The Tax Cuts & Jobs Act passed by Congress and signed into law by President Trump in December provides a new deduction for businesses that pass through income to owners, but professionals say the new rules are confusing and they are unsure which clients will actually benefit.
The law created a new provision in the tax code, the Qualified Business Income Deduction described in section 199A, that allows some taxpayers to deduct 20 percent of income they receive from businesses that pass through net income to owners, who pay taxes on that income at their individual rates. Those businesses can include partnerships, LLCs, subchapter S corporations and sole proprietorships.
A tax professional--and a very good one--is key when calculating this new and complicated deduction. “At every step of the calculation are places where a CPA needs to understand the definitions, the types of inputs and the planning aspects of how to best maximize the deduction,” said Christopher Wittich, CPA, senior manager with Boyum & Barenscheer, Bloomington, Minn.
“Many articles market this as a 20 percent deduction. There are a few tests in the law that may make the computation a lesser amount,” said Patrick Daly, CPA and partner at Citrin Cooperman in New York and member of the Manhattan/Bronx chapter of the New York State Society of CPAs.
The deduction is limited to the lesser of 20 percent of qualified business income or 50 percent of the total W-2 wages paid by the business. The 50 percent limitation does not apply if the total taxable annual income of the business owner is less than $315,000 for a married filer, $157,500 for a single filer.
“There are several limitations on the deduction involving wages paid and/or assets owned by the business, and there are income limits below which some of these limitations do not apply,” added Mike Crabtree, CPA and partner at the Minneapolis accounting firm Boulay. He maintains that one major complication is that the deduction does not apply to “reasonable compensation paid to the taxpayer” for services rendered with respect to the business. Tax authorities may question a taxpayer on what portion of income is for their own services and how much is business profit.
“Also, certain types of businesses such as doctors, lawyers, CPAs, consultants and brokers are generally excluded from the deduction unless the taxpayer’s income is below certain thresholds--but the ‘reasonable compensation’ rule still may apply,” Crabtree said.
Among other underlying and still-unclear issues, the new law contains a catchall provision that may disqualify businesses with one, two or three key individuals, Daly said. The law also reads “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 or owners” will not qualify for the deduction. Most tax experts decline to even speculate on what kinds of businesses might fit this classification. Until the IRS releases guidance--and as yet, the agency hasn’t said when that will be--this clause remains one of the most unclear in the new law.
How will the 199A deduction apply to real estate rental activities? “It seems like there was an intent to include real estate rentals as eligible for the 20 percent deduction,” Crabtree said, “but since there’s no definition of ‘trade or business’ … there’s been some debate as to whether some or all real estate rental activities will be eligible.”
Most tax experts advise waiting for forthcoming IRS guidance before setting plans regarding tax treatment of pass-through income. Meanwhile, Daly recommends these questions and strategies for high-net-worth individuals: