By Anthony Diosdi
The Tax Cuts and Jobs Act of 2017 implemented various changes to the Internal Revenue Code that impacted business. A notable change is that the act provides that all C corporations are taxed at a flat 21 percent of taxable income. Prior to the enactment of the Tax Cuts and Jobs Act, C corporations were tax at a rate as high as 35 percent. In order to lower the federal tax rates of business owners that are not C corporations, the Tax Cuts and Jobs Act enacted Section 199A of the Internal Revenue Code. Section 199A was designed to provide non C corporate business owners with a 20 percent deduction from qualified business income. The 20 percent deduction is effective for taxable years beginning after December 31, 2017 and sunsets after December 31, 2025.
Eligible Business Owners and Qualified Trade or Business
Any person (domestic or foreign) other than a corporation carrying on a qualified U.S. trade or business can claim a 20 percent deduction from qualified business income derived from such U.S. trade or business. The term “qualified trade or business” means 1) any trade or business other than the trade or business of performing services as an employee or 2) a specified service of a trade or business.
A “specified service trade or business” is defined as: 1) any trade or business involving the performance of services in the fields of health, accounting, actuarial service, performing arts, consulting, financial services, brokerage services or any trade or business in which the principal asset of the trade or business is the reputation of skill of one or more of its employees or owners; or 2) which involves the performance of services that consist of investing and investment, trading, or dealing in securities, partnership interest or commodities.
Qualified Business Income
A Section 199A deduction is only available on “qualified business income” or “QBI.” QBI includes income, gain deduction, and loss with respect to a qualified trade or business. Qualified business income does not include the following forms of investment income: 1) any items of short-term capital gains, short-term capital loss, long term capital gain, or long-term capital loss; 2) any dividend, income equivalent to a dividend, or payment in lieu of dividends; 3) any interest income other than interest income which is properly allocable to a trade or business; 4) any net gains from commodities transactions or foreign currency gains; 5) income from hedging transactions; and 6) any amount received from an annuity which is not received in connection with the trade or business.
In addition, QBI does not include 1) reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business; 2) any guaranteed payment described in Internal Revenue Code Section 707(c) paid to a partner for services with respect to the trade or business.
20 Percent Deduction Computation
The 20 percent deduction is computed by taking the lesser of:
1) the “QBI component” plus 20 percent of (qualified real estate investment trust dividends and qualified publicly traded partnership income from relevant passthrough entities) or
2) 20 percent of the amount by which the individual’s taxable income exceeds net capital gains.
The “QBI component” is the sum of the following for each separate trade or business: the lesser of 1) 20 percent of QBI for the qualifying trade or business or 2) the greater of the taxpayer’s allocable share of: i) 50 percent of the W-2 wages with respect to a qualified trade or business; or ii) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property
Qualified property means physical depreciable assets, including real estate, furniture, and equipment of a flow-through entity or an individual taxpayer that has not yet exceeded the longer of its depreciable life or 10 years. A taxpayer may take into consideration the unadjusted basis of property only for a year for which the depreciable period of the property has not ended.
The W-2 wage and qualified property limitations do not apply to individuals when taxable income does not exceed a certain threshold amount. For 2019, the threshold amount for taxpayers who are married and file a joint return is $321,400 while the threshold for single files is $160,700. As a result of these limitations, high earners may well be advised to segregate income from personal services such as (income received in the fields of health, law, accounting, actuarial services, performing arts, consulting, financial services, or brokerage services) from services which qualify for the 20 percent deduction if the wage and qualified property requirements are met. Individuals may also consider using a C corporation, which are in a 21 percent federal income tax bracket. The law in this area will develop rapidly, and planning structures may save significant monies for the well-advised business person.
Diosdi Ching & Liu, LLP represents clients in a wide variety of domestic and international tax planning and tax controversy cases.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.