed for beneficiaries of trusts and estates and certain agricultural or horticultural cooperatives, and individual taxpayers with qualifying REIT or cooperative dividends and publicly traded partnership income for the year. The deduction is available for taxable years beginning January 1, 2018 and expires after December 31, While the technical aspects of the deduction are complicated and will be fleshed out over time, the following example highlights some of the principle characteristics of the new deduction and its potential value to eligible taxpayers. Example 1: S corporation (Dentist) Dr. Dentist is the sole owner of Dentistry Corp., an S-corporation, and is married filing jointly. Dr. Dentist s spouse (Spouse) is a partner in a qualified business that is not a specified service business and Spouse s allocable share of that qualified business income is $220,000, and Spouse s allocable share of wages from that qualified business is $80,000. Dr. Dentist is paid $200,000 in salary (W-2 wages), pays multiple hygienists and billing staff W-2 wages, and, after all expenses are paid, Dentistry Corp. has allocable business income of $100,000. As a pass-through entity, Dentistry Corp. has no tax liability, but instead passes through the net income to Dr. Dentist, the sole shareholder of the company. Dr. Dentist s and Spouse s joint income is $520,000 (with $0 capital gain or REIT or cooperative dividends), which exceeds the income ceiling amount for married couples filing jointly. Therefore, the W-2 wages limitation applies and is fully phased-in. Dr. Dentist s $100,000 allocable business income from Dentistry Corp. does not qualify as qualified

6 business income and does not qualify for a 199A deduction. Similarly, Dr. Dentist s $200,000 of salary W-2 wages from Dentistry Corp. are not qualified business income. Spouse s allocable share of qualified business income is $220,000 and Spouse s allocable share of W-2 wages from the qualified business is $80,000. The unadjusted basis of all qualified property used in such qualified business is $1,000,000. The 199A deduction for Spouse s qualified business income is $40,000, which is the sum of: (a) the lesser of: (1) $40,000 (the combined qualified business income amount for the year determined below), or (2) $104,000 (20% of the taxable income ($520,000) over any net capital gain and qualified cooperative dividends ($0)); plus (b) the lesser of: (1) $0 (20% of qualified cooperative dividends ($0)), or (2) $520,000 (taxable income ($520,000) reduced by net capital gain ($0)). The combined qualified business income amount is $40,000, the sum of: (a) $40,000 (the sum of the deductible amount determined for the qualified business), plus (b) $0 (20% of the taxpayer s qualified REIT dividends and qualified publicly traded partnership income ($0)). The deductible amount for the qualified business is $40,000, as the lesser of: (a) $44,000 (20% of the qualified business income ($220,000), or (b) because the W-2 wages limit applies in full, the greater of: (1) $40,000 (50% of the W-2 wages with respect to the qualified business ($80,000)), or (2) $75,000 (the sum of 25% of such W-2 wages ($50,000), plus 2.5% of the unadjusted basis of all qualified property used in the qualified business ($25,000 = 2.5% x $1,000,000)).

7 Example 2: Partnership (Software Company) A technology company, Paytech, LLC, licenses payroll software to a variety of companies. Paytech, LLC, taxed as a partnership, is owned by Sally and Mary, each of whom perform services for the company but take no guaranteed payment and no salary compensation, and each are single tax filers. The principal asset owned by the company is the intellectual property associated with the software, and Paytech provides virtually no ongoing technical support to its licensees. Further, Paytech, LLC has no employees and no qualified property. In 2018, Paytech, LLC earns $1,000,000 of qualified business income, allocated half to Sally and half to Mary. Sally and Mary have no other dividends, capital gains or other income for the year aside from their shares of the qualified business income. This case highlights a couple of points. First, do Sally and Mary get to take the 199A deduction on the full $1,000,000? Under the statute, the deduction applies only to qualified business income, and guaranteed payments, as well as reasonable compensation paid, is excluded from this class of income. Here, Sally and Mary do not have guaranteed payments or salary but do provide services to the company. One could argue that a certain amount of distributed profits should be characterized as reasonable compensation paid to the owners of the company, reducing the amount of qualified business income. Assuming the above argument is correct, Sally and Mary should determine what portion of their respective receipts of the profits distributed by Paytech, LLC would be reasonable compensation for running Paytech, LLC. Suppose this reasonable compensation amount is equal to $100,000 each because that is the prevailing wage in the industry for comparable services. Then, the qualified business income would be $800,000 allocated equally to Sally and Mary. Next, as single filers, Sally and Mary are both over the phase out and threshold limits described above. In this case, Sally and Mary qualify for the deduction because they are not among the specified service professionals, and the principal asset of the business is the intellectual property, not Sally or Mary s skill. However, the deduction would be equal to $0 because the income limitations require Sally and Mary to calculate the deduction based on the formula tied to W-2 wages paid by Paytech, LLC. In this scenario, Paytech, LLC has no employees, so it pays no W-2 wages. Thus, the W-2 wages limitation on the deduction will be equal to $0. Now assume, however, Paytech LLC does own and use machines and qualified property with an unadjusted basis of $500,000 in its business. In such case, Sally and Mary could take a deduction equal to 2.5% of the unadjusted basis in the machines and other qualified property used in the qualified business, or $12,500. Consider a slight variation on the example above. Paytech, LLC, in addition to licensing the payroll software, provides significant amounts of training and technical support through the life of the license to the point that the skill of Sally and Mary as technology experts is the principal asset of the company. In that case, Paytech,

8 LLC would be a service provider and, because Sally s and Mary s income exceeds the applicable income thresholds, the deduction would fully phase out just as it does for the specified service professionals. Thus, Sally and Mary would not be eligible for a 199A deduction on their income earned through Paytech, LLC. Going Forward The examples above are intended to highlight the principles of the new Section 199A deduction. Various subtleties, including benefits applicable to REITs, Co-Ops, and others, are beyond the scope of this introduction to the new pass-through business deduction. As illustrated in these examples, the deduction is complex, designed with a lot of nuance, and subject to many unresolved issues. Each particular situation requires a fact-intensive discussion and analysis to determine the benefit, if any, the new deduction provides. Contact a member of the tax team to discuss this new Section 199A deduction. Contacts David S. Lionberger dlionberger@hf-law.com Joshua D. Kelly jkelly@hf-law.com James W.C. Canup jcanup@hf-law.com Steven Skaist sskaist@hf-law.com J. Kevin Muldowney kmuldowney@hf-law.com Attorney advertising materials. These materials have been prepared for informational purposes only and are not legal advice. This information is not intended to create an attorney-client or similar relationship. Please do not send us confidential information. Past successes cannot be an assurance of future success. Whether you need legal services and which lawyer you select are important decisions that should not be based solely upon these materials. Contact: James L. Weinberg, President,, The Edgeworth Building, 2100 East Cary Street, Richmond, Virginia 23223,