Section 199A deduction

The information needed to calculate the section 199A deduction is not based on the legal entity, but rather on a trade or business level. Every company must first determine whether they have trades or businesses and then determine whether each is deemed a qualified trade or business (QTB) or a specified service trade or business (SSTB).

The distinction is important because the new section 199A deduction applies only to qualified business income earned by a QTB. Outside of a few specific examples, section 199A defines a QTB by explaining what it’s not. Effectively, every trade or business qualifies unless they are SSTBs or services performed as an employee rather than a business.

An SSTB, on the other hand, is any business involved in the fields of health, law, accounting, consulting, performing arts, trading, financial services, and a handful of others. An SSTB is also determined to be any business in which the principal asset is the “reputation or skill” of one or more of its employees or owners. Just because a business is an SSTB doesn’t mean the reporting for it isn’t necessary, because the income it generates could still result in a benefit at the owner’s level if their income is below certain threshold amounts.

The more underlying trades or businesses an organization has, the more challenging it may be to gather the necessary and relevant data for its owners, and it may even require some planning considerations to the extent that the taxpayer has QTB and SSTB activity as part of the same trade or business.

What makes this particularly burdensome on companies is the need to capture specific information from every trade or business in order to calculate the section 199A deduction.

Every pass-through must determine the qualified business income from each underlying trade or business. Income that qualifies generally includes qualified items of income or loss with respect to each QTB, so long as they aren’t disallowed or suspended under other rules and are effectively connected with the conduct of a domestic QTB. Income that doesn’t qualify includes that from capital gains, dividends, net gains from foreign currency, and certain interest and other items listed under the law.

Finally, there’s the allocation of expenses. This is another challenge, as the current rules don’t define how to go about this but instead allow for any “reasonable” method. Once a method is chosen, there is no going back. The final regulations clearly state that taxpayers must consistently apply the chosen reasonable method for each item in all subsequent years. That means they need to think critically about—and plan around—the approach they want to use for allocating expenses as part of the 2018 tax return process.

Once these calculations are done for every QTB and SSTB, this information is then shared with each owner as part of the tax return process.

After this information is shared, each owner of the business must determine the amount they can deduct. At this point, they might be tempted to just take 20 percent of the qualified income to claim as the deduction. Not so fast. Even after all of this work, the amount of the deduction may be further limited by wage and property considerations.

These limitations include a number of “greater of” calculations involving W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of property used by the trade or business. Those calculations require a lot more than simply pulling a number from your payroll or depreciation reports. Rather, they involve one of three permissible methods for the W-2 wage limitation and several manual adjustments for UBIA.

As the pass-through deduction is calculated at the owners’ level, the pass-through entities won’t always know what limitation would be most beneficial to the individual or trust. As a result, both W-2 wages and UBIA may need to be reported to provide the owners with all of the information required to calculate the pass-through deduction at their level. Under the final regulations, if a pass-through fails to report an item of QBI, wages, or UBIA, the unreported item will be presumed to be zero.

In addition, there’s the issue of aggregation. Owners will need to assess whether to aggregate activity of qualifying yet related trades or businesses. If two or more trades or businesses meet certain qualifications, their respective section 199A activity can be aggregated to enhance the benefit of the deduction. The rules provide that either the pass-through entity or its individual owners can elect to aggregate separate trades or businesses. If the pass-through entity aggregates certain trades or businesses, the owners of these entities retain the entity aggregation. Like the expense methodology above, the choice to aggregate is locked in once it’s made, since once a decision to aggregate is made, one must consistently report the aggregated trades or businesses in all subsequent taxable years. This puts pressure upon the businesses and its individual owners to exercise foresight when deciding to make the election.