On December 22, 2017, President Trump signed into law tax reform legislation (the “Act”) formerly known as the Tax Cuts and Jobs Act. In addition to lowering the federal corporate income tax rate, the Act lowers the effective tax rate on certain income earned by individuals indirectly through pass-through entities (such as partnerships and S corporations) and directly through sole proprietorships. This reduces the difference between the income tax rates applicable to business income earned by corporate and non-corporate businesses, mitigating the tax incentive to operate in one form of business over the other.
The Act adds new Section 199A to the Internal Revenue Code of 1986, as amended (the “Code”). Code Section 199A allows individual taxpayers to deduct up to 20% of the qualified business income derived from a qualified trade or business (the “199A Deduction”) through 2025. The 199A Deduction also allows individuals to deduct 20% of their aggregate REIT dividends, qualified cooperative dividends, qualified publicly traded partnership income and certain other income.
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. The language referring to an employee’s reputation may be interpreted broadly and exclude activities that the 199A Deduction was otherwise intended to benefit.
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, (ii) is not specifically excluded as an ineligible investment item, such as dividends, interest, and capital gains, and (iii) is not reasonable compensation paid by an S corporation, a payment from a partnership to a partner described in Code Section 707(a) or a guaranteed payment described in Code Section 707(c).
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”). The capital component of the 199A Limitation was added in the final version of the Act while prior versions determined the 199A Limitation based solely on W-2 wages to encourage employment. The addition of the capital component benefits capital intensive businesses with few employees and encourages capital investment.
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. As a result, amounts paid to employee-partners will not constitute W-2 wages. Moreover, amounts distributed on profits interests issued as incentive compensation do not constitute W-2 wages and do not increase the 199A Limitation. The foregoing implications of the W-2 wage component of the 199A Limitation may encourage businesses to avoid profits interests and utilize phantom equity. Furthermore, taxpayers may more carefully consider existing legal authorities addressing the issue of whether partner-employees can be a W-2 recipient.
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. Because the 199A Limitation is determined by reference to the unadjusted tax basis of qualified property, the amount of the 199A Deduction each year that is attributable to capital will not change on account of depreciation, including bonus depreciation.
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.
 The Act is titled “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”
 Note, however, that the new corporate income tax rate of 21% is significantly lower than the top individual tax rate of 29.6% (assuming the 199A Deduction is fully utilized) applicable income earned through a non-corporate business such as a partnership. In situations where corporate profits are expected to be reinvested for long periods without the payment of dividends, the deferral of the second level of tax may cause the corporate form to be advantageous.
 Trusts and estates may also claim the deduction.
 Perhaps the “Bluebook” to be prepared by the staff of the Joint Committee on Taxation in 2018 will provide more insight on the issue.
 The 199A Deduction does not reduce the effective tax rate on foreign-source income.
 Qualified business income does not include investment-type income such as capital gains and losses, dividends and dividend equivalents, interest that is not attributable to the trade or business, foreign currency gains and losses, items from notional principal contracts, or gains and losses from commodities transactions.
 Note that the 199A Limitation does not apply to the 199A Deduction for REIT dividends and qualified publicly-traded partnership income.
 See Rev. Rul. 69-184, 1969-1 C.B. 256.
 The depreciable period for qualified property is the longer of (i) ten years, or (ii) the applicable recovery period specified for such property under Code Section 168.