We are all aware that huge tax changes known collectively as the Tax Cuts and Jobs Act (TCJA) were passed in 2017 and went into effect January 1, 2018. A significant addition was a 20% pass-through income deduction (26 U.S. Code § 199A) to many small businesses with “qualified business income.” The intent was to give deductions to certain small businesses in order to somewhat level the playing field with C corporations which now enjoy a 21% tax rate.
When Congress passed Section 199A, it left a lot of questions unanswered and looked to the IRS to work out the details. The IRS published proposed regulations in August, then reviewed comments in order to publish the final regulations on January 19, 2019. These final regulations enable taxpayers and advisors to determine how best to structure their 2018 returns, the first ones that will be affected by the new law. The final regulations are 274 pages long, so of course we cannot cover them all in one article. However, we will cover some of the most-discussed highlights. Be aware that the 20% pass-through deduction along with many provisions of the TCJA will expire at the end of 2025 unless renewed,
- What Do You Mean by Pass-Through Income?
- What Do You Mean by Qualified Business Income?
- Amount of Your Qualified Business Income Matters
- Can I Quit My Job and Freelance to Get the 199A Deduction?
- Does This Impact How I Structure My Small Business?
- Is My Real Estate Business Eligible for the Pass-Through Deduction?
- Get Expert Tax Help
What Do You Mean by Pass-Through Income?
C corporations are taxed as separate entities from their owners or shareholders. But for many other types of business structures, income passes to the owners before it is taxed as their personal income. Section 199A will impact sole proprietorships, partnerships, LLCs and LLPs, S corporations and some trusts and estates if they own interests in pass-through businesses. Traditional small businesses like the corner sole-proprietorship grocery store are not the only ones affected. Eligible professionals and independent contractors can also enjoy the 20% deduction.
What Do You Mean by Qualified Business Income?
Qualified business income is the normal income from running a business after expenses and not including investments, capital gains, wages paid to S corporation shareholders, interest, dividends or money earned as an employee. For the sake of the statute, the status of qualified business income only applies to domestic business activities. It may include money from real estate businesses with some exceptions.
Qualified business income must be derived from a business as described in 26 U.S. Code § 162, Trade or Business Expenses. The statute does not define such businesses in detail, so it is necessary to look at case law. It is established that to qualify under Section 162, you should be regularly and continuously involved in the business. A hobby is not going to cut it. You also cannot claim that your trade or business is as an employee.
Certain specified trades or businesses are disqualified in some cases. They include health care, accounting, legal, athletes, professional entertainment and more, but there are exceptions in those categories. The final regulations went a long way toward clarifying exactly what specified trades or businesses are ineligible for the Section 199A deduction.
Amount of Your Qualified Business Income Matters
If your qualified business income is less than $157,500 for 2018 (or adjusted to $160,700 for 2019), calculations for your deduction under Section 199A are relatively easy. You don’t need to be concerned about what kind of business you have, your , W-2 wages or the basis of property. But if your qualified business income is above that figure, things become more complex, and you will probably want to seek the help of a good tax attorney. For example, if your qualified business income exceeds $160,700 for 2019, you must worry about whether your business is a specified trade or business that is ineligible for the deduction.
Can I Quit My Job and Freelance to Get the 199A Deduction?
When Section 199A was first revealed, a lot of people thought it would make sense for many employees to quit their jobs and go back to work in the same roles as independent contractors, thus becoming eligible for the 20% pass-through deduction. Sorry, but no, at least not for three years. At the end of that time, yes, you can take the deduction. There is a bit of wiggle room however, so talk to your tax lawyer if you have a good reason for giving up your W2 employment for independent contractor status.
Does This Impact How I Structure My Small Business?
If you are setting up a new business, the impact of the Section 199A pass through deduction is definitely something you will want to consider. You may even want to change your current business structure.
Before §199A, it was advantageous to structure your business as an S corporation rather than a sole proprietorship, because any income you did not pay yourself as the owner was not subject to employment taxes.
After §199A, there is more to consider. Wages paid to Sub S corporation owners are ineligible for the Section 199A tax deduction. Therefore, the decision between setting up as an independent contractor or a Sub S corporation is now more complex. In some cases, it may be more advantageous to be an independent contractor and report income on your Schedule C than to have an S corporation.
Is My Real Estate Business Eligible for the Pass-Through Deduction?
IRS Notice 2019-7 provided “safe harbor” for real estate businesses regarding qualifying for the Section 199A pass-through deduction. However, there is an exception. If you are leasing property where the lessee not only pays rent but also maintains the property, insures it and pays real estate taxes, your business is ineligible. These are known as triple net leases. To be eligible, you must meet requirements showing you are active in the business including working at least 250 hours per year in it. However, if your business is renting property to itself or one of its entities, it should still be eligible for the deduction even in the case of triple net leases.
Get Expert Tax Help
There is a lot more to Section 199A than we have touched on here. If you think you may be able to shield some of your income with this new law or you have questions about it, this is the best time to get the advice of an experienced tax attorney both to shield as much income as possible for your 2018 taxes and to plan for 2019 taxes.