The second day of the 53rd Heckerling Institute conference featured an insightful and detailed presentation by Melissa J. Willms, partner in the law firm of Davis & Willms in Houston, on the new IRC §199A deduction.
IRC §199A is a new income tax deduction from the Tax Cuts and Jobs Act of 2017, which, if applicable, offers a maximum 20 percent deduction on qualified business income from pass-through entities. Pass-through entities include sole proprietorships, partnerships, disregarded LLCs and S-corporations. While it is strictly an income tax rule, many estate planners do need to have a fundamental understanding of how it works and its importance to clients. The new rules are not permanent and are set to expire in 2025.
The new deduction can be categorized in three strata:
- Stratum I — Individuals with taxable income at or below a certain threshold level (for taxable year 2019: $160,700 for single filers and $321,400 for married filing jointly). If the individual falls into this category, then the 199A deduction is the lesser of the taxpayer’s combined qualified business income (QBI) or 20 percent of the taxpayer’s taxable income minus the taxpayer’s net capital gains. QBI is the net income, gain, deduction and loss with respect to any qualified trade or business.
- Stratum II — Individuals with taxable income above the threshold in Stratum I and below the threshold in Stratum III. Those falling into this group will get a phase-in limit on their deduction.
- Stratum III — Individuals with taxable income above a certain threshold level (for taxable year 2019: $210,700 for single filers and $421,400 for married filing jointly). Filers falling into this group may not get the benefit of the deduction.
If an individual falls within Stratum II or III, then additional factors are involved, including whether the business is an SSTB and how much, if any, W-2 wages or UBIA of qualified property there are in the business. The rules, in their basic form, are as follows:
SSTB is Specified Service Trade or Business. Together with the Proposed Regulations §1.199A-5(b) and Section 1202(e)(3)(A), the SSTB list includes services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and management, trading, dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. Notably, engineering and architecture are excluded from the definition. Any amount associated with SSTB is not allowed a deduction for Stratum III individuals, and a phase-in amount for Stratum II individuals is permitted based on a formula.
UBIA is the Unadjusted Basis Immediately After Acquisition of qualified property. The Proposed Regulation §1.199A-2(c)(3) offers a more-detailed definition, but for the majority of the cases, this will mean original basis. For Stratum III individuals, the QBI is further modified (as compared with Stratum I individuals) to be the lesser of 20 percent of QBI or the Alternative Limitation. The Alternative Limitation is calculated by the greater of 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of UBIA of qualified property. Stratum II individuals will have a phase-in amount based on a formula.
Section 199A also applies to trusts and estates. Specifically, they apply to non-grantor trusts and estates. The trust or estate may itself be treated as an individual and qualify for the deduction, or it can be treated as an RPE (Relevant Pass-Through Entity) because the trust or estate passes the QBI, W-2 wages and/or UBIA of qualified property to the beneficiaries, who themselves could take the 199A deduction on their individual returns.
The above is a “simple” introduction to the 199A deduction. There are other, more-complicated rules such as how to handle negative QBI, aggregation and family attribution rules that come into play for families with complex structures and assets. If the deduction is applicable, it can represent a significant tax savings for clients. Practitioners would be well served to spend time understanding at least its basic rules and applications.
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