As I noted in a prior blog post, the new tax bill (TCJA) creates new Code Section 199A that provides for a 20% deduction for the non-wage portion of pass-through income. NOTE: The deduction is limited to 50% of an entity’s W-2 wages for married joint filers with income over $315,000 and single filers with income over $157,500. This deduction sunsets after 2025.
The limitations on the 20% deduction were intended to deter high-income taxpayers from attempting to convert wages or other compensation for personal services to income eligible for the 20% deduction under the provision.
The deductible amount for each trade or business is the lesser of: A) 20% of the taxpayer’s qualified business income with respect to the qualified trade or business, or B) the greater of: i) 50% of the W–2 wages with respect to the qualified trade or business, or ii) the sum of 25% of the W–2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. The overall deduction is limited to: 1) the lesser of A) the taxpayer’s combined qualified business income, or B) an amount equal to 20% of the excess of i) the taxpayer’s taxable income for the taxable year, over ii) the sum of the taxpayer’s net capital gain plus the aggregate amount of the qualified cooperative dividends, plus 2) the lesser of A) 20% of the aggregate amount of the taxpayer’s qualified cooperative dividends for the taxable year, or B) the taxpayer’s taxable income reduced by the net capital gain for the taxable year. NOTE: The deduction cannot exceed taxable income reduced by the taxpayer’s net capital gain for the taxable year.
Pretty complicated stuff. Clearly not tax simplification. Get your CPA involved now with the calculations.
Limitation Based on W-2 Wages and Capital
The bill modifies the wage limit applicable to taxpayers with taxable income above the threshold amount to provide a limit based either on wages paid or on wages paid plus a capital factor. Under the bill, this limitation is the greater of (a) 50% of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. “W-2 wages” generally refers to the amounts paid by the sole proprietor or the pass-through entity with respect to employment of employees by the entity during the calendar year, subject to certain statutory exceptions. See my prior blog on how real estate developers with newer properties and renovations may be able to take advantage of this limitation.
What is Qualified Property?
“Qualified property” means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year, and which is used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property under section 168 (without regard to section 168(g)).
The Conference Committee Report gives the following example:
A taxpayer (who is subject to the limit) does business as a sole proprietorship conducting a widget-making business. The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of (a) 50% of W-2 wages, or $0, or (b) the sum of 25% of W-2 wages ($0) plus 2.5% of the unadjusted basis of the machine immediately after its acquisition: $100,000 x .025 = $2,500. The amount of the limitation on the taxpayer’s deduction is $2,500.
Application at the Partner/Shareholder Level
For pass-through entities (i.e., partnerships and S corporations), these rules are applied at the partner/shareholder level, and each partner/shareholder takes into account their allocable share of each qualified item of income, gain, deduction, and loss. In addition, each partner/shareholder is treated as having W–2 wages and unadjusted basis immediately after acquisition of “qualified property” for the taxable year in an amount equal to such person’s allocable share of the W–2 wages, and the unadjusted basis immediately after acquisition of qualified property of the partnership or S corporation for the taxable year. A partner’s/shareholder’s “allocable share of W–2 wages” is determined in the same way that a partner’s/shareholder’s allocable share of wage expenses is calculated, and a partner’s/shareholder’s allocable share of the unadjusted basis immediately after acquisition of “qualified property” is determined in the same manner as a partner’s/shareholder’s allocable share of depreciation. This will obviously create new line items and reporting on Schedule K-1 attached to the pass-through tax return and given to the partners/shareholders.
Trusts & Estates
The final bill allows pass-through entities owned by trusts or estates to take the deduction (the Senate bill would have prohibited this). In addition, the bill states that W-2 income from entities owned by trusts and estates is apportioned between the beneficiaries and the fiduciary under Section 199(d)(1)(B)(i), another Schedule K-1 reporting complication.