The Section 199A Qualified Business Income Deduction, enacted as part of the Tax Cuts and Jobs Act in 2017, was meant to provide a tax benefit to smaller flow-through businesses in response to the large decrease in the C corporation tax rate from 35% to 21%.
Under current law, for taxable years 2018 through 2025, individuals and trusts generally may deduct 20 percent of qualified business income from partnerships, S corporations or sole proprietorships, in addition to a separate component of the deduction for aggregate qualified real estate investment trust dividends and qualified publicly traded partnership income.
There are certain other requirements and limitations, however, that come into play. The amount deductible, for instance, may not exceed 20 percent of taxable income for the taxable year (reduced by net capital gain). Limitations based on W-2 wages and capital investment generally also apply. A disallowance of the deduction of income for specified service trades or businesses (e.g., accounting, legal and consulting businesses) also phases in above a threshold amount of taxable income, indexed for inflation. For 2021, the threshold amount is $329,800 for married filing joint returns, $164,925 for married filing separate returns and $164,900 for all other returns. Other than through the limitations above, the maximum dollar amount of the deduction was essentially unlimited to the extent of 20% of the eligible income.
The Build Back Better Act proposes to add a fixed-dollar limitation, not indexed for inflation, on the maximum amount of the deduction for tax years beginning after December 31, 2021. The amount proposed is to not exceed $500,000 for a joint return or surviving spouse, $250,000 for a married individual filing a separate return, $400,000 for certain other taxpayers and only $10,000 for a trust.
Present law phaseouts of the deduction above the threshold amount would continue to apply, but while the Build Back Better legislation proposes to make the excess business loss limitation permanent, it does not propose to permanently extend the 199A qualified business income deduction, which is still slated for termination for taxable years beginning after December 31, 2025.
Keeping in mind that this change still must survive in a final version of the bill, taxpayers with the potential ability to accelerate income into 2021 (while deferring significant deductions and/or losses) may want to begin considering these options now to optimize the total federal taxes paid over 2021 and 2022. Otherwise, the impact of the proposed changes on the 199A deduction coupled with the impact of other proposals (see our articles on the proposed changes to net investment income tax and the proposed surcharge tax) could subject a taxpayer to a substantial increase in their overall effective tax rate on certain levels of trade or business income from 29.6% (37% tax rate multiplied by 80% income subject to tax) to an effective rate in excess of 46%.
Proposed highest individual income tax rate on trade or business income
More than the 199A fixed-dollar deduction limitation
Proposed change in Net Investment Income Tax Regime
Surcharge tax regime on certain High-Income Taxpayers
Highest Total Effective Tax Rate
As an example, consider a single taxpayer who materially participates in a trade or business that has a qualifying business income of $10 million for 2021. Assuming the taxpayer can obtain the maximum benefit under section 199A after application of other limitations, tax on this income in 2021 would be approximately $2.96 million. Now assume the same taxpayer earns the same amount of qualifying business income in 2022 under the proposed law. Projected tax on the income could approximate $4.4 million (39.6% of $10M less $500,000, plus 3.8% NIIT on $10M and 3% surcharge on $5M), for a potential effective tax rate exceeding 44% (the effective rate approaches the highest effective rate of 46.4% as income increases), representing an increase in tax of approximately $1.4 million and an increase of 14.4% in the effective rate.
Trustees may want to begin reviewing their options to optimize the impact of the proposed changes between taxes paid by trust and taxes assessed on individual beneficiaries resulting from trust distributions of income.
As with other provisions in the proposed legislation, taxpayers and advisors will need to monitor this provision closely. We will continue to monitor developments as these proposed changes move through the legislative process. Additional articles and analyses will be provided in the coming weeks. In the meantime, if you have any questions, please reach out to your Schneider Downs tax consultant or contact us at [email protected].
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.