The mammoth GOP tax reform of 2017 impacted taxpayers in many, many different ways. The bill itself was so big and complex that many elements of it weren’t particularly clear or even defined for months after the bill passed. In some cases, different rules and regulations were delayed by a year because the job of sorting all this out has become a Herculean task.
Understanding The New Section 199A Tax Rules
Fortunately, there is finally some clarity in the realm of business pass-through deduction, a rule known as Section 199A. If you’re new to the bookkeeping and accounting side of running a business, then here’s the basic idea: a pass-through business is one that is registered as either:
- Sole proprietorship
- S corporation
- Limited liability company
- Limited liability partnership
The majority of small businesses fall under this umbrella. The pass-through deduction was created as part of the 2017 tax overhaul in order to let small businesses receive some of the benefits handed out to large C corporations, including the biggest benefit of a flat 21% corporate tax rate.
Now, how does all of it work? In theory, it’s pretty simple — there’s a limit, and if you qualify under the limit, you can deduct 20% of business income. The reality is much more refined than that, and that is why the IRS had to post new regulations regarding this.
Here are the basic rules for the pass-through deduction if you own a business registered as above and if your personal taxable income is less than $315,000, you can deduct up to 20% of your business income. If your personal taxable income is above that, you will need to talk to your tax advisor, as the deduction phases out.
Sounds simple, right? Unfortunately, when you get into the finer rules and regulations, it becomes much messier.
184 Pages Of Official Explanation
On August 8, 2018, the IRS released their official explanation of the rules and regulations of the pass-through deduction. For those hoping for something simple, the 184 pages of legalese made it clear that this wasn’t going to be a beach read.
What’s involved? A lot, obviously. And most importantly right now, know that these rules aren’t set in stone — they are a proposal and the IRS is asking for feedback from stakeholders. But to get a basic understanding of it, you don’t need to be a certified CPA. Here’s the basic rundown:
Sec 199A by definition only applies to “trade or business” entities. So what does that mean exactly? That definition is a major point involved with the IRS’ proposed regulations. Because the tax code doesn’t give clear and decisive definitions — in fact, it falls back on previously established precedent, which is a messy and time-consuming endeavor — there is wiggle room. However, the new regulations as they stand (remember, these are proposals will evolve over time) finds 100% passive rental real estate activities qualify as “trade or business” and will benefit from Section 199A.
Once the “trade or business” qualification has been identified, then the next step is to examine how the numbers crunch. Married or single status creates the usual divisions, in this case $315,000 or $157,500 as stated above. Keep in mind that the limit used is for all taxable income, not just a single business. If you only own and operate one business, then this calculation is fairly straightforward — just itemize all your deductions, hit the Enter button, and see if the number is above or below the line.
However, when you add in multiple revenue streams, it becomes a little more nitpicky. Remember that the taxable income must be below $315,000/$157,500 — it can be from a combination of your LLC, your spouse’s W2, and passive rental income. If the cumulative number is below that line, then anything in your qualified business income (QBI) can be deducted by another 20%. Please note that this does not change your adjusted gross income or your self-employment tax.
That’s the simplest way to calculate Sec 199S. But what about when things go above that line? As mentioned, taxable income between $315,000-415,000 (married) or $157,500-207,500 (single) still receives some Sec 199A benefits — it’s just at a phased level. Calculating that phasing, though, is a task in itself.
The limitations in this range are a several different moving parts based on these variables:
1) Is your business a Specified Service Trade or Business (SSTB)?
2) How much did your business pay in W2 wages?
3) What is the unadjusted basis (UBIA) of property used by the business?
For #1, the trick is to look at the agreed-upon list of SSTBs as defined by the IRS. Some of the most common businesses falling under this definition include doctors/dentists/veterinarians, law offices, performing artists, any type of consultation, financial and accounting services, and brokerage services. The list has more business types besides this, and the best thing to do is to contact your accounting professional about this.
For #2 and #3, there is a formula: the Section 199A deduction is the lesser of 20% of QBI or a calculated value known as the Wage Limit. The Wage Limit is the greater of:
- 50% of paid W2 wages
- 25% of paid W2 wages + 2.5% of UBIA
Thus, for any business that fits in that range, there’s a little bit of math that has to come into play. To ensure that the proper deduction is calculated, you’ll need absolute accuracy in your records; one wrong record and it could make a huge difference in whether you’re able to deduct Section 199A or not.
Also, if your taxable income is above the $415,000/$207,500 threshold, sorry but you’re out of luck: the deduction is lost completely and you will have to pay taxes using your individual tax rate.
Other Variables For Section 199A Deductions
It’s clear that calculating Section 199A deductions isn’t straightforward. The other variables to consider are whether or not your have partners or S-Corp shareholders in your business entity. Remember, the ability to calculate deduction is based solely on an individual or household tax filing. Thus, you can’t assume that all partners or shareholders will receive the same Section 199A deduction. Two households with completely different taxable incomes but the exact same split in partnerships can experience their own unique deductions.
For example, let’s say two partners get an equal split of QBI at $150,000. Partner A is single and that’s her only job. Partner B is married and has a spouse who earns $200,000, and they have $15,000 in passive real estate income.
For Partner A, her calculation is simple — she gets a straight deduction of 20%. For Partner B, though, he will have to go through Wage Limit calculation to see what his family’s ultimate deduction is.
Get Passthrough Deduction Help In San Rafael
Are you still confused even after reading all that? Don’t feel bad — you’re not alone. It’s complicated stuff, and even a seasoned accounting professional needs time to grasp the new rules. For Marin County residents, we invite you to schedule a free consultation at our San Rafael office. Fear not, pass-through deductions are not easy, but we’ll get you through it!