A Planning Introduction to the 2017 Tax Act – The 20% Of Business Income Deduction – Part 2

THE BASIC 20% MATH AND THE “IF-LESS RULE”

As discussed below, special rules may apply to certain service providers.

The computation measures the deduction looking to “combined qualified business income amount” or if less, 20 percent of any excess of taxable income over any net capital gain as defined in Section 1(h). ((Sec. 199A(a).)) The latter might be termed the “if less rule.”

In general, the “if less” component introduces a new complexity to planning. In the opinion of the authors, the statute here refers to taxable income from all sources, not just business income. ((One author opines, “It is unclear whether the taxpayer’s taxable income refers to the taxpayer’s taxable income from all sources or just income from all qualified trades or businesses. My best guess is that it refers to all sources.” “Qualified Business Deduction Under New Section 199A,” Teresa Rankin Klenk, Gentry, Tipton, McLemore, 12/20/17, http://www.tennlaw.com/12/can-you-qualify-for-the-sec-199a-qualified-business-deduction/.)

The concept of “combined” qualified business income nets income and losses.  For example, one of only two examples in the Senate Report shows one spouse with a business loss and another spouse with business income, and the loss offsets income in figuring the net business income that gives rise to the 20% deduction in a joint return. ((The conferees were relatively terse in their explanations but they made some very significant changes while basically following the Senate version. Conf. Rep., p. 221, 222.))

We noted above that there is a concept of carrying forward a loss within the Section 199A rules from a previous year.  Within this concept of a loss related to Section 199A calculation, presumably such a carryover could only be post-2017; i.e., couldn’t precede the Section 199A rules.

But query the impact of a net operating loss carryover from 2017 or earlier on the calculations under Section 199A? The issues here should be considered in deciding whether to elect to carryover any NOL incurred in 2017.

First, how does an NOL carryover affect the basic 20% of business income computation? The 20% is applied to “qualified business income with respect to the qualified trade or business,” subject to some limitations, or more specifically, “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business.” ((Sec. 199A(b)(1)(A) and 199A(c).)) We also note Section 199A(c)(3) defining the relevant items as “effectively connected with the conduct of a trade or business within the United States…” It goes on to ask if such amounts are “included or allowed in determining taxable income for the taxable year.” ((Sec. 199A(c)(3)(A)(ii).)) One could argue the language here includes an NOL deduction arising even from pre-enactment years, at least as it relates to business losses.

Computing the NOL under Section 172 is complicated but it basically works from taxable income with adjustments, such as removing personal exemptions and nonbusiness deductions except to the extent of nonbusiness income. So it is roughly true that an NOL carryover would reflect losses from a trade or business.  Yet an added complication is that it is possible an NOL would reflect non-business casualty losses as all or part of the NOL, which could also raise issues of order of absorption if the NOL also includes business losses.

When losses of non-corporate taxpayers exceed $250,000 or $500,000 in a joint return in tax years beginning after 2017, there is a new rule which can add such losses to the NOL carryover rather than allow such losses to offset non-business income. ((Conf. Rep. p. 19, 238-239, amending Sec. 461(l) for losses in tax years beginning after December 31, 2017.)) A possible argument for including consideration of the NOL deduction in Section 199A is that due to new Section 461(f), there are some scenarios where business losses don’t seem to get deducted except as NOL carryovers.  The express language of the statute refers to “disallowance.” ((Conf. Rep., p. 19; Act Sec. 11012.)) Rather than press an argument based on such an unusual provision, one could also argue for special computations but that would also raise issues of order of use when the figures include such amount as only one of the NOL components.

One could also argue that to include the NOL deduction in measuring business income under Section 199A runs counter to the focus of the statute on the results of the particular year and whose goal was to encourage business and reward post-enactment results.

