Decoding the Tax Cuts and Jobs Act Pass-Through Deduction
Internal Revenue Code § 199A (“§ 199A”), effective beginning in 2017, added by the Tax Cuts and Jobs Act (“Act”) has been less publicized than the Act’s famous reduction of the corporate tax rate, but within the circles of tax professionals there is a confused buzz. With the highly debated reduction in the corporate tax rate to 21%, Congress needed to formulate a similar deduction for pass-through entities, including sole proprietorships, partnerships, limited liability companies, and s-corporations. Its answer was § 199A—but § 199A could turn out to be even more contentious than the cut to the corporate tax rate.
The intent of I.R.C. § 199A was to deliver a deduction equally beneficial to pass-through entities as is the rate cut for c-corporations, but the effect of the provision may not live up to the goal. In simplified terms, under § 199A, pass-through entities are potentially eligible to take a deduction equal to 20% of their qualified business income. Although that seems straightforward, qualified business income under § 199A specifically excludes many types of business income. The § 199A deduction was important to avoid the potential reorganization of many pass-through entities to c-corporations solely to take advantage of tax benefits. Congress was concerned that with the lower corporate tax rate, structuring a business as a c-corporation would have become more attractive than structuring a business as a pass-through entity, incentivizing the switch.
The deduction, however, is riddled with exceptions, exclusions, phase-outs, and gray areas, making its application not only very technical, but also in some cases impossible. Many pass-through entities are finding the use of this deduction severely limited, incredibly uncertain, or entirely inapplicable to their particular businesses. This renews the sentiment of confusion on how to proceed under the Act, with many businesses still questioning whether a change in business organization might be the correct answer.
The basics of § 199A are that if a business is structured as a pass-through entity and it qualifies, 20% of the qualified business income it earns that year can be deducted by the pass-through owner. If the business does not qualify, however, the pass-through owner is taxed at current individual federal rates, up to 37%. If the qualified business income earned from the business is more than $157,500 for single filers or $315,000 for married filers, the deduction is further limited. In the gray area as a business begins to earn over the appropriate thresholds, there is a complicated phase-out which leads to an eventual exclusion. But there is an even bigger, more disfavored exclusion: if the business is in the service industry, such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, this deduction is, for all intents and purposes, unavailable except in very limited circumstances.
The rationale behind the exclusion for service businesses is that service industry owners do not have to invest significant capital in buying equipment or inventory. Their profit is primarily due to their own efforts and thought-products instead of tangible goods. Congress reasons that this requires a smaller investment, and therefore service business owners should not be entitled to the same level of tax deduction as those who had larger up-front capital investments. This may encourage the exploitation of a potential loophole, however, in how a business is classified. Right now, a service business is defined as a trade or business where the principal asset is the reputation or skill of the employees or owners. This is nebulous at best, and it may cause some businesses to attempt to reclassify away from service industries.
Another group of taxpayers not eligible for the deduction are employees other than s-corporation employees. This is leading people to consider making the conversion from employee, where the deduction is unavailable, to independent contractor, where the deduction may potentially be available. Although this solution may look attractive on the surface, the federal tax law and regulations governing what constitutes an employee as opposed to an independent contractor is well-established, therefore, this potential ‘solution’ has limited viability.
For now, most tax experts are proceeding with caution. Given the uncertainty involved with any new section of the Code, many are advising clients not to make any sudden moves. It may seem that making big changes to take advantage of the new provisions is the best way to go; however, the Code may not stay as it is forever, and rates are often the easiest parts of the Code to change. Further, tax benefits should not be the only consideration when it comes to the management decisions of a business. So before deciding to change a business formation to a c-corporation, trying to reclassify a service business into a non-service industry, or trying to become an independent contractor rather than an employee, a taxpayer should consult with his or her tax professional to consider all the implications and options carefully.