Introduction. The Tax Cuts and Jobs Act of 2017 (the “Act”) added Section 199A to the Internal Revenue Code (the “Code”). Section 199A provides a deduction that reduces the effective tax rate on qualified business income (“QBI”) for owners of businesses taxed as sole proprietorships, partnerships, limited partnerships, limited liability companies, S corporations and similar pass-through entities (each hereinafter, a “pass-through entity”). However, as described below, there are significant limitations placed on the deduction for a “specified service trade or business” (“SSTB”), and these limitations can affect not only the SSTB, but related parties as well.
Qualified Businesses and QBI. Most businesses owned and operated by a pass-through entity within the United States, including real estate rental and investment activities, will be a “qualified trade or business,” and be entitled to a deduction on QBI (as explained below, SSTBs are an exception). QBI is defined as the net amount of items of income, gain, deduction and loss attributable to each qualified business conducted by a sole proprietor or pass-through entity, with certain exclusions for compensation and payments to owners, and certain specified investment-related items.
Allowable QBI Deduction. An owner or investor in a qualified business may deduct up to 20% of QBI, subject to the following limitation: the QBI deduction may not exceed the greater of: (i) 50% of W-2 wages paid to employees of the qualified business during the taxable year, or (ii) the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis (usually the original acquisition cost) of qualified property. “Qualified property” means tangible, depreciable property, including tangible property and real property improvements, used in the qualified business for the production of income, and for which the depreciable period has not ended before the close of the tax year.
The Threshold Amount. The W-2 wage limitation, above, does not apply unless an owner’s taxable income exceeds $157,500, or $315,000 for joint filers (the “Threshold Amount”) (note: these amounts are adjusted for inflation, and, for 2020, are $163,300 and 326,600). The full 20% QBI deduction is allowed for owners with taxable incomes under the Threshold Amount, and the W-2 wage limitation is phased in for taxable income over the Threshold Amount until taxable incomes exceed the Threshold Amount by $50,000 for individuals and $100,000 couples.
Specified Service Trades and Businesses. SSTBs are specifically excluded from the definition of “qualified trade or business.” SSTBs include any trade or business in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services and any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architectural services are expressly excluded from the definition of SSTB. Owners of SSTBs with taxable income below the Threshold Amount are eligible for the full 20% QBI deduction. However, once such owners reach the Threshold Amount, the QBI deduction is phased out, and eliminated altogether for owners exceeding the Threshold Amount by $50,000 for individuals and $100,000 for couples.
Related Parties and SSTBs. The regulations under Section 199A (Section 1.199A-5(c)(2)) provide that, if an otherwise qualified business is providing services to an SSTB, and there is 50% or more common ownership between the business and the SSTB, then the portion of the business consisting of providing services to the SSBT will itself be considered a separate SSTB. The attribution rules apply—i.e., an individual is attributed the ownership of lineal descendants and siblings, and entities are attributed the ownership of related entities as defined in Sections 267(b) and 707(b).
Example. Taxpayer owns B LLC that, through its employees, provides information technology services to other businesses. B LLC is a qualified business under Section 199A. 40% of B LLC’s business consists of providing IT services to S PC, a law firm owned by Taxpayer’s sister. S PC is an SSTB under Section 199A. Taxpayer has taxable income of $250,000.
Because S PC is owned by Taxpayer’s sister, Taxpayer is attributed his sister’s ownership and treated as though Taxpayer owns S PC as well as B LLC. Since S PC is an SSTB, and Taxpayer is treated as owning both B LLC and S PC, the 40% of B LLC’s business that consists of providing services to S PC is also treated as an SSTB. Because Taxpayer’s taxable income exceeds the Threshold Amount ($163,300) plus the phase out amount ($50,000), 40% of B LLC’s income will not be eligible for the Section 199A deduction. The other 60% will be eligible for the Section 199A deduction (assuming no other services are provided to related SSTBs) subject to the W-2 wage limitation described above.
Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.