Six clarifications regarding the 20% deduction for passthrough businesses
The new tax law enacted in December of 2017 included many noteworthy provisions. In some cases, the law generated more questions than answers about how taxes would look in 2018 and beyond. One provision that couldn’t be fully understood without significant guidance from the IRS was the 20 percent deduction for passthrough businesses, or “Section 199A.”
Congress created Section 199A so that owners of these entities could deduct a piece of their business income “off the top” before calculating their personal tax. That sounds simple enough in theory, but in order to give businesses a break without creating a wealth of opportunities for tax avoidance, certain limitations and special circumstances needed to be addressed.
Clarifying How Section 199A Will Work in Practice
The IRS recently released several pieces of Section 199A guidance designed to clarify how the law would apply in practice.
- Operational rules: This section takes Congress’ legislative language and begins to translate it into instructions on a tax form. It covers the nuts and bolts of how the provision works when there are no special circumstances to address. For instance, many taxpayers will fall within the income limits ($315,000 for joint returns or $157,500 for other filers) that allow them to take the full 20 percent deduction from their passthrough income. Those folks may have a relatively uncomplicated calculation to determine their deduction.
- Limits based on wages paid: In some situations, the deduction may be limited based on a percentage of the wages a passthrough business pays to employees. The guidance includes 3 possible methods for calculating this limitation.
- Limits calculated from basis in acquired property: The regs offer guidance on limitations based on an owner’s basis in different types of property. Given the variety of property types and special circumstances based on the timing of property transactions during the year, the calculation of the deduction limitation gets very complicated if this section applies.
- What constitutes "business income?" If the only passthrough businesses these rules had to cover were grocery stores owned by Mom and Pop as partners, it would be pretty easy to determine what M & P’s business income was. However, passthroughs can be created to invest in other passthroughs and they can have a wide variety of income types that may or may not look like income from a business. In addition, some types of income might be business income for some businesses but not for others. For instance, income from real estate holdings could be business income to a real estate partnership, but not to a grocery store that owns its building and rents space to tenants.
- Aggregating business income for owners of multiple passthroughs: Many taxpayers own interests in multiple passthrough entities. The rules allow taxpayers to aggregate multiple entities for purposes of applying the wage and property limitations.
- Provisions aimed at keeping businesses from turning employees into small businesses: Congress intended for Section 199A to deliver tax relief to passthrough entities that would be comparable to the tax rate relief it enacted for corporations. It was not their intent to encourage every employer and employee to recharacterize their relationship as contractor and contractee in order to game the system. The guidance includes rules aimed at limiting the ability of businesses to make such a change.
The recent Section 199A guidance covers a lot of ground when it comes to answering questions raised by the 2017 law. But much of what the IRS has released is “proposed” guidance, meaning that it’s not the last word on the topic. and the Service expects to hear from tax professionals and taxpayers about questions the guidance didn’t answer as well as new questions that have arisen as a result of the guidance.
Connect with Us to Discuss Your Section 199A Opportunity
If your tax return includes income from a passthrough business, you need to stay in touch with your tax adviser in the months ahead to understand just how the new law will affect you in 2018 and beyond.
If you want to discuss your situation and eligibility for the 20% deduction, please email me at Mike.VanRemmen@FreedMaxick.com or call me at 716.847.2651. As always, if you need additional information about any aspects of the Tax Cut and Jobs Act, please contact the Freed Maxick Tax Team.