One could add the following argument, emphasizing that pre-2018 law permitted NOL carryovers up to twenty years and the new law permits indefinite carryforwards. Congress envisioned a new concept which focuses on trade or business income post-2017 and it added rules that in some circumstances can even require separating such income into the income or loss of “each” separate trade or business. An NOL deduction arising from carryovers from many distant years could require analyzing such figures to segregate losses into separate trades or businesses when the returns and records may no longer even be available, and require practically impossible calculations looking to absorptions of such losses in years after they were incurred. The years of absorption may also be very distant. One would reasonably argue that Congress did not contemplate integrating an NOL carryover deduction into this mix of considerations within Section 199A.

Also, Section 199A has its own carryover rule which focuses on post-2017 net losses that arise within its rules. ((Sec. 199A(c’)(2).)) Seemingly this raises the question of duplication. How would the taxpayer apply the carryover rule within the new code section and also the normal NOL carryover rules?

Within the Section 199A rules, there is statutory provision dealing with carryover of unused, excess loss, but not carryback, which may raise such questions as this: Does the taxpayer losing $100,000 in year 1 and earning $100,000 in year 2 get no 20% deduction in either year, but as to the person who earns $100,000 and then loses $100,000 in the second and last year of the business, does this person, whom we assume retires, get to deduct 20% of $100,000 in year 1 and the $100,000 loss from the discontinued business just carries over until his/her death, then disappears? This would seem to be the result given the new law contemplates carryover of unused losses but no carryback.

As to the basic question of whether the NOL deduction should reduce the base of the 20% of business income calculation, we would argue that this particular deduction should not reduce the base, and this should hold true of NOLs from pre-enactment and post-enactment years.

On the other hand, the authors would anticipate that the IRS will likely conclude an NOL carryover, even though from a year or years before enactment of the Section 199A concept, would reduce taxable income under the “if less” portion of the calculation. This figure is just basically taxable income with certain adjustments times 20%, and the list of adjustments doesn’t include any NOL carryover deduction. For example, if a taxpayer elects to carryover a large NOL from 2017 to 2018, we would caveat that this would likely have a significant detrimental effect on any benefit under the new Section 199A rules.

Planning point: In deciding whether to carryback an NOL from 2017, consider that as an NOL carryover, it may have a detrimental effect in so far as accessing the 20% of business income deduction.

Planning point: Not to suggest that a couple will often opt out of a joint return because of these rules but it may arise in some circumstances; e.g., if one spouse has a business loss that offsets business income of the other spouse that might otherwise benefit from the 20% deduction. It is not impossible the regulations may try to limit such planning.

As one reads the statute, the term “qualified business income amount” doesn’t have a “20%” beside it, but it is a 20% figure. ((See Sec. 199A(a)(1)(A), (b)(1)(A), (b)(2)(A).))

Planning point re business expense elections: Assuming the basic computation looks to 20% of qualified business income and the “if less” concept focusing on taxable income doesn’t otherwise apply, one can see that decisions that maximize business expenses have to be viewed from the standpoint of their effect on the Section 199A deduction. For example, if the taxpayer opts to expense a capital expenditure rather than claim normal depreciation, this reduces taxable income and saves tax. But while one can normally calculate tax savings of an incremental deduction by applying the marginal tax rate to the deduction, one needs in these circumstances to factor in the fact that the decision to call a capital expenditure an expense will also reduce the 20% of qualified business income deduction directly. By reducing taxable income, it may also bring into play the “If less rule” that focuses on 20% taxable income with adjustments.

Planning point re Keogh contributions: A Keogh contribution can also bring into play the taxable-income-if-less rule when the deduction would otherwise be based on net business income. Such decisions as whether have a Keogh or whether to maximize the deduction may now have to be weighed against projected or potential long-term reductions in the new Section 199A deduction. It may also be an issue whether or to what degree Keogh or other benefit programs may be considered as directly reducing the 20% of business income calculation, and whether, e.g., one distinguishes payments benefitting owners.

Planning point re nonbusiness expenses and nonbusiness income: Under the basic concept that the deduction is 20% of qualified business income or, if less, 20% of taxable income as reduced by the sum of net long-term capital gains in excess of short-term capital losses and qualified dividends, one can see certain areas where the 20% deduction is pared down by nonbusiness deductions, including the standard deduction, which was increased with the new legislation. For example, under the “if less rule” looking to 20% of taxable income, assuming a taxpayer with just qualified business income and the standard deduction, the standard deduction triggers a reduced 20% deduction, whereas it would not if there were, say, interest income in an amount equal to the standard deduction. One can envision circumstances where if this particular scenario applied, the taxpayer would have been better off investing in high-yield bonds versus low-yield growth stocks.

