Posted by The TaxAdvocate Group, LLC

Breaking Down Section 199A

Breaking Down Section 199A

Pass-through businesses are likely to file early tax returns this year. Trusts, estates and individuals who own pass-through businesses can claim a deduction under section 199A for the first time this tax year. The Tax Act of 2017 (reference: (P.L.115-97) allowed owners of pass-through businesses to claim this deduction which would allow the filers some consolation considering that the biggest beneficiaries of the Tax Act are corporations who received a huge cut in the corporate tax rates.

Those eligible can claim the deduction from tax year 2018 onwards and can continue to claim the deduction for every tax year that begins before December 31, 2025. Owners of pass-through businesses are allowed to deduct a maximum amount not exceeding 20 percent of the qualified amount of revenue shown by the return filer as his/her domestic qualified business income (QBI). The claim will be subject to other limitations that could be significant in character. The final regulations for the deduction were issued in February of 2019.

While section 199A offers a tax benefit, it also presents a challenge to return filers who seek to comply for the deduction which is complex rather than a simple subtraction that would be easy to compute. To arrive at the deductible amount, pass throughs must gather new information and share such information with their owners and assess and calculate multiple times before complying with several limitations.

Some business owners may seek to amend the way their businesses are structured to ensure that they optimize their benefits from the provision relating to the deduction. The provision makes it mandatory for pass-throughs to provide relevant information relating to the deduction to owners on an ongoing basis.

Claiming the pass-through deduction

Three main questions are required to be answered by claimants of the deduction under section 199A.

Is the claimant a qualified (QTB) or a specified service trade or business (SSTB)?

The trade or business level, rather than the legal entity, will determine the nature of information the claimant would need in order to compute the amount of deduction under section 199A.

Does the company have any trades or businesses? Is each business a QTB or SSTB? This is an important distinction because income earned by a SSTB does not qualify for the deduction.

Barring some examples that are negligible in number, a QTB is defined in negative terms by detailing what it should not be. Any trade or business that is not a SSTB or a service performed by an employee rather than a business owner will qualify for the deduction.

By contrast, an SSTB is defined as a business entity that operates in the fields of financial services, trading, performing arts, consulting, accounting, law, and health among others.

If the reputation or skill of any employee or owner of a business is deemed to be its principal asset, such business is defined as an SSTB. An owner of an SSTB could still qualify for a deduction under section 99A if his/her income is below a certain threshold level.

The challenge of gathering data that’s relevant and necessary for the deduction becomes even more daunting with every underlying trade or business an organization may have. The taxpayer may even have to resort to a planned inclusion of SSTB and QTB activity in his business or trade.

What is the qualifying income?

There is a need to compute the qualified business income from every underlying business or trade before a pass-through can establish the deduction amount to be claimed. Such listing of revenues would necessarily include any item of loss or income related to a QTB that is not suspended or disallowed under other tax rules. 

The law excludes net gains from foreign currency, dividends, capital gain and some interest and other items from the qualified income that allows the taxpayer to claim the deduction.

Lastly, expenses need to be allocated. There is no defined method of listing expenses under the current rules. A method once chosen cannot be changed in subsequent years. In other words, much critical thought and planning must precede the selection of a method used to allocate expenses while filing a return for tax year 2018.

These calculations for every SSTB and QTB, once completed, must be communicated to every owner to allow proper filing of tax returns for the said tax year.

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