Back in December 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA), the first significant overhaul of our tax system since 1986. One provision of that new law—commonly known as 199A, or the 20% pass-through deduction—presented a unique opportunity to many small business owners: the chance to deduct 20% of their “qualified business income” (QBI) earned from a “qualified trade or business.”
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This new deduction can benefit the owners of many businesses structured as pass-through entities (i.e., sole proprietorships, partnerships, limited liability companies, and S corporations), including yours—unless your business is a “specified service trade or business.” And it has the potential to make a big difference in the amount of tax an individual owes.
When the law was first passed, it was not clear which businesses would actually be eligible for the deduction. The law prohibited owners of a “specified service trade or business” (SSTB) from taking the 20% pass-through deduction, leaving people with a lot of questions, specifically about what would be considered an SSTB.
Okay, so which businesses qualify for the 20% pass-through deduction?
To determine whether or not your business qualifies, you’ll need to answer some questions. Let’s take these one by one:
Question 1: Do you own a pass-through business?
As a reminder, the major types of pass-through businesses are sole proprietorships, partnerships, limited liability companies, or S corporations. So, does your business take one of these forms?
- Yes! Great, move on.
- No. Sorry, you’re not eligible.
Question 2: What is your taxable income?
- Less than $157,500 (Single, Married Filing Separately, Head of Household) or $315,000 (Married, filing jointly): BOOM, you’re in! You can take the 20% deduction.
- $157,500 or more (Single, Married Filing Separately, Head of Household) or $315,000 or more (Married, filing jointly): Uh oh. Your deduction may be limited. You’ll have to answer a few more questions. Taxpayers with taxable income above $207,500 and $415,000, respectively, are not eligible for the deduction at all.
Question 3: What does your business do?
For taxpayers who earn more than the thresholds above, the law only allows those who are in engaged in a “qualified trade or business” to take the deduction.
The deduction is equal to 20% of “qualified business income.” Qualified business income is the sum of income and gains (excluding some investment income such as capital gains or dividends) minus deductions and losses that are connected with the running of that qualified trade or business.
Oddly, what defines a “qualified trade or business” is what the business is not. Your business will qualify for the 199A deduction if it is not a “specified service trade or business” (SSTB). So, if your business is:
- Not a specified service trade or business: Cool! You’re moving on.
- A specified service trade or business: Your deduction will be limited. Keep reading.
Hold on. What exactly is a “specified service trade or business”?
Good question! There was a lot of uncertainty around this, and imaginative lawyers and accountants had all kinds of ideas for new business structures and arrangements (e.g., “crack and pack”) to allow more businesses to qualify for the 20% pass-through deduction.
In August 2018, the Treasury Department released its proposed regulations that answered a lot of the questions that tax experts had, including, yes, what exactly an SSTB is. Simply, an SSTB is any trade or business that performs service in the following fields:
- Actuarial science;
- Brokerage services;
- Financial services;
- Performing arts;
- Any business that consists of investing and investment management, trading or dealing in securities, partnership interests or commodities.
- Any business where the principal asset is the reputation or skill of one or more of the employees or owners;
But, as usual, the devil is in the details. The regulations include further explanation, including exceptions for each of the disqualified groups.
Among health businesses, for example, services by dentists, nurses, pharmacists, physical therapists, physicians, psychologists, and “other similar healthcare professionals who provide medical services directly to a patient” are considered SSTBs and therefore not eligible for the deduction. However, those that operate health clubs or health spas may be eligible, as may businesses that research, test, manufacture, or sell pharmaceuticals or medical devices.
The regulations also include a lengthy explanation for businesses whose main asset is the reputation or skill of one or more of its owners or employees. An example would be a celebrity chef who endorses kitchen utensils branded with their name and image.
So what if your business sells products and performs services? To answer that question, the regulations established a “de minimis exception” which says your business qualifies for the deduction if:
- Its gross receipts are below $25 million and less than 10% of your business comes from disqualified services; or
- Its gross receipts are more than $25 million and less than 5% of your business is from disqualified services.
Whew! That’s complicated. So, are we done?
Sorry, we have a couple more questions. Hang in there.
Questions 4 & 5: Does your business pay wages or own real estate?
If your business pays wages or has “qualified property”—like real estate or other tangible assets (excluding inventory and land) that can be depreciated—then you have to crunch a few numbers to figure out if how much of the deduction you are eligible for.
So, if your business pays wages or owns qualified property, your deduction will be the lesser of:
- 20% of qualified business income (or the “tentative deduction”); or
- The greater of:
- W-2 wages paid x 50%; or
- W-2 wages paid x 25% + the unadjusted basis (i.e., cost) of your qualified property x 2.5%
Yes, we have an example.
Six-Shooter McGavin, a single taxpayer, is the sole owner of Sinister Moustache, LLC, a business that sells facial hair products for villains. Under the TCJA, Sinister Moustache is not considered to be a specified service trade or business, and McGavin’s total taxable income for 2018 is $200,000. This means that while his business is eligible for the deduction, it is limited because Shooter’s taxable income is greater than $157,500.
Here are some more details: In 2018, Sinister Moustache:
- Earned $100,000 in qualified business income;
- Paid $30,000 in W-2 wages;
- Had unadjusted basis of $50,000 in qualified property.
With these facts, let’s figure out Part A, the tentative deduction, from above first:
- $100,000 (QBI) x 20% = $20,000
And now let’s first solve Part B from above. It’s the greater of:
- $30,000 in wages x 50% = $15,000; or
- $7,500 ($30,000 in wages x 25%) + $1,250 ($50,000 x 2.5%) = $8,750
Since $15,000 is greater than $8,750, we’ll compare it to the 20% of QBI from Part A. Remember, the deduction is the lesser of the two:
- 20% of QBI: $20,000
- 50% of wages: $15,000
So in this scenario, the taxpayer’s deduction would be $15,000.
There are many more nuanced details of this 20% pass-through deduction that may apply to your business, so make sure to consult with an accountant.