There can be scenarios in which the 20% of business income deduction goes up with incremental nonbusiness income. Nonbusiness income planning can significantly affect planning here if the deduction looks to taxable income.

Planning point re charitable donations: One can envision the Section 199A rule being a disincentive in some circumstances for charitable donations because the contributions increase itemized deductions and bring into play the “if less rule” looking 20% of taxable income with adjustments rather than 20% of business income. We later show another scenario in which the charitable donation looks to enhance the deduction.

Planning generally gets much more mathematical, particularly considering the breadth of the two components we discuss, one being combined “business income” which includes flow-through income which is often difficult to predict, and the other being “taxable income.”

An IRS exam that adjusts taxable income may well result in a re-computation of this deduction and it could affect either of the two major components that determine the basic deduction.  One can envision circumstances where an IRS exam would increase taxable income without adjusting business income and the result would be diminution of the if-less limitation, such that the Section 199A deduction increased and mitigated the tax increase arising from the IRS adjustment.

There is a third rule saying the deduction can never exceed taxable income as reduced by net capital gain as defined in Section 1(h). ((Sec. 199A(a), last sentence.)) As discussed below, net capital gain for this purpose appears to be net long-term capital gains in excess of short-term capital losses plus qualified dividends.

GAINS AS A COMPONENT OF BUSINESS INCOME

In the beginning of this complex statute, Section 199A(a) has two sentences; the first sentence is a “whopper.”  We will disregard the portion dealing with cooperative dividends.

Section 199A(a)(1)(A) and (B) provide two basic rules governing the deduction. The taxpayer gets the lesser of these two calculations.

The language of Section 199A(a)(1) (A) says the taxpayer gets to deduct “the combined qualified business income amount of the taxpayer.” The real rule is 20% of such amount; the “20%” is there although it isn’t expressed in this particular sentence. ((See Sec. 199A(a)(1)(A), (b)(1)(A), (b)(2)(A).)).

The definition of qualified business income generally means “any amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” ((Sec. 199A(c’)(1).))  The new law goes on to define the above as related to a trade or business within the United States. ((Sec. 199A(c’)(3).)) It goes on to except “investment items” of income, gain, deduction or loss, including capital gains or losses, dividends, interest, etc.

But we note that within the statute defining the base for computing the 20% of business income deduction is included not only ordinary operating income and loss but also “gain” and “loss.”

Sales of inventory, including sales of say constructed homes or buildings by a contractor, are ordinary income and conspicuously within the concept of the type of income that is the focus of this statute.

In general, the sale of fixed assets used in the business, including say a building that houses the employees and operating assets, would fall within the concept of “Section 1231” gains and losses. If the business has a net Section 1231 loss in a year, such loss is generally an ordinary loss. If the business has a net Section 1231 gain in a year, such gain is generally treated as long-term capital gain. Within the complex mix of these rules are such concepts as depreciation recapture which can convert gains to ordinary income that might otherwise be treated as long-term capital gains. (( See generally Sec. 199A(c)(1) defining business income as inclusive of gains.  See generally the following discussion of Sec. 1231 gains; https://taxmap.irs.gov/taxmap/pubs/p544-015.htm.))

An argument for including gains under Section 199A even when such gains are tax advantaged might stress this example.  Assume a sole proprietor has inherently a break even situation, $1,000 of unrealized loss on one machine and $1,000 of unrealized gain on another machine. The sale of both machines in one year would yield zero gain or loss, and no impact because surely one can net gains and losses on the sale of business equipment in this scenario. If one machine was sold in December and the other machine was sold a month later, one would argue that similarly, the $1,000 gain or loss should enter into the Section 199A computations in each year regardless of whether the $1,000 loss is ordinary as a Section 1231 loss, and whether the $1,000 gain is ordinary income due