Tax Act First Look: The Complex New World of the Qualified Business Deduction Rule: Implications for Partnerships, S Corporations, and Sole Proprietorships

By August, Jerald David | The CPA Journal, January 2018 | Go to article overview

Tax Act First Look: The Complex New World of the Qualified Business Deduction Rule: Implications for Partnerships, S Corporations, and Sole Proprietorships


August, Jerald David, The CPA Journal


President Trump signed the Tax Cuts and Jobs Act (TCJA), H.R. 1, into I law on December 22, 2017. The law was passed by Congress two days earlier, on December 20, 2017. In general, the effective date of the TCJA is January 1, 2017. Many of the provisions of the TCJA will sunset on January 1, 2027, although some provisions are permanent. While the conference committee resolved the differences between the House and Senate bills- and there were indeed many differences-the Conference Committee selected the final parts of the bill and sent it back or passage.

This article will summarize the TJCA section 11011, which enacted the new IRC section 199A allowing an owner of a pass-through entity to claim a deduction up to 20% of the qualified business income (QBI) of each portion of a qualifying business owned by the taxpayer. This marks the first time in the history of the federal income tax that pass-through business income is taxed at a lower rate than the tax rate that applies to salary, interest, and similar items. With a new maximum marginal income tax rate of 37% for taxpayers other than corporations, this 20% deduction can reduce the federal income tax rate for pass-through entities to as little as 29.4%. In addition to sole proprietors, shareholders in S corporations, and partners in partnerships, the law states that trusts and estates are eligible for the 20% deduction rule. Rules similar to the new IRC section 199A will apply for apportioning between fiduciaries and beneficiaries the W-2 wages and unadjusted basis of qualified property under the limitation.

As for the entire set of business reforms introduced by the TCJA, time will tell whether this hastily drawn tax blueprint will become popular with business entities and their owners. The proposed changes with respect to unincorporated businesses institute a lower tax rate based on the type of business activity that the owners are engaged in, as well as the level of wages that the business entity pays. As a result, while partners and owners of S corporations will see their taxes reduced, forecasting just how much will very much depend upon individual circumstances.

Becoming familiar with changes to the income tax rate to individuals is an impor- tant prerequisite to understanding the changes to the pass-through regimes, such as partnerships and S corporations, as well as for determining the tax rates on capital gains. It is also helpful to understand the coming changes made to the individual alternative minimum tax.

Reduction of Individual Income Tax Rates

Current law. Under current law, individuals are subject to federal income tax at graduated rates, starting at 10% on taxable income not over $9,235, and climbing to a maximum marginal rate of 39.6% for taxable income over $418,400. In seven tax brackets, the rate of tax increases as taxable income levels climb over higher thresholds. For married couples filing joint returns, the marginal tax rate of 39.6% applies to joint taxable income over $470,700. Estates and trusts, as treated under current law, quickly hit the maximum marginal rate of 39.6% on taxable income over $12,500.

With respect to capital gains, for an individual, estate, or trust, the amount of adjusted net capital gain, which otherwise would be taxed at the 10% or 15% rate, is not taxed at all. Adjusted net capital otherwise taxed at rates over 15% but below 39.6% (over $37,950 in taxable income but less than $418,400 in taxable income for single individuals for example) is taxed at a 15% rate. For taxable income levels subject to the maximum individual income tax rate of 39.6%, adjusted long-term capital gain is taxed at a 20% rate. Adjusted net capital gain is increased by the amount of "qualified dividend income," as defined under IRC section l(h)(ll)(B), which includes dividends received from domestic corporations and qualified foreign corporations. [A special holding period requirement is set forth with respect to qualified dividend income. …

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