Aspects of the Tax Cuts and Jobs Act of 2017

Below is the first of two articles about aspects of the Tax Cuts and Jobs Act of 2017. The first is an expert analysis of the Act in Questions and Answers on the Qualified Business Income Deduction by Sidney Kess that first appeared in the New York Law Journal. The second piece is shorter and focuses on the employee/independent contractor issue. Those of you who are particularly interested in the independent contractor issue will want to be sure to read the second article next week, then refer back to Kess’ tax analysis for the definitions of the terms used.

Tax Tips
by Sidney Kess
Questions and Answers on the Qualified Business Income Deduction

The Tax Cuts and Jobs Act of 2017 introduced a new write-off for owners of pass-through entities that runs from 2018 through 2025. This deduction doesn’t require any cash outlay or special action to be eligible for it, but using it reduces the effective tax rate on business income. There is much confusion about this new deduction and some clarification will need IRS guidance. Here is what is clear so far, how it impacts attorneys, and what needs IRS and/or Congress to explain further.

Overview
Q: What is the new deduction?
A: Under new Code Section 199A there is a 20% deduction for qualified business income from a sole proprietorship or a pass-through entity.

Q: Where is the deduction taken?
A: The deduction is not a business deduction used to reduce profits subject to tax; it does not reduce net earnings for self-employment tax purposes. It is not a reduction to gross income taken in the Adjusted Gross Income section of Form 1040. It is a deduction from adjusted gross income much like the standard deduction or itemized deductions used to reduce taxable income.

Terminology
Q: What is a pass-through entity for purposes of Code Sec. 199A?
A: Many business owners may be eligible to take the deduction on their personal returns, including:

Schedule C filers: Sole proprietors, independent contractors, and single-member limited liability companies (LLCs)
Schedule E filers: S corporation shareholders, partners, members in multi-member LLCs, real estate investors, beneficiaries of trusts and estates, owners of REITs, and those with interests in qualified cooperatives
Schedule F filers: farmers and ranchers

Q: What is qualified business income?
A: The deduction applies to this income, but it isn’t merely the owner’s share of net income from the business. It is the net amount of income, gain, deduction, and loss from a qualified U.S. trade or business (including Puerto Rico). It does not include investment items, such as short-term and long-term capital gains and losses, dividends, and interest other than what’s allocable to the business. And it doesn’t include reasonable compensation or guaranteed payments to owners. But it does include most REIT dividends and income from publicly traded partnerships.

Q: What is a specified service trade or business?
A: This is a business where the owner must reduce the amount of qualified business income on which the deduction is taken (explained below). It includes any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, as well the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities. It also includes 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.

The TCJA deleted engineering and architecture, but the IRS could still view such businesses as a qualified service business based on the “reputation or skill” clause.

Deduction amount
Q: What is the deduction amount?
A: Technically the deduction is the sum of:

The lesser of (1) the individual’s combined qualified business income or (2) 20% of the excess of taxable income over net capital gain plus qualified cooperative dividends
The lesser of (1) 20% of cooperative dividends or (2) taxable income reduced by net capital gains.

Essentially, the deduction is 20% of qualified business income. But due to the technical definition of the deduction, it means that the 20% deduction is based on taxable income if it is less than qualified business income.

Q: Who can claim the full 20%-of-qualified business-income deduction?
A: An individual who has taxable income below set levels can apply the 20% deduction against qualified business income. This is so whether or not the taxpayer is in a qualified service business. For 2018, the taxable income limit is $315,000 for a married couple filing a joint return and $157,500 for any other filer. These taxable income thresholds are where the 24% tax brackets end and the 32% tax brackets begin for 2018. The taxable income limit will be adjusted for inflation after 2018. Thus, an attorney or accountant with taxable income below the applicable threshold amount for his or her filing status would be able to claim the deduction with respect to income from a practice.

Limitations
Q: What is the W-2 limitation?
A: If the owner’s taxable income is above the threshold, then a limitation comes into play. The deduction is the lesser of:

20% of qualified business income, or
The greater of (1) 50% of W-2 wages for the qualified business, or (2) 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis (immediately before acquisition) of qualified property.

If the amount of qualified business income is greater than the taxpayer’s taxable income, then the 20% applies only to the extent of taxable income as explained earlier.

W-2 wages are amounts reported as such to the Social Security Administration for owners and other employees. Payments to independent contractors do not factor in. For partners, LLC members, and S corporation owners, the allocations of W-2 wages and the unadjusted basis of property are made in the same way as the allocation of qualified business income, and likely will have to be reported on Schedule K-1.

Q: What is the limitation for a qualified service business?
A: For purposes of figuring the W-2 limitation, the owner of a qualified service business with taxable income above the threshold reduces the amount of qualified business income to which the deduction applies. The reduction is a percentage derived from the ratio of taxable income for the year in excess of the threshold over $100,000 on a joint return or $50,000 for all other filers. In effect, if taxable income for the owner of a qualified service business who files jointly is $415,000 or over in 2018 (or $207,500 for other filers), then no deduction can be claimed because there is no qualified business income on which to apply the deduction. Thus, attorneys with taxable income over $415,000, or $207,500, depending on filing status, cannot claim any deduction.

If an individual above the taxable income threshold owns a qualified service business as well as a nonqualified service business, it is not yet clear whether the deduction can be taken with respect the nonqualified service business even though he or she phases out for the deduction on the qualified service business income.

Q: What is a Section 199A loss and how does it impact the deduction?
A: If the net amount of income, gain, deduction, and loss is less than zero, the net amount is treated as a loss in the succeeding year.

It is not clear whether the loss is carried forward only to the following year or continues to be carried forward indefinitely until used up. And it’s not clear whether the loss is used to offset only income in the subsequent year from the business that generated it or must be used to offset income from all of a taxpayer’s businesses.

Conclusion
As is clear from the questions and answers above, much is not clear. Additional guidance from the IRS may not be immediately forthcoming in this tax filing season. Once this is done, then business owners can decide on what to do, including changing their form of entity, deciding whether to add independent contractors to the payroll, or taking other actions.

Sidney Kess, CPA-Attorney, is of Counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company