Update Dec. 16: As expected, the Conference Agreement (CA) adopted the Senate Amendment on the pass-through deduction, and it reduced the rate to 20% from 23%. To meet the House part-way, it lowered the taxable income threshold to $157,500 single and $315,000 married, for the “specified service activity” (SSA) and wages limitations. The CA retained the phase-out ranges above the threshold of $50,000 single and $100,000 married. If an individual’s taxable income is over $207,500 single or $415,000 married, he or she won’t get a pass-through deduction on an SSA. But, they might get a deduction on a non-SSA, subject to the wages limitations. The CA added an alternative to the 50% wage limitation: 25% of wages plus 2.5% of “unadjusted basis, immediately after acquisition, of all qualified property.” The House bill had a capital percentage, so contrary to media reports, a capital factor did not come from out of the blue. In the CA on pages 28 – 37, there are examples for how the phase-out range works. The CA raised the C-Corp flat tax rate to 21%, and it adopted the House commencement date in 2018.
The Senate Finance Committee posted the legislative text for the “Tax Cuts and Jobs Act” bill. There are five haircuts on calculating the deduction on qualified business income (QBI) for pass-through entities.
It’s a bit of a maze, but it could be a significant deduction and will take plenty of tax compliance work to determine and support it. Trader tax status traders using Section 475 are service businesses, which may use the QBI deduction providing their taxable income is under the upper-income limitation.
Haircut No. 1: 50% of wages limitation
On each separate pass-through entity (PTE), the 17.4% QBI deduction may not exceed 50% of employees’ W-2 wages in that PTE. One PTE may have a wage limitation and another may not. Look for wage amounts on 2018 Schedule K-1s from partnerships and S-Corps.
Exception from wage limit: The 50% wage limitation does not apply to taxpayers with taxable income under $500,000 married and $250,000 for others. There is an annual inflation adjustment on the threshold. Per the modified mark, “the application of the W-2 wage limit is phased in for individuals with taxable income exceeding this $500,000 (or $250,000) amount over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.” The phase-in calculations are even more complicated and beyond the scope of this article.
Haircut No. 2: Service businesses limited to upper-income threshold
The bill excludes “specified service activities” from taking a QBI deduction unless the taxpayer has taxable income under $500,000 married and $250,000 for others. There is an annual inflation adjustment on the threshold. The modified mark states, “the benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.” The phase-out calculations are also quite complicated and beyond the scope of this article.
The bill states, “The term ‘specified service trade or business’ means any trade or business involving the performance of services described in section 1202(e)(3)(A), including investing, and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”
In Section 475 Traders May Be Eligible For Pass-Through Tax Cuts, I expected the Senate legislation text would mirror the House bill’s definition.
Haircut No. 3: Deduction on QBI or modified taxable income
Calculate the 17.4% QBI deduction based on total QBI or modified taxable income — whichever amount is lower.
First, calculate the 17.4% deduction on domestic QBI per PTE, after applying the wage limitation, and total it up. Next, figure modified taxable income: Take taxable income and exclude long-term capital gains and qualified dividend income (capital gains preferences). Calculate 17.4% of modified taxable income. Finally, take the lower of those two amounts.
Here’s an example: An S-Corp consulting service business has net income of $150,000 after deducting officer compensation of $50,000 (reasonable compensation of 25% of net income), business expenses and employee benefits (health insurance and retirement plan). The 50%-wage limitation doesn’t apply since the taxpayer is under the upper-income threshold. There are no investment-related items to exclude from QBI. The taxpayer has itemized deductions of $30,000 due to charitable contributions. Therefore, taxable income is $170,000, comprised of $50,000 wages, $150,000 S-Corp net income, and less $30,000 itemized deductions. This single taxpayer should calculate the 17.4% QBI deduction on taxable income of $170,000 since it’s lower than total QBI of $200,000. The QBI deduction is $29,580.
Haircut No. 4: Exclude capital gain preferences
Assume the same taxpayer also has $40,000 of long-term capital gains and $5,000 of qualified dividends. Gross income is $245,000 and taxable income is $215,000. Modified taxable income is $170,000 after excluding the capital gains preferences. The result is the same as above: Use the 17.4% QBI deduction based on modified taxable income since it’s less than the QBI deduction based on QBI of $200,000.
Haircut No. 5: Carryover of losses
The Senate bill requires a carryover of total qualified business losses (QBL) to the subsequent tax year. For example, assume total QBL in 2018 is $50,000, and QBI in 2019 is $300,000. The 2018 QBL is carried over to 2019, which reduces 2019 QBI to $250,000. It’s important to note that this QBL carryover does not change taxable income; it only affects the QBI deduction in the subsequent tax year.
The Senate bill has a separate provision (Limitation On Excess Business Losses For Noncorporate Taxpayers) limiting losses, which does change taxable income for the current and subsequent tax years. (See How The Senate Tax Bill Disallows Excess Business Losses In Pass-Throughs.)
Reason for the haircuts on the QBI deduction
The Senate provides the 17.4% QBI deduction to incentivize small businesses to create jobs and increase wages. It targets non-service activities, like manufacturing for “Made in America.” The Senate includes all pass-throughs, including service businesses and passive-activity owners, in waiving the wage limitation and using the upper-income threshold.
The tax code is voluminous because Congress adds complicated anti-abuse provisions to block taxpayers and tax advisers from gaming their tax regime. Several haircuts for this deduction prevent “double-dipping” of tax loopholes. The Senate Finance Committee felt it would be inappropriate to provide a QBI deduction that leads to a net operating loss (NOL) carryover, on income already taxed at lower capital gains tax rates, or on itemized deductions. It also did not want to leave out service businesses and passive-activity owners. It had to meld this code with existing code. Slaying the tax code beast is nearly impossible.
These haircuts make the tax code more complicated and will lead to confusing tax compliance, which is contrary to the goals of tax reform. These provisions are significantly different from the House’s bill, too. There could be changes to the Senate bill this week when it’s subject to floor debate and amendments. Stay tuned to our blog as we continue to cover this fluid situation.
Darren Neuschwander CPA contributed to this blog post.