** May 2019 Update: Sage Fixed Assets - Depreciation 2019.1.2 has a new Section 199A Report to calculate the capital limitation component for the QBI deduction. **
** The 2019.1.2 release is an update to version 2019.1 **
This post is about the new U.S. IRS Code Section 199A, Qualified Business Income. It discusses when Section 199A applies to taxpayers and which business entity types need to calculate the 2.5% capital limitation.
Using Sage Fixed Assets—Depreciation to calculate the Section 199A capital amount
Sage Fixed Assets 2019.1.2 has a Section 199A report to calculate the 2.5% capital limitation component for the QBI deduction. More details on the report are available in the product and at the knowledgebase article: Section 199A Report.
For tax years beginning after 2017, a U.S. federal income tax deduction is available for taxpayers with income from partnerships, limited liability companies (LLCs), S corporations, trusts, estates and sole proprietorships. This deduction does not apply to regular corporations, also referred to as c-corporations. The deduction is provided by Section 199A of the Internal Revenue Code, as added by the Tax Cuts and Jobs Act (P.L. 115-97) on Dec. 22, 2017.
The deduction can be up to 20% of the domestic qualified business income (QBI) generated by those businesses. The calculation of the taxpayer’s QBI deduction depends on the taxpayer’s taxable income.
This article will recap the basics of the deduction and discuss when a wage and capital investment calculation, which may limit the taxpayer’s QBI deduction, applies. If this calculation applies to your business, Sage Fixed Assets has the tools to help you; suggested calculation steps are in the linked PDF document below.
Want more details? Section 199A has complexities and exceptions not covered in this article. Also, the IRS is expected to issue regulations and guidance. The May 2018 Journal of Accountancy article, Mechanics of the new Sec 199A deduction for qualified business income, goes into greater depth on many of facets of Section 199A.
Qualified Trade or Business Distinction
Distinguishing whether a business is a "qualified trade or business" (QTB) under section 199A is essential to determine if the wage and capital limitation calculation is required.
Under section 199A(d), the term "qualified trade or business" means "any trade or business other than a specified service trade or business, or the trade or business of performing services as an employee." Therefore, specified service businesses are excluded from meeting the definition. Examples of such excluded service businesses include those providing legal, health, accounting, consulting, athletic, and financial services.
Specified Service Businesses
Specified service businesses and trades are generally excluded from the QBI deduction because they are not considered a qualified trade or business. However, Congress did extend the QBI deduction to ‘smaller service business’. Thus, specified service businesses (and thus their owners) are eligible for the deduction if the taxpayer's taxable income is below $157,500 ($315,000 for joint filers). They are barred from the deduction once taxable income reaches $207,500 ($415,000 for joint filers). Between these two ranges, the QBI deduction is phased down from the maximum allowed amount to zero. (The threshold values provided are for 2018; they will be indexed for inflation in future years.)
Specified service businesses do not need to calculate the wage or capital limitation on their qualified business income. As we will see later, the wage and capital limitation only applies to qualified trades and businesses, and then only once the taxpayer’s income exceeds the lower threshold.
Note: Not all service and trade business fall into the ‘specified’ category. For example, engineering and architecture service businesses are not in the specified category.
To recap, owners of specified service and trade businesses are eligible for the deduction if their taxable income does not exceed the lower threshold, and partially eligible if their income is between the lower and upper thresholds. The deduction is limited to 20% of the taxpayer's taxable income, as calculated without regard to the QBI deduction or any net capital gain.
Qualified Trade or Businesses
If the business is a qualified trade or business (thus not a specified service trade or business) and the taxpayer's taxable income is above the lower threshold of $157,500 ($315,000 for joint filers), the ‘W-2 wage and capital’ calculations are needed. As shown below, there are two calculations – one with wages only, the other with wages and capital. The higher amount of the two calculations, if less than 20% of the company’s QBI, may limit the potential QBI deduction amount.
For taxpayer’s above the upper threshold $207,500 ($415,000 for joint filers), the potential QBI deduction is limited to the higher of the two wage and capital calculations. For taxpayers between the upper and lower thresholds, the wage and capital limitation is partially applied. For taxpayers below the lower threshold, the wage and capital limitation does not apply. In all three scenarios, the taxpayer’s deduction cannot be more than 20% of their taxable income, without regard to net capital gains.
Since the application of the capital and wage limitation is determined at the individual taxpayer level, not the company level, most every pass-through entity will need to calculate both the wage and the capital components at the company level. (A closely held business where the owners are below the lower threshold, or a business with a loss for the year, may be the only exceptions.)
In the case of partnerships and S-corporations, the QBI, wage, and capital amounts must be allocated to the partners/shareholders. For the capital amount, allocate each owner's portion in the same manner as depreciation is allocated (199A(f)(1)(A)).
Wage and Capital Limitation on QBI
The deductible QBI amount for the business is equal to the lesser of:
(1) 20% of the business's QBI, or
(2) the greater of:
(a) 50% of the W-2 wages for the business, or
(b) 25% of the W-2 wages plus 2.5% of the business's unadjusted basis in all qualified property.
Calculating the Capital Limitation
Qualified property definition
For purposes of 199A, qualified property is defined as 1) depreciable tangible property, which is 2) used during the tax year to produce qualified business income, and 3) held by and available for use in the qualified trade or business at the close of the tax year.
Furthermore, for an asset to be included in the calculation, the asset’s depreciable period must extend beyond the close of the current tax year. Interestingly, the depreciable period is not merely the asset's recovery period (life) under the MACRS General Depreciation System (GDS). Instead, the rules state the depreciable period ends on the later of:
(1) the date 10 years after the placed-in-service date, or
(2) the last day of the final full year of depreciation under MACRS depreciation, without regard to the alternative depreciation system (ADS). [Thus, do not include assets in the year they become fully depreciated].
Your Feedback is Appreciated
What are your thoughts on this article and the new report? Do you have suggestions that may help others affected by this new calculation? Please feel free to comment below to start the conversation.