Wage and Property Limitations Under Section 199A

Earlier this month we outlined the new Section 199A of the Tax Cut and Jobs Act, which provides a 20% deduction to certain pass-through businesses. Today we take a closer look at the asset and wage limitations that restrict the deduction for high-earners.

While “high income” may be a rather subjective term, Sec. 199A sets a “threshold amount” above which certain restrictions apply – $315,000 of taxable income for married taxpayers filing a joint return, and $157,500 of taxable income for everyone else. Note that the threshold contemplates the taxpayer’s total income from all sources after deductions (ie, line 43 of their Form 1040), rather than the income of the pass-through entity itself.

For taxpayers below this threshold, their qualified business income (QBI) is simply 20% of the net income of their pass-through business. For taxpayers above this threshold, a restriction is phased in ratably over the next $100,000 or $50,000, meaning it applies fully to married taxpayer’s filing a joint return with over $415,000 in taxable income, and to other taxpayers with over $207,500 of taxable income.

The restriction, which applies partially to taxpayers above the threshold amount and fully to taxpayers above the phase in range, states that QBI is limited to the greater of (1) 50% of the W-2 wages paid by the businesses, or (2) 25% of the W-2 wages paid by the business, plus 2.5% of the business’ unadjusted basis in all qualified property.

W-2 wages include traditional wages, elective deferrals for retirement accounts, deferred compensation, and Roth 401(k) payments. Use of a third party payroll processor does not jeopardize one’s W-2 wage calculation. Contractor expenses (reported on Form 1099) and guaranteed payments to partners aren’t W-2 wages.

W-2 wages must be calculated for each trade or business line, whether run directly by the individual or through a pass-through entity, such as a partnership or S Corporation. For entities that operate multiple lines of businesses, W-2 wages must be apportioned between each one. This is necessary because under the default rule, the Section 199A deduction for each line of business is capped at 50% of the W-2 wages paid by such business. For instance, a business manufactures widgets and services gadgets, all under the umbrella of a single S Corporation. W-2 wages paid for the manufacturing and servicing components must be separated for §199A calculation purposes.

For many pass-through entities, this calculation will be fairly simple; in the context of mergers, acquisitions, and shareholder redemptions, it may be more complex. For an acquisition or disposition of a trade or business, wages are apportioned between the entities based on the periods in which each trade or business employed the individuals. For businesses with short taxable years, W-2 wages are allocated as they are actually paid, elective deferrals as actually made, and compensation as actually deferred during the short taxable year.

Amounts treated as W-2 wages for a taxable year may not be used in any other period, and no amount may be treated as W-2 wages for more than one trade or business. Thus, no doubling-up is allowed. “Reasonable compensation” for S Corporation owners and guaranteed payments for partners in a partnership

UBIA

Alternatively, taxpayers can choose to use the wages + UBIA test. The §199A deduction is instead capped at 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of qualified property. The second prong of the limitation will help taxpayers who have substantial capital invested in depreciable assets, such as many residential landlords.

Wages are calculated as before, but limited to 25% instead of 50%. “Qualified property” means buildings, equipment, and other tangible depreciable property held for use in a trade or business and depreciable under IRC §167. Land, as well as intangible assets such as patents, trademarks, etc. do not qualify. The qualified property must be held by the business at the end of the year,  And the property must not have reached the end of its “depreciable period.” Note, however, that the depreciable period may be different than the property’s lifespan otherwise shown on your tax return. Under Sec. 199A(b)(6)(B), the depreciable period is the later of its useful life under Sec. 168 (disregarding subsection (g)) or ten years. This means that electing a longer depreciation period than that allowed under Sec. 168 provides no benefit, but also that which are normally fully depreciated after five years will continue to provide a benefit under this test for ten years.

Further, issues arise when property has been improved or modified after it was placed in service. Does a significant improvement to the property extend the depreciation period for purposes of §199A, or are taxpayers stuck with not being able to claim this improvement as UBIA? The Service has clarified that improvements will be treated as a separate piece of property with its own depreciation schedule beginning at the time when the improvement is placed into service.

There are also anti-abuse provisions to prevent stuffing the balance sheet in December. Property does not qualify if it is acquired within 60 days of the end of the year, disposed of within 120 days, and not used in the business for at least 45 days prior to disposition, unless the taxpayer can demonstrate that his principal purpose of the transactions was not to increase his §199A deduction. The following examples from the regulations further clarify the above:

Example 1. D, an unmarried individual, owns several parcels of land that D manages and which are leased to several suburban airports for parking lots. The business generated $1,000,000 of QBI in 2018. The business paid no wages and the property was not qualified property because it was not depreciable. After allowable deductions unrelated to the business, D’s total taxable income for 2018 is $980,000. Because D’s taxable income exceeds the applicable threshold amount, D’s section 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. D’s section 199A deduction is limited to zero because the business paid no wages and held no qualified property.

Example 2. Assume the same facts as in Example 1 except that D developed the land parcels in 2019, expending a total of $10,000,000 to build parking structures on each of the parcels, all of which are depreciable. During 2020, D leased the parking structures and the land to the suburban airports. D reports $4,000,000 of QBI for 2020. After allowable deductions unrelated to the business, D’s total taxable income for 2020 is $3,980,000. Because D’s taxable income is above the threshold amount, the QBI component of D’s section 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. Because the business has no W-2 wages, the QBI component of D’s section 199A deduction will be limited to the lesser of 20% of the business’s QBI or 2.5% of its UBIA of qualified property. Twenty percent of the $4,000,000 of QBI is $800,000. Two and one-half percent of the $10,000,000 UBIA of qualified property is $250,000. D’s section 199A deduction is thus limited to $250,000.

In our next post, we’ll discuss what constitutes a specified service business and whether landlords can claim the deduction.

If you’d like to reach us in the meantime, send us a message through the form below or call our firm at 816-561-5000.

*This post was originally published on October 10, 2018