What Every Business Person Should Know About New Internal Revenue Code Section 199A
New Internal Revenue Code Section 199A is one of the most complex provisions of the Internal Revenue Code, and it is one of the hardest to apply. But, for owners of small businesses whose businesses are properly structured, it offers extraordinary federal income tax deductions. These deductions can amount to 20 percent or more of their business income.
The most comprehensive explanation of the section is set forth in a book by section 199A attorney John M. Cunningham entitled Maximizing Pass-Through Deductions Under Internal Revenue Code Section 199A—a Section 199A Practice Manual, published by Wolters Kluwer Law & Business. Maximizing Pass-Through Deductions Under Internal Revenue Code Section 199A is the only book about section 199A that is published by a recognized legal and tax publisher. John’s practice is focused on LLCs and section 199A. He has assisted clients in obtaining tens of thousands of dollars of section 199A deductions.
Many section 199A issues cannot be resolved without the use of LLCs. LLC practice and section 199A practice are profoundly interdependent and mutually supportive. Mr. Cunningham is one of the few lawyers with extensive experience in representing not only section 199A clients but also LLC clients, and he is the principal author of Drafting Limited Liability Company Operating Agreements, the leading LLC formbook and practice manual.
The chief features of section 199A can be briefly stated as follows.
- Effective date and expiration of section 199A. Section 199A became effective on January 1, 2018. By its terms, it will expire at the end of 2025, but there is a good chance that before then, Congress will extend it indefinitely.
- Types of section 199A deductions. Section 199A provides deductions to owners of pass-through businesses, to investors in Real Estate Investment Trusts and publicly traded partnerships, and to farmers, horticulturists and farm and horticultural cooperatives. However, for most Americans, the most important section 199A deductions are, by far, the pass-through deductions addressed below.
- Who may receive pass-through deductions? Persons eligible for pass-through deductions include active and passive owners of pass-through businesses who are U.S. or foreign individuals subject to federal income tax; trusts and estates; and S corporations and entities taxable as partnerships. Individuals who are employees of their companies are not eligible for pass-through deductions.
- “Qualified trades or businesses” and “specified service trades or businesses.” The pass-through deduction available to business owners may depend on whether their businesses are “specified service trades or businesses” or “qualified trades or businesses.” Specified service trades or businesses are, in general, professional businesses such as the practice of law, and businesses involving investments and the provision of investment advice. Qualified trades or businesses are all other types of business except the business of serving as an employee.
- Cap on pass-through deductions. In general, the pass-through deduction available to eligible taxpayers are capped at 20 percent of their taxable income less the amount of any net capital gains they have realized in the relevant taxable year.
- What are “pass-through businesses”? Pass-through businesses consist of sole proprietorships, S corporations and entities taxable as partnerships. Most multi-member LLCs are taxable as partnerships.
- Factors determining the amount of pass-through deductions. Four key factors determine the amount of the pass-through deduction available to business owners:
- Their taxable income for the relevant year;
- Their “threshold amount” (defined below);
- Their “phase-in range” (defined below); and
- The federal tax structure of their business.
- Threshold amounts and phase-in ranges of married individuals filing jointly. For married individuals filing joint federal tax returns, the threshold amount is $315,000 and the phase-in range is between $315,000 and $415,000.
- Threshold amounts and phase-in ranges of all others. For persons not filing joint returns, the threshold amount is $157,500 and the phase-in range is between $157,500 and $207,500.
- Rules governing the computation of pass-through deductions. The rules governing the computation of pass-through deductions are complex, and I will not address them in detail here. However, briefly (and subject to the above cap):
- Persons whose taxable income for the relevant taxable year do not exceed their threshold amount can receive pass-through deductions of 20% of their business income (“Section 199A(b)(2)(A)” deductions).
- The pass-through deductions available to persons who own qualified trades or businesses and whose taxable income is within their phase-in range in the relevant taxable year will be determined at least in part by the amount of the W-2 wages their businesses pay to their employees and the cost of the depreciable real and personal property owned and used by these businesses (“Section 199A(b)(2)(B)” deductions).
- The pass-through deductions of owners of qualified trades or businesses whose taxable income exceeds their phase-in range will be the lesser of their Section 199A(b)(2)(A) deductions and their Section 199A(b)(2)(B) deductions.
- The pass-through deductions of owners of specified service trades or businesses whose taxable income is within their phase-in range will generally be less than those of owners of qualified trades or businesses.
- The owners of specified service trades or businesses whose taxable income exceeds their phase-in range in the relevant taxable year will receive no pass-through deductions.
- The need of many business owners for substantial restructuring in order to maximize their pass-through deductions. About 50 million American business owners are eligible for pass-through deductions. However, in order to maximize their pass-through deductions, many millions of these business owners must substantially restructure their personal, financial, business or federal tax arrangements.
- Examples of necessary restructuring. In particular, in order to maximize their pass-through deductions:
- Millions of shareholders of S corporations must convert their businesses to single-member LLCs taxable as sole proprietorships or to multi-member LLCs taxable as partnerships; and
- Millions of owners of sole proprietorships or entities taxable as partnerships must convert them to S corporations.
- Restructuring of C corporations. Shareholders of entities taxable as C corporations can receive pass-through deductions if they convert the federal tax regimen of their company to a pass-through regimen, and most of them should make this conversion.
- The need of many business owners to consult section 199A experts. All American business owners with significant business income should consult with a section 199A expert to determine how, if at all, they should restructure the above arrangements in order to maximize their pass-through deductions.