Section 199A: The pass-through deduction explained
Plus, changes to carried interest rules
Austin Bradley, CPA
The Tax Cuts and Jobs Act (TCJA) brought with it many drastic changes to the tax law. Arguably the most important – and complex – is the 20% deduction allowable for pass-through income, covered by Section 199A of the Internal Revenue Code. This is BIG for businesses, so let’s breakdown what it means for you.
Before we dive into the details, what is pass-through income anyway? Pass-through income is earnings generated by partnerships and S Corporations, which are subsequently “passed-through” to the owners of the business. The owners then pay the tax on this income, rather than the entity itself paying the tax. Under TCJA, this income is eligible for an up to 20% deduction on the individual’s tax return. However, there are numerous variables that determine how much, if any, of the 20% deduction a taxpayer is entitled to.
Specialized service trade or business
The first question that needs to be answered is whether the entity generating pass-through income constitutes a “Specialized Service Trade or Business,” or SSTB. Industries treated as SSTBs include:
- Investment services
- Performing arts
Income generated by an SSTB is subject to stricter rules when calculating the 20% pass-through deduction. For married taxpayers with total taxable income of $315,000 or more, the 20% deduction begins to phase out based on taxable income. Once taxable income reaches $415,000, no deduction is allowed for income received from SSTBs. For married taxpayers with taxable income under $315,000, however, the calculation is easy – they will receive the full 20% deduction for SSTB income.
What about businesses that do not fall under the SSTB rules? Similar to the example above, as long as taxable income for a married taxpayer is below $315,000, he or she will receive the full 20% deduction of pass-through income. Once the $315,000 threshold is crossed, however, the calculation becomes more complicated. At this point, the amount of the deduction you are entitled to is based on the amount of wages paid to employees by the pass-through entity, and on the amount of depreciable property owned by the entity.
Specifically, the deduction is limited to the greater of 50% of W-2 wages paid, or 25% of W-2 wages paid plus 2.5% of the unadjusted basis of depreciable property owned. Not confusing enough? This limitation only applies in full once your taxable income exceeds $415,000. Between taxable income of $315,000 and $415,000, the wage and property limitation is only partially in effect – it is phased in gradually as income increases between the two thresholds.
Other qualified entities
Despite being known primarily as a pass-through deduction, there are several other situations in which you can take advantage of the 20% deduction. Sole-proprietor business owners reporting their income and expenses directly on Schedule C of their individual tax return are eligible for the deduction – however, bear in mind that the SSTB and income limitation rules still apply.
Many owners of rental real estate will also qualify for the deduction. However, there are additional considerations that you must be aware of. As far as real estate activities are concerned, the 20% deduction is only available if your real estate activities rise to the level of being considered a trade or business, rather than purely an investment activity. The IRS has never explicitly defined what constitutes a trade or business but, based on a long-standing ruling by the Supreme Court, a taxpayer should be involved in an activity with “continuity and regularity” for their participation to be considered a trade or business.
The higher the level of participation, the stronger the case for calling your real estate activities a trade or business. You can bolster your case by being involved in management decisions; regularly communicating with and overseeing the activities of a management company, if one is being used; and filing any necessary Forms 1099 for vendors and service providers. It is worth noting that if you own properties subject to a triple net lease, it’s highly unlikely you’ll qualify for the 20% deduction. This is because, in this situation, the property owner is essentially just paying the real estate taxes and collecting rents, which generally is not sufficient participation to be considered a trade or business.
As part of the finalized regulations for Section 199A issued on January 19, the IRS has added a “safe harbor” provision for owners of rental real estate. This safe harbor essentially means that if a taxpayer meets certain standards laid out by the regulations, the IRS will not challenge the treatment of the taxpayer’s rental properties as a trade or business. The three requirements that must be met in order to qualify for the safe harbor are:
- The taxpayer maintains separate books and records to reflect income and expense for each real estate enterprise
- 250 or more hours of rental services performed per year with respect to each real estate enterprise
- Important to note: this is not solely hours worked in the enterprise by the taxpayer. It is a combination of hours from the taxpayer, and from anyone the taxpayer pays to assist in the real estate enterprise, such as employees, independent contractors, managers, etc. Travel time to and from rental properties is NOT included
- The taxpayer maintains contemporaneous records, including time reports, logs or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services
- This requirement is not applicable to tax year 2018
You may have noticed a new term while reading those requirements – “real estate enterprise.” As part of the safe harbor provision, the IRS will allow taxpayers to group their rental properties into “enterprises” for purposes of meeting the safe harbor requirements. For example, a taxpayer with three rental properties may not meet the requirements for any of the individual properties, but when viewed cumulatively, the requirements may be met.
Note that commercial and residential properties are not allowed to be grouped together, and that only properties held directly by the taxpayer may be grouped. For example, properties owned partially by a taxpayer via a partnership interest cannot be grouped for purposes of the safe harbor. It is also important to note that properties rented on a triple net lease basis cannot qualify for safe harbor, regardless of whether the tests are met.
Lastly, keep in mind that meeting the safe harbor is not a necessity for trade or business treatment of rental properties. If a taxpayer’s facts and circumstances support trade or business treatment, but the safe harbor requirements are not quite satisfied, they may still have a very good case for treating the rentals as a trade or business, and as a result qualifying for the potential 20% deduction.
Carried interest rules
While the pass-through deduction seems to have taken center stage, there were many other significant changes enacted by the new tax law. Changes to the carried interest rules are another important piece of the tax reform puzzle. Carried interest is a tool used frequently by hedge fund managers and real estate developers. It’s an ownership interest in a partnership that allows the general partners to receive capital gain treatment on partnership income, which, in other cases, would be treated as ordinary income.
Prior to TCJA, the underlying assets held by a partnership needed to be held for at least one year to be eligible for capital gains rates for the carried interest partners. Under the new law, that holding period has been extended to three years. For example, if a real estate development partnership acquires a parcel of land, develops it and then sells it four years later, the profits related to that parcel would be eligible for capital gains treatment for the carried interest partners. If it was sold only two years after acquisition, however, that income would be taxed at ordinary rates, which are generally much higher.
Talk to your CPA
This article includes a lot of information, but we haven’t even scratched the surface of all the changes related to the Tax Cuts and Jobs Act. Check out our Tax Consulting + Compliance Services for more coverage of Section 199A and its impact on you. You can also subscribe to our Tax Insights blog for weekly updates on the latest tax news.
Questions? Check out our tax services and be sure to consult your trusted Henry+Horne tax advisor with any questions on the 20% pass-through deduction, carried interest rules or any of the myriad of other tax reform issues.