If you (or your trust or estate) own an interest in a pass-through construction company, you’ll want to take note of two of the more significant changes regarding deductions made by the recently enacted Tax Cuts and Jobs Act (“the Act”).
First, the Act repeals the Domestic Production Activities Deduction (DPAD) for tax years beginning after 2017. As you may recall, the DPAD generally provided taxpayers (including individuals, estates and trusts) with a deduction equal to 9% of the lesser of qualified production activities income or taxable income, subject to a limitation of 50% of wages paid (IRC Code Section 199).
The Act also institutes the Qualified Business Income Deduction, or QBID (IRC Code Section 199A), which allows an individual, estate or trust to deduct up to 20% of domestic qualified business income from a partnership, S corporation or sole proprietorship for tax years 2018 through 2025. The QBID is generally limited to the greater of (1) 50% of W-2 wages paid by the business, or (2) the sum of 25% of the W-2 wages paid plus 2.5% of the unadjusted basis of certain property the business uses to produce qualified business income.
Example: A taxpayer operates a construction company as a sole proprietorship. The company buys a machine for $100,000 and places it in service in 2020. In that year, the business has no employees and $20,000 of taxable income (before the QBID). The W-2 wages/qualified property limit on the business’ deductible amount for 2020 is $2,500, which is the greater of (1) 50% of W-2 wages ($0 × 50% = $0), or (2) the sum of 25% of W-2 wages ($0) plus 2.5% of the unadjusted basis of the machine immediately after its acquisition ($100,000 × 0.025 = $2,500).
Assuming joint taxable income is greater than $315,000, the QBID for 2020 is $2,500, which is the lesser of (1) the wage limitation calculated above, or (2) 20% of the Qualified Business Income ($20,000 × 20% = $4,000).
Modifications to W-2 wages/qualified property limit. The W-2 wages/qualified property limit described above does not apply if taxable income without regard to the QBID for the tax year is equal to or less than a $157,500 threshold ($315,000 for taxpayers filing a joint return; adjusted for inflation; Code Sec. 199A(b)(3)(A)).
Qualified trade or business. A taxpayer can claim the QBID for income from many types of trades or businesses, but not for certain “specified service trades or businesses,” described below. Also, performing services as an employee is not a qualified trade or business, according to Code Sec. 199A(d)(1).
A specified service trade or business is any trade or business that:
- Involves the performance of services in the fields of accounting, actuarial science, athletics, brokerage services, consulting, financial services, health, law or the performing arts; or
- Involves the performance of services consisting of investing and investment management, trading or dealing in securities, partnership interests or commodities; or whose principal asset is the reputation or skill of one or more of its employees or owners (Code Sec. 199A(d)(2).
Note that architecture and engineering are not specified service trades or businesses and, therefore, can be qualified trades or businesses for Code Sec. 199A purposes if they otherwise qualify.
Determining how these changes will impact your construction company is not as straightforward as it may seem. There are a significant number of rules, exceptions and phase-out provisions related to the new the 20% QBID that are far beyond the scope of this article. We also have not addressed what impact these deductions may have when computing taxable income in any state that your construction company operates.
If you have any questions about the QBID and the potential benefits to your construction company, do not hesitate to contact Mark Di Pietrantonio or another member of the Schneider Downs Construction Focus Group.