One of the most highly touted aspects of tax reform is the cutting of the corporate tax rate from a maximum rate of 35% to a flat rate of 21%. Many corporations showed their gratitude for the tax cut by paying out bonuses to their employees or promising to boost the economy in other ways.
But what about businesses that aren’t organized as corporations? For many years, taxpayers had been incentivized to set up businesses as “pass-through” entities, such as sole proprietorships, partnerships and subchapter S corporations (small corporations that meet certain requirements). Why? Because this pass-through income is not taxed at the entity level. Rather, it is taxed at the individual level where tax rates may have been lower in the past.
Although the Tax Cuts and Jobs Act (TCJA) did cut individual tax rates, the cut was not nearly as drastic as the corporate tax rate cut. However, the TCJA did introduce IRC Section 199A to help bring parity between the tax rates of corporations and income from pass-through entities.
What is IRC Section 199A?
In its most simplified form, IRC Section 199A provides for a qualified business income deduction (QBID) of up to 20% of qualified business income, applied at the individual level. For example, this means a taxpayer with $100,000 of pass-through business or sole proprietorship income would receive a deduction of $20,000 against that income. Essentially, their tax rate on that income would be 80% of what it otherwise would have been (e.g.,, maximum rate of 37% would now be only 29.6%). If you have multiple businesses, the QBID is calculated on a business-by-business basis.
Note that rental real estate is generally considered a business for purposes of the new qualified business income deduction.
If a qualified business generates a loss in one year, the loss will carry forward and will offset the qualified business income in the following year for purposes of this deduction.
What is the Impact on High-Income Taxpayers?
For high income taxpayers, being able to claim the QBID comes with a few more hoops to jump through. In this case, high income is taxable income over $315,000 for married taxpayers filing jointly ($157,500 for single taxpayers).
At these income levels, the potential QBID of 20% begins to phase out and may be limited to the greater of 50% of allocated business wages or 25% of allocated business wages plus 2.5% of allocated unadjusted cost of tangible depreciable property. This is an important test for taxpayers in pass-through real estate entities that often don’t pay wages.
In addition, high income taxpayers whose businesses are classified as a specified service business (consultants, doctors, dentists, attorneys, accountants, financial services, etc.) may be subject to a complete phase-out of their potential QBID. This phase-out begins at taxable income over $315,000 for married taxpayers filing jointly ($157,500 for single taxpayers), and potential QBID becomes fully phased out when taxable income is over $415,000 for married taxpayers filing jointly ($207,500 for single taxpayers). This hurdle is intended to keep taxpayers from running their wage income through pass-through entities in an attempt to get a reduced tax rate.
Guidance Is Still Needed
With new tax law comes new rules and new exceptions to the rules. It is important to note that IRC Section 199A brings about many new terms that haven’t been precisely defined by tax law yet. Also, there has not been enough guidance on complex pass-through structures and how the QBID will apply to them. The IRS has acknowledged that addressing this area of tax reform is on the top of their list.
Need More Information?
As more guidance is released, we at Clark Nuber will do our best to keep you informed. For now, we’re happy to walk through different scenarios and planning given our current understanding. This article should not be construed as tax advice. Before making any decision that may affect you or your organization, consult a qualified tax advisor or contact Clark Nuber. Be sure to visit our dedicated Tax Reform Information and Resources web page for other TCJA articles and blog posts.
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