Can Doctors and Lawyers Take the 199A Pass-Through Deduction? Well, It Depends…
November 6, 2018
There’s a lot of hype about tax reform’s new pass-through deduction that lets taxpayers deduct 20% of the income from entities such as limited liability companies and partnerships, but many people won’t be able to take advantage of it.
The new pass-through deduction provision in section 199A of the tax code was meant to allow business owners who pay taxes at individual rates rather than through the corporate tax structure to enjoy a semblance of the corporate tax reduction that was the hallmark of President Donald J. Trump’s Tax Cuts and Jobs Act signed into law last year.
Pass-throughs make up more than 95 percent of business tax filings, although the majority of them are non-business entities such as trusts and estates, according to The New York Times.
The new section 199A pass-through deduction is available for taxpayers who own pass-through businesses for which income is reported and taxed on the owner’s personal income tax filing. Those with 2018 taxable income that is lower than $315,000 for joint filers or $157,500 for single filers can deduct a full 20% of qualified business income (QBI).
Thanks to a new lower tax rate on ordinary income for individuals, which is now 37% compared with 39.6% previously, the section 199A pass-through deduction could further reduce the effective rate on QBI for certain owners of pass-throughs to 29.6%.
But there’s a catch. A lot of catches, actually.
The section 199A pass-through deduction language in the new law is riddled with limitations, exceptions, prohibitions, phase-outs and other criteria that narrowly define who can take advantage of the full 20% deduction on their QBI.
For example, certain professions such as law, accounting, healthcare and financial services are called “specified service trade or business” (SSTBs) under the new tax law, and taxpayers in those fields have a greatly diminished ability to take the pass-through deduction if their income exceeds the aforementioned statutory limits.
The Internal Revenue Service issued 184 pages of proposed regulations in Augustthat outline in greater detail how the 199A deduction works, although many questions remain about exactly which businesses qualify and under which circumstances.
Proposed IRS Regulations
Some of the confusing elements that the proposed IRS regulations clarified include:
- Taxpayers may not aggregate trades or businesses according to section 469’s grouping rules for purposes of applying the 199A deduction.
- To reduce administrative complexity, there is a proposed de minimisrule under which a trade or business won’t be considered an SSTB as long as it has gross receipts of $25 million or less in a tax year and less than 10% of those gross receipts are attributable to the performance of services in a SSTB. For businesses with more than $25 million in gross receipts, they won’t be treated as an SSTB if less than 5% of those gross receipts are attributable to the performance of services in a SSTB.
- Taxpayers with multiple trades or business can use reasonable expense allocation methods among those trades or businesses, such as direct tracing or allocation based on gross income, as long as the method is applied consistently across tax years and clearly reflects the income of the business.
- Taxpayers may be able to aggregate rental or licensing of property with other business interests if certain criteria are met, which would let them maximize 199A deductions in calculating W-2 wage and unadjusted basis immediately after acquisition (UBIA) limits on property.
- To prevent taxpayers from circumventing income thresholds by spreading assets among multiple trusts, there’s a proposed anti-avoidance rule that would treat multiple trusts with substantially the same grantors or beneficiaries as a single trust for federal income tax purposes.
- The deduction doesn’t reduce net earnings from self-employment under section 1402 or net investment income under section 1411, so those sections must be calculated as though there isn’t a 199A deduction.
- Gains attributed to assets of a publicly traded partnership (PTP) may constitute qualified business income (QBI) if other requirements of 199A are met.
Yet even with some of those questions clarified, accountants and taxpayers are trying to determine the best approach for tax planning when there are many unknown factors such as whether a taxpayer is going to get a year-end bonus that might push a married couple’s income above the threshold for taking the full deduction.
How to Calculate It
Taxpayers in certain professional services fields who are considered SSTBs face the additional complexity of diminishing opportunities to take the pass-through deduction if their taxable income exceeds $315,000 for joint filers, or $157,500 for single filers.
Those SSTB joint filer taxpayers with taxable income between $315,000 and $415,000 or single filers with income between $157,500 and $207,500 will have phased-in limitations wherein the deduction benefit is reduced in accordance with how far over the threshold their taxable income is. In other words, joint filers with $320,000 of taxable income get more of the QBI deduction benefit than those with $410,000 of income.
For high earners in other non-SSTB industries, there is still a cap on the 199A deduction that’s calculated by tallying the larger of 50% of W-2 wages paid, or the sum of 25% of the W-2 wages plus 2.5% of the tangible depreciable property. This provision means that pass-throughs that pay high employee wages can take larger deductions than those that pay smaller wages. Likewise, those in capital-intensive industries can deduct more than those who aren’t, according to Forbes.
If a taxpayer has more than one qualified trade or business, the deductible amount of QBI is calculated separately and then added up. This sum faces a second set of limitations equal to the excess of taxable income for the year over the sum of net capital gain plus the total amount of qualified dividends. That structure was intended to disallow the 20% deduction for income that’s already taxed at preferential rates.
Another wrinkle for tax planning is that the 199A pass-through deduction will sunset in 2025, and is only available for eight tax years beginning in 2018.
Three QBI Scenarios
Here are three scenarios that illustrate the complexity of how the 199A deduction works for three taxpayers in different income brackets.
Imagine there are three partners in a boutique law firm, which falls under the SSTB limitations. Each partner draws $200,000 in guaranteed payments, and there is taxable income of $1 million on their K-1 schedules. The firm pays $500,000 in salaries, and doesn’t own property. Each partner is married to a spouse who earns $50,000, and each couple files jointly and has itemized deductions of $40,000.
The most junior partner of the firm is a 10% owner, so he and his spouse have combined taxable income of $310,000: $200,000 from the guaranteed payment, $100,000 of K-1 income and $50,000 of spouse income, minus the $40,000 of itemized deductions. He can take a QBI deduction of $20,000.
The mid-level partner of the firm is a 20% owner, and he and his spouse have combined taxable income of $410,000: $200,000 from the guaranteed payment, $200,000 of K-1 income and $50,000 of spouse income, less $40,000 of itemized deductions. He can take a QBI deduction of $1,000.
The senior partner of the firm is a 70% owner, and she and her spouse have combined taxable income of $910,000: $200,000 from the guaranteed payment, $700,000 of K-1 income and $50,000 from her spouse’s job, minus $40,000 in itemized deductions. She can’t take any QBI deductions from the law firm because she earns too much. However, she also owns a stake from a passive investment in a retail shopping center that generates $50,000 in yearly income, and she can take the full 20% pass-through deduction of $10,000 on the QBI from that investment.
Now let’s imagine the law firm gets a new client on the last day of December and they receive $200,000 in advance fees, which are now taxable income for that year.
The junior partner’s income would increase by $20,000 (for his 10% stake), and his QBI deduction would drop to $18,800. The mid-level partner’s income would increase by $40,000 (for his 20% stake), which pushes him over the threshold so he can no longer take any QBI deduction.
The senior partner’s income rises by $140,000 (for her 70% stake) and doesn’t change her situation because she already earned too much to take the QBI deduction. Likewise, her QBI deduction for her real estate income is also unaffected because that’s a separate business entity that has nothing to do with her law firm income.
The new section 199A of President Trump’s tax reform law allows the owners of pass-through entities such as LLCs, S corporations, partnerships and trusts to deduct as much as 20% of their qualified business income (QBI).
Calculating QBI is complex and must take into account whether the taxpayer owns property for their business, salaries paid to employees, itemized deductions and, for joint filers, a spouse’s income. The deduction for a portion of QBI from unrelated businesses owned by the same taxpayer, such as income from rental properties, can often be taken even if the taxpayer’s income from their primary job is too high.
The new tax code contains specific income threshold limitations for taxpayers in certain professions such as lawyers, doctors, dentists, accountants, architects and athletes. The IRS proposed guidelines in August that clarified some, but not all, of the confusion about how to interpret the 199A deduction.