A new provision of the Tax Cuts and Jobs Act of December 2017, titled Section 199A, stipulates that owners of sole proprietorships, S corps. or partnerships can deduct up to 20% of the income earned by the business. The idea behind Section 199A is to afford the owners of these types of businesses their own variation of the tax cuts provided to corporations in the original Tax Cuts and Jobs Act.
Unlike C corporations, which are subject to double taxation – at both the entity and the shareholder levels – income earned by sole proprietorships, S corps or partnerships are only subject to one level of taxation. The owner of the business reports his or her share of the income of the business directly on his or her tax return, and pays the corresponding tax at his or her ordinary rate.
As a result of Section 199A, qualifying businesses now retain the same federal tax rate advantage over the owners of C corps that they had prior to the enactment of the Tax Cuts and Jobs Act. Although the purpose of Section 199A is clear, its language is not. There are countless limitations, exceptions, phase-ins and -outs, and poorly defined terminology that leave all of us wondering, “Will it get better?” The answer is, “We hope so!”
How Does Section 199 Work?
Beginning with the 2018 tax year and up until January 1, 2026, taxpayers other than corporations are entitled to take a deduction equal to 20% of the taxpayer’s “qualified business income” earned in a “qualified trade or business,” with some limitations. The purpose of the limitations is to ensure that the 20% deduction is not taken against income that is taxed at preferential rates.
Who Can Claim the Deduction?
Any taxpayer “other than a corporation” can claim the deduction. This includes:
- Individual owners of sole proprietorships
- Owners of rental properties, S corporations, or partnerships
- An S corporation, partnership, or trust that owns an interest in a pass-through entity
How do you define a “Qualified Trade or Business”?
Every trade or business is a qualified business except for:
- The trade or business of performing services as an employee, and
- A specified service trade or business.
The first restriction aims to prevent an employee from claiming a 20% deduction against his or her wage income. The second restriction aims to prevent the conversion of personal service income into qualified business income.
What is Qualified Business Income?
Once a taxpayer establishes that he or she is engaged in a qualified business, the taxpayer must determine the “qualified business income” for each separate qualified trade or business in which he or she is engaged.
Qualified business income is the net amount of qualified income, gain, deduction and loss with respect to a qualified trade or business that is connected with the conduct of a business within the U.S. Certain types of investment income are excluded.
There is a lot more to Section 199A than we can share in one blog post. It is important to note that while Section 199A provides a significant benefit to owners of sole proprietorships, S corporations and partnerships, there are many questions surrounding its actual execution. We hope to see additional clarification as time goes on so that the benefits become clearer to both taxpayers and to us as tax advisors. To learn more about how Section 199A applies to your business, please contact Diamond & Associates at 215-497-8888.