Taxing Definitions

Definitions — Proposing a deduction

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In the language of math, 199 is an odious number. In the language of tax, 199 was an internal revenue code section for the domestic production activity deduction that was repealed with the Tax Cuts and Jobs Act of 2017.

That tax law also created another section 199—section 199A, a new deduction for qualified business income. This deduction was enacted to provide relief to sole proprietorships and passthrough entities, since these businesses didn’t benefit from the new law’s reduced federal income tax rates for regular corporations.

This week, the IRS released guidance for applying section 199A to 2018 federal income tax returns.

You already know section 199A provides a deduction of up to 20% of income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate.

The new deduction will be reported on page 1 (currently on line 9) of the new, shorter Form 1040, US Individual Income Tax Return, for 2018 and taxpayers don’t have to itemize to benefit. The section 199A deduction is limited when taxpayers have taxable income of more than $315,000 (for married filing jointly), or $157,500 (for all other taxpayers).

Here are a few basic examples from the proposed regulations so you can test your knowledge about this new deduction.

1.

The proposed regulations define “trade or business” for purposes of section 199A because the actual law (and legislative history) does not.

The IRS says internal revenue code section 162 provides the most appropriate definition of “trade or business” for purposes of section 199A. That means the deduction does not apply to performing services as an employee. The deduction also does not apply to income earned through a regular “C” corporation.

In addition, the deduction is not available for a “specified service trade or business” when taxpayers have taxable income of more than $315,000 for a married couple filing a joint return ($157,500 for all other taxpayers).

A “specified service trade or business” includes a trade or business involving the performance of services in the fields of

health

law

accounting

actuarial science

performing arts

consulting

athletics

financial services

investing and investment management

trading

dealing in certain assets

or

any trade or business where the principal asset is the reputation or skill of one or more of its employees

Note: The proposed regulations provide a “de minimis rule.” That means a trade or business is not a “specified service trade or business” if less than 10% of the gross receipts (5% if the gross receipts are greater than $25 million) of the trade or business are attributable to the performance of services in a specified service activity.

 

Question 1.

A taxpayer is in the business of providing services to assist clients with finances. The taxpayer studies a client’s financial situation, including present income, savings and investments, and anticipated future economic and financial needs. Based on the study, the taxpayer helps the client make decisions and plans about financial activities, including a personal budget and investment strategies.

The taxpayer’s business has taxable income in excess of the threshold amount (more than $315,000 for a married couple filing a joint return, and $157,500 for all other taxpayers).

Is the taxpayer engaged in the performance of services in a specified service trade or business?

or

 

2.

In the above definition, the proposed regulations limit the meaning of the “reputation or skill” clause to a taxpayer engaged in the trade or business of:

(1) receiving income for endorsing products or services

(2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity

or

(3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).

 

Question 2.

A taxpayer is a well-known chef and the sole owner of multiple restaurants, each of which is owned in a disregarded entity. Due to the taxpayer’s skill and reputation as a chef, the taxpayer receives an endorsement fee of $500,000 for the use of the taxpayer’s name on a line of cooking utensils and cookware.

The taxpayer’s business has taxable income in excess of the threshold amount (more than $315,000 for a married couple filing a joint return, and $157,500 for all other taxpayers).

Since the taxpayer’s business of being a chef and owning restaurants is not a specified service trade or business, does the endorsement fee fall under the reputation or skill clause?

or

 

3.

The section 199A deduction is based on “qualified business income,” which is defined as the net amount of qualified items of income, gain, deduction, and loss from a trade or business. Only items effectively connected with a US trade or business and included in taxable income are counted. Capital gains and losses, certain dividends, and interest income are excluded.

 

Question 3.

An unmarried taxpayer owns and operates a computer repair shop as a sole proprietorship. The business generates $100,000 in net taxable income from operations in 2018.

The taxpayer has no capital gains or losses.

After allowable deductions not related to the business, the taxpayer’s total taxable income for 2018 is $81,000.

 

 

4.

The general calculation of the section 199A deduction when a taxpayer’s taxable income is less than the threshold amount (more than $315,000 for a married couple filing a joint return, and $157,500 for all other taxpayers) is:

20% of the total qualified business income amount (including qualified business income attributable to specified service trade or business)

plus

20% percent of the combined amount of qualified real estate investment trust dividends and qualified publicly traded partnership income.

Compare that sum to 20% of the taxpayer’s taxable income minus net capital gains.

The lesser of the two amounts is the section 199A deduction.

Remember, the specified service trade or business limitation does not apply if a taxpayer’s taxable income is below $315,000 for a married couple filing a joint return and $157,500 for all other taxpayers.

If the taxpayer’s taxable income is above the $315,000/$157,500 thresholds, the deduction may be limited based on whether the business is a specified service trade or business, the W-2 wages paid by the business, and the unadjusted basis of certain property used by the business.

The limitations are phased in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500.

If the taxpayer’s taxable income exceeds the phase-in range, no deduction is allowed with respect to any specified service trade or business.

The threshold amounts and phase-in range are for tax year 2018 and will be adjusted for inflation in subsequent years.

Question 4.

 

Question 5.

In 2018, a taxpayer will report taxable income under $315,000 and file married filing jointly.

 

 

Question 6.

In 2018, a taxpayer will report taxable income between $157,500 and $207,500 and file as single.

 

***

Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

***

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Right answer!

Yes, the taxpayer is engaged in the performance of services in a specified service trade or business in the field of financial services as defined in the proposed regulations.

See Example 5, page 167 of the proposed regulations.

Sorry, wrong answer :(
Right answer!

The taxpayer is in the trade or business of being a chef and owning restaurants and such trade or business is not a specified service trade or business.

However, the taxpayer is also in the trade or business of receiving endorsement income.

The taxpayer’s trade or business consisting of the receipt of the endorsement fee for the taxpayer’s skill and/or reputation is a specified service trade or business within the meaning of the proposed regulations.

See Example 8, page 168 of the proposed regulations.

Sorry, wrong answer :(

The business’s qualified business income is $100,000, the net amount of its qualified items of income, gain, deduction, and loss.

See question 1, page 114 of the proposed regulations.

Editorial note: The proposed regulations also contain more complicated examples.

The section 199A deduction for 2018 is $16,200, the lesser of 20% of the qualified business income from the business ($100,000 x 20% = $20,000) and 20% of the taxpayer’s total taxable income for the taxable year ($81,000 x 20% = $16,200).

See question 1, page 114 of the proposed regulations.

Editorial note: The proposed regulations also contain more complicated examples.

No, if the taxpayer’s 2018 taxable income is below $315,000 (for married filing jointly), or $157,500 for all other filing statuses, the specified service trade or business limitation does not apply.

The taxpayer can deduct the lesser of:

20% of qualified business income, plus 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income,

or

20% of taxable income minus net capital gains.

See question 8, Deduction for Qualified Business Income FAQs, on the IRS website.

Yes.

Because taxable income is above the threshold amount, the section 199A deduction with respect to any specified service trade or business will be limited.

However, because the taxpayer is within the phase-in range, the taxpayer may be allowed some section 199A deduction with respect to a specified service trade or business.

In addition, for taxpayers above the threshold amount, the section 199A deduction with respect to any trade or business, including a specified service trade or business, may be limited by the amount of W-2 wages paid by the trade or business and the unadjusted basis immediately after acquisition of qualified property held by the trade or business.

The phase-in range is $315,000 to $415,000 for joint filers and $157,500 to $207,500 for all other filing statuses.

See question 9, Deduction for Qualified Business Income FAQs, on the IRS website.

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