Major tax savings afoot
New IRS code includes bigger deductions for sole proprietors, and most S corp. and LLC members
On Jan. 1, new Internal Revenue Code Section 199A became effective under the Tax Cuts and Jobs Act of 2017. Section 199A provides sole proprietors, S corporation shareholders and most members of single-member and multi-member LLCs with federal income tax deductions of up to 20 percent of their business income.
As many as 40 million American business owners, including many tens of thousands in New Hampshire, can qualify for Section 199A deductions.
Tax savings under the section can be major.
If you’re a New Hampshire business owner or a lawyer, accountant, banker, financial adviser or other professional who serves New Hampshire business owners, here are the main things you should know about Section 199A:
• As you probably know, the act reduced the C corporation federal income tax rate from a maximum of 35 percent to a flat 21 percent. The purpose of Section 199A is to preserve the 10 percent federal income tax advantage that pass-through entities had vis-a-vis C corporations before Jan. 1.
• Under the act, Section 199A will expire on Dec. 31, 2025 unless Congress extends it. However, given the tens of millions of business owners who will benefit from Section 199A, my guess is that Congress will eventually make the section permanent.
• Only owners of “pass-through businesses” — sole proprietors, S corporation shareholders and most LLC members — can qualify for the deduction. Employees can’t qualify unless they are employees of S corporations of which they are also shareholders, and C corporation shareholders can’t qualify at all.
• The deduction that pass-through business owners can obtain under the section can’t exceed 20 percent of their taxable income (less net capital gain). But for many married couples, this taxable income cap won’t be a big deal.
• Two of the most important concepts in Section 199A are the concepts of “threshold amount” and “phase-in range.” The threshold amount of married taxpayers filing jointly is taxable income of $315,000 and their phase-in range is between $315,000 and $415,000. The threshold amount of all other taxpayers is taxable income of $157,500 and their phase-in range is between $157,500 and $207,500.
• For pass-through business owners whose taxable income doesn’t exceed their threshold amount, their Section 199A deduction will be 20 percent of the net income of their business.
• For pass-through business owners whose taxable income is within their phase-in range, their Section 199A deduction will be a blend of the above 20 percent deduction and their “(2)(B)” deduction. Their (2)(B) deduction will be the greater of (a) 50 percent of the W-2 wages they pay their employees and (b) 25 percent of these wages and 2.5 percent of the “unadjusted basis” of their company’s depreciable property.
• Section 199A makes a key distinction between “specified service trades or businesses” (SSBs) and “qualified trades or businesses.” SSBs consist mainly of professional and investment businesses. Qualified trades or businesses comprise all other types of businesses. SSB owners get lower Section 199A deductions than qualified trade or business owners if their taxable income is in their phase-in range, and if it exceeds their phase-in range, they get no deductions.
• Although Section 199A is intended to benefit small businesses, it is one of the lengthiest and most complex provisions in the tax cut act and one of the hardest to understand and apply. However, I’ve written a book about the section that seeks to explain all of its provisions in plain English. (For more information about my book, visit www.section-199A.com.)
• In order to maximize your Section 199A deduction, you need to have the right personal and business arrangements, and you should have those arrangements in place as soon as possible in each relevant taxable year. For example, in order to maximize their Section 199A deduction, some married pass-through business owners will have to stop filing jointly and start filing separately, and some sole proprietors will have to become single-member LLCs and make S elections. And special Section 199A structures are necessary for startup businesses realizing losses.
• The Section 199A deduction will be available to C corporation shareholders if they make S elections. These elections will almost always be a smart idea. However, a very few C corporation shareholders in high federal income tax brackets may want to forgo Section 199A deductions altogether because of the C corporation 21 percent federal tax rate. But I almost always advise against this strategy.
John Cunningham, principal of the Law Offices of John M. Cunningham and of counsel to McLane Middleton, can be reached at 603-856-7172 or firstname.lastname@example.org.