The Tax Cuts and Jobs Act (TCJA) was signed into law on Dec 22, 2017, and provides sweeping tax changes for business and individual taxpayers. One of the provisions of the TCJA is to reduce the entity-level income tax rate of C corporations from a top rate of 35% to a flat rate of 21%. As an equalizing provision, a new section of the Internal Revenue Code, Sec. 199A, was created to bring the effective tax rate of sole proprietorship, S corporation and partnership owners closer to the new lower rate afforded to C corporations; possibly to a rate as low as 30%.
Sec. 199A attempts this equalization by affording the owners of flow-through entities a deduction of up to 20% of qualified business income (QBI) on the taxpayer’s 1040. This 20% deduction is subject to a number of limitations, phase-ins and phase-outs. We will focus on the language set out in Sec. 199A(b)(2) that limits the taxpayer’s potential deduction to the lesser of the following:
1) 20% of the taxpayer’s QBI with respect to the qualified trade or business.
2) The greater of (A) 50% of the W-2 wages paid by the qualified trade or business, or (B) The sum of 25% percent of W-2 wages paid by the qualified trade or business plus 2.5% of the unadjusted basis immediately after acquisition of all qualified depreciable property.
These limitations become engaged once the taxpayer reaches a certain taxable income level per Sec. 199A(b)(3)(B). The taxable income limits are $157,500 for single taxpayers and $315,000 for taxpayers filing a joint return. The phase-in ranges for these limits are $50,000 and $100,000, respectively, and the taxpayer’s QBI deduction becomes 100% subject to the W-2 wages and Adjusted Basis limitations in Sec. 199A(b)(2) once taxable income exceeds the phase-in ranges. If the taxpayer’s taxable income exceeds the phase-in range by an amount less than the entire phase-in range, then the taxpayer’s QBI deduction will be limited by the percentage taxable income – less the taxable income threshold – to make up the phase-in range. For example, a single taxpayer with $170,000 in taxable income will be limited to 75% of their QBI deduction in excess of the Sec. 199A(b)(2) limits: 1 = 75%.
The following are examples of the mechanics of the limitations and planning opportunities for taxpayers qualifying for the Sec. 199A QBI deduction. These examples assume a sole proprietor taxpayer filing a joint return with the owner’s QBI income as the only source of taxable income. In this case, the W-2 wages used to calculate the Sec. 199A(b)(2) limits would be wages paid to the owner’s employees since sole proprietors – as well as partners – are not permitted to pay themselves W-2 wages. They are not considered employees in the eyes of the IRS.
The taxpayer exceeds the phase-in limitations in all three scenarios and is subject to the Sec. 199A(b)(2) limitations as a result; however, the third scenario presents a planning opportunity to increase the taxpayer’s QBI deduction. Assuming that the taxpayer has $40,000 in extra cash flow, paying out a $40,000 bonus before the end of the tax year could increase the taxpayer’s deduction by up to $20,000 (column 1 vs. column 3), despite the fact that the taxpayer fully exceeds the phase-in range.
Tax accountants can help their clients weigh this compensation planning option, along with other expense bunching strategies to minimize their tax liability. Given the complexity of Sec. 199A, taxpayers need to carefully examine their tax planning strategies since increasing W-2 compensation can either increase or lower their QBI deduction based on their taxable income levels. There are also special rules for service type businesses that include more restrictive limitations and phase-outs of the QBI deduction that need to be considered during tax planning.