Tax Reform Provides New Tax Benefits to Unincorporated Businesses
On December 22, 2017, President Trump signed into law tax reform legislation (the “Act”)
The Act adds new Section 199A to the Internal Revenue Code of 1986, as amended (the “Code”). Code Section 199A allows individual taxpayers
Qualified Trade or Business
The 199A Deduction may enable individuals to reduce taxes owed on profits derived from a qualified trade or business. In determining whether an individual has a qualified trade or business, the first step is to determine whether the individual’s activities constitute a trade or business under general tax principles. If the taxpayer’s activities do not constitute a trade or business (e.g., investment activity), the 199A Deduction is not available.
The next step is to determine whether the taxpayer’s trade or business is a qualified trade or business for purposes of Code Section 199A. A qualified trade or business is broadly defined as any trade or business other than a specified service trade or business (the “Service Business Exclusion”) or the trade or business of performing services as an employee. A specified service trade or business includes (i) 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, and (ii) service businesses involving investing and investment management, trading, or dealing in securities, partnership interests, or commodities. It is unclear what types of trades or businesses would be treated as those in which the principal asset is the reputation or skill of one or more of its employees.
Qualified Business Income
The 199A Deduction lowers the effective tax rate applicable to qualified business income. The term qualified business income means the net amount of qualified items of income, gain, deduction or loss with respect to a qualified trade or business. An item of income, gain, deduction or loss is a qualified item only if the item (i) would be effectively connected with a U.S. trade or business within the meaning of Code Section 864(c) if it were derived by a non-U.S. person,
Qualified Business Losses
Net loss from one qualified trade or business will reduce the 199A Deduction available to offset net income of a different, profitable qualified trade or business. If the net amount of all qualified items of income, gain, deduction and loss from all of the taxpayer’s qualified trades or business results in an overall loss for the taxable year, the loss is carried forward to the succeeding taxable year and will reduce the 199A Deduction available for that year.
An individual’s 199A Deduction is limited to the greater of (i) 50% of taxpayer’s allocable share of the W-2 wages paid in respect of such qualified trade or business or (ii) the sum of 25% of taxpayer’s allocable share of the W-2 wages paid in respect of such qualified trade or business plus 2.5% of the unadjusted basis immediately after acquisition of qualified property used in such qualified trade or business (the “199A Limitation”).
W-2 wages includes wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment during the taxable year. Importantly, the Internal Revenue Service has long held the position that remuneration received by partner from a partnership is not wages with respect to employment.
Qualified property means tangible property subject to depreciation under Code Section 167 that is held by, and available for use in, in a qualified trade or business at the close of the taxable year, is used in the production of qualified business income, and the depreciable period for which has not ended before the close of the taxable year.
Certain Exceptions Based on Income
Taxpayers subject to the Service Business Exclusion generally are not entitled to the 199A Deduction to reduce their tax liabilities on income derived from their specified service trade or business. However, the Service Business Exclusion does not apply to taxpayers with taxable income for the year from all sources below $157,500 (or $315,000 in the case of a joint return). Taxpayers with taxable income below this threshold can fully utilize the 199A Deduction. The amount of the 199A Deduction is phased out as taxable income increases above the threshold, with the Service Business Exclusion fully eliminating the 199A Deduction for taxpayers with taxable income in excess of $207,500 (or $415,000 in the case of a joint return).
Likewise, the 199A Limitation does not apply to taxpayers with taxable income of less than $157,500 (or $315,000 in the case of a joint return). The income exception to the 199A Limitation allows individuals with income below the specified threshold to fully utilize the 199A Deduction. Similar to the income exception to the Service Business Exclusion, the 199A Limitation is phased in as taxable income increases above the threshold with the 199A Limitation being fully applicable to individuals with taxable income in excess of $207,500 (or $415,000 in the case of a joint return).
The maximum amount of the 199A Deduction for any taxable year cannot exceed an individual’s taxable income (less net capital gain) for the year.