The recently enacted Tax Cuts and Jobs Act (TCJA) added Section 199A to the tax code, providing a new 20% deduction for owners of “pass-through entities.” The deduction is designed to help these entities compete with C corporations, which now enjoy substantially reduced corporate tax rates. It’s available from 2018 to 2025.
Although the concept is simple, the new tax break is one of the more complex provisions of the TCJA, particularly for professional services firms. Here is an introduction to the deduction and guidance on determining whether your firm qualifies.
Sec. 199A in a Nutshell
The deduction is available to all entities whose owners report business income on their individual returns. This includes pass-through entities — such as S corporations, partnerships and LLCs — as well as sole proprietorships. So “pass-through deduction” is a bit of a misnomer because a sole proprietorship isn’t legally an entity.
Generally, the deduction is equal to the lesser of:
- 20% of an owner’s qualified business income (QBI) from the entity, or
- 20% of an owner’s taxable income, less any net capital gains.
QBI generally refers to an owner’s allocable share of net qualified items of income, gain, deduction and loss from the entity. “Qualified items” excludes capital gains, dividends and non-business-interest income. QBI doesn’t include reasonable compensation received by S corporation shareholders or guaranteed payments received by partners.
The write-off is a “below-the-line” deduction — that is, it’s subtracted from adjusted gross income (AGI) in calculating taxable income. But it’s not an itemized deduction, so it can be claimed in addition to the standard deduction.
Limitations and Phaseouts
Here’s where things get complicated. The deduction is subject to two important limitations: a W-2 wages limit, which may reduce or eliminate it, and a phaseout of the deduction for specified service businesses, including most professional services providers other than architects and engineers. (See “What is a specified service business?”)
Neither limitation applies, however, unless a business owner’s taxable income exceeds a threshold amount (currently, $315,000 for joint filers and $157,500 for others).
W-2 wages limit. Owners of all businesses, including specified service businesses, are subject to a W-2 wages limit. When taxable income exceeds a specified threshold, the deduction is limited to 50% of an owner’s allocable share of the entity’s W-2 wages. The limit is phased in gradually, beginning at $157,500 of taxable income ($315,000 for joint filers), and reaches full force once taxable income reaches $207,500 ($415,000 for joint filers).
Note: There’s an alternative limit equal to 25% of W-2 wages plus 2.5% of the original cost basis of qualified depreciable property. This limit benefits capital-intensive businesses with little or no W-2 wages, but generally is not relevant to professional services firms.
Phaseout for specified service businesses. For owners of specified service businesses, including most professional services firms, the deduction is reduced when taxable income exceeds $157,500 and eliminated once it reaches $207,500. For joint filers, the phaseout range is $315,000 to $415,000.
Are You Eligible?
If your firm is organized as a sole proprietorship or pass-through entity, it’s important to determine whether, and to what extent, you’re eligible for the 20% deduction. If your taxable income is below the threshold amounts discussed above, you should be entitled to the tax break regardless of your industry or whether you pay any W-2 wages.
If you’re above the threshold, however, the deduction may be reduced or eliminated by the W-2 wages limit, the specified service business phaseout, or both. In that case, you might consider strategies for optimizing the deduction. For instance, a sole proprietor prevented from claiming the deduction by the W-2 wages limit might hire a contractor as an employee or convert to an S corporation and pay himself or herself a salary.
Sidebar: What Is A Specified Service Business?
Owners of specified service businesses aren’t entitled to claim the pass-through deduction if their taxable income exceeds a certain threshold. “Specified service business” is defined as:
- Any trade or business involving the performance of services in the fields of:
- Actuarial science,
- Brokerage services,
- Financial services,
- Law, or
- Performing arts,
- Any trade or business whose principal asset is the reputation or skill of one or more of its employees or owners, or
- Any trade or business involving the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests or commodities.
The definition expressly excludes architecture and engineering.