Tax Considerations for Pass-Through Entities: §§ 199A and 163(j)

Posted on Tue, Jul 30, 2019 ©2019 Drucker & Scaccetti

Ferman1By: Jeremy Ferman, CPA, MA

 

The Tax Cuts and Jobs Act (“TCJA”) added several complicated tax laws to the books, adding a level of complexity for even the smallest pass-through entity returns.  As we enter the home-stretch of the extended filing season, we will examine arguably the two most difficult areas for pass-throughs to navigate: §§ 199A and 163(j). 


Section 199A: The 20% Pass-Through Deduction

Written to help lessen the gap between the corporate tax rate and the individual tax rates for pass-through income, § 199A allows a deduction of up to 20% of qualified business income reported by a pass-through entity.  While simple at face-value, the application of § 199A is far from it. 

 

First, because the section distinguishes between a “Qualified Trade or Business” and “Specified Service Trade or Business” (“SSTB”), an entity must determine how to classify itself.  This classification determines which limitations the partners/shareholders will be subject to when calculating the deduction on their personal returns.  Section 199A and its corresponding regulations list a number of service industries that qualify as SSTBs (e.g., accounting, law, healthcare, or financial services), and any type of business not mentioned is a qualified trade or business.  It is far more favorable to be a qualified business than a specified service business as the deduction stemming from income from qualified businesses is subject to less limitations. 

 

Second, an entity must make all adequate disclosures on its schedule K-1's so that the members of the pass-through can calculate their respective § 199A deduction.  These disclosures require an entity to determine its qualified business income (“QBI”) for the entity, W-2 wages paid, and the unadjusted basis immediately after acquisition (“UBIA”) of property used by the trade or business.  For a more in depth summary of § 199A please see Intro to 199A and for the 199A aggregation rules (not covered in this article) see Section 199A Aggregation Rules.

 

Section 163(j): The Business Interest Expense Limitation

Just as complex as § 199A, § 163(j) limits the deduction for business interest expense to 30% of adjusted taxable income, plus business interest income, plus floor-plan financing interest expense.  Despite the fact that the actual limitation applies only to businesses (and individuals) with average gross receipts greater than $25 million, as well as entities classified as tax shelters, every single pass-through has some level of required reporting. The code section must be applied at each level, entity and individual, until the interest is either limited or allowed; therefore, every pass-through must provide their partners/shareholders with the information to compute the limitation regardless of whether the entity itself was subject to the limitation.  For example, if a business, classified as a small business for the limitation, has an owner that has total gross receipts of greater than $25 million (from their share of other pass-throughs, Schedule C businesses, investment income, etc.), then that owner must calculate the interest limitation on their personal 1040 using information from each of their interests in businesses that were not previously subject to § 163(j), including any small businesses.  If your head hurts after that explanation, rest assured that you're not alone.

 

When your pass-through entity qualifies as small business, and you are not responsible for preparing the individual partner or shareholder returns, you may be tempted to breathe a sigh of relief and simply disclose the items listed above, but I would caution you that there’s another wrinkle.  As I mentioned before, the limitation also applies to tax shelters, and the definition of "tax shelter" in the interest limitation includes entities known as "syndicates." 

 

Syndicates are entities that allocate losses to passive investors where those investors are allocated more than 35% of the loss during a tax year.  Thus, a company’s syndicate status can change on a yearly basis depending how it allocates losses.  This can trap many entities that would otherwise think they are not tax shelters and ultimately subject them to the business interest limitation - whether they are small businesses or not.  If you need more information about the interest limitation, please see my three-part series: Part I, Part II and Part III.

 

While TCJA introduced several new laws that have some in the tax world questioning their life choices, your Tax Warriors here at Drucker & Scaccetti are nerding-out over the plethora of complicated statutes and regulations we get to advise our clients about on a daily basis. If you have any questions on the topics discussed above, or any other tax questions, feel free to contact us

Topics: Pass-through entities, Trump Tax Reform, Qualified business income deduction, 20% deduction, Specified Service Business, Qualified Trade or Business, Tax Cuts and Jobs Act of 2017, IRC section 163(j), IRC Section 199A, unadjusted basis immediately after acquisition

Read & Submit A Comment