On December 22, 2017, the President signed into law the Tax Cut and Jobs Act. Since the law has been passed, much has been discussed of the changes to the structure of the individual itemized deductions and changes to the corporate tax rates. One area that has not been subject to much press as of yet is the new deduction for pass-through business income that will take effect in 2018. This new deduction could have varying effects on taxpayers in construction related and real estate operating businesses, versus taxpayers investing in real estate holding companies.
In general, the new law provides a 20% deduction, for a noncorporate taxpayer, of domestic “qualified business income” from a partnership, S Corporation, or sole proprietorship, which is subject to limitations and thresholds. Qualified business income is defined as ordinary income less ordinary deductions, and does NOT include wages/compensation of an S Corporation shareholder or guaranteed payments/distributions to a partner for services. Quick example; a taxpayer owns an S Corporation where he/she receives $50,000 in wages and is allocated $90,000 of income on the K-1. The qualified business income from the S Corporation is $90,000, the wages of $50,000 are not included.
The 20% qualified business income deduction is generally limited to the greater of:
- 50% of W-2 wages paid by the business, or
- 25% of W-2 wages paid by the business, plus 2.5% of the unadjusted basis of all qualified property.
Further, the deduction does not apply to taxpayers in a “specified service business.” The specified services are as follows:
- Any trade or business activity involved in the performance of services in the fields of health, law, accounting, actuarial sciences, consulting, athletics, brokerage services, financial services, or the performing arts, or
- Any trade or business where the principal asset is the reputation or skill of one or more of the owners or employees.
- Excluded from the specified services are engineering or architecture businesses.
Please note, there are no limitations, including the specified service business limitation for taxpayers whose taxable income does not exceed $157,500 for individuals or $315,000 for married filing joint.
To expand on the limitations listed above, the W-2 limitations are not the total W-2 wages paid by the company (unless if the taxpayer owns 100%), but the taxpayer’s allocable share of the company’s W-2 wages. Qualified property is described as depreciable tangible property held by and available for use in the qualified trade or business at the end of the tax year, and is used to produce qualified business income. Property sold is no longer available for use in the trade or business, and is not taken into account determining the qualified property limitation.
The 20% deduction on qualified business income is available to taxpayers other than C corporations. An S Corporation or partnership that has multiple tiers appears to be eligible for this deduction as well. Part of the tax code, Section 199A(f)(4)(B), states that regulations will be forthcoming “for the application of this section in the case of tiered entities.”
The following is a set of basic examples of scenarios that illustrate the new tax law:
Operating companies – construction related and real estate trade or business
Bryan is a 100% owner of an S Corporation that is a real estate developer, and the company actively develops and sells condos and other buildings, generating ordinary income. Bryan receives a W-2 for $250,000, a K-1 with net ordinary income of $1,000,000 and wages of $800,000. Bryan’s qualified business income is $1,000,000, and the 20% deduction is $200,000. The 50% W-2 limitation is $400,000. Therefore, he would be eligible to receive the full 20% deduction.
Mr. Graves is a 25% owner in an S Corporation, where the trade or business is a general contractor. Mr. Graves receives a W-2 for $85,000, a K-1 with net ordinary income of $500,000 and his allocable share of the company’s W-2 wages of $250,000. Mr. Graves’ qualified business income is $500,000, and the 20% deduction is $100,000. The 50% W-2 limitation is $125,000. Therefore, he would be eligible to receive the full 20% deduction.
Assume the same facts above, except that Mr. Graves’ allocable share of the company’s W-2 wages is $150,000. The 50% W-2 limitation is now $75,000. Therefore, Mr. Graves’ deduction would be limited to $75,000.
Holding companies – real estate trade or business
Leslie is a 20% partner in a real estate holding LLC. The LLC invests in and holds commercial buildings. Leslie does not receive wages, but she receives a K-1 with $1,000,000 in rental income. The LLC does not pay any W-2 wages, but pays a management fee to another entity. Leslie’s share of the unadjusted basis in the property is $5,000,000. Leslie’s qualified business income is $1,000,000, and the 20% deduction is $200,000. The LLC would not have a 50% W-2 limitation, because no W-2 wages were paid by the company. However, the taxpayer would be eligible for a $125,000 deduction related to the 2.5% of the unadjusted basis of all qualified property ($5,000,000 x 2.5%). The deduction is limited to the lesser of $200,000 as compared to the greater of $0 (50% W-2 limitation) and $125,000 (25% W-2 limitation + 2.5% of qualified property).
Rental Property – schedule E
David owns three rental properties that produce net incomes of $50,000, $75,000 and one with a loss of $15,000, for a total of $110,000 of income. The unadjusted basis in the three properties is $800,000. David files as married filing joint, and does not have any additional taxable income. David is entitled to a 20% qualified business income deduction of $22,000 as no limitations apply in this scenerio.
Assume the same facts as above except that David has taxable income of $500,000. Since his taxable income is over the threshold of $315,000, the limitations do apply. David’s qualified business income is $110,000, and the 20% deduction is $22,000. David would not have a 50% W-2 limitation because no W-2 wages were paid. Similar to the holding company example above, he would be eligible for a deduction, but would be limited to a $20,000 deduction due to the 2.5% unadjusted basis of all qualified property rule ($800,000 x 2.5%).
There will undoubtedly be many unique circumstances that will yield vastly different results and will likely result in further clarification and judicial interpretation in the years to come. At Cassady Schiller, we are here to help you navigate these complex rules and sticky issues and help you plan with them in mind. We welcome the opportunity to discuss your unique circumstances to help you navigate these waters. Please feel free to reach out to Cassady Schiller to see how we can help you take full advantage of this new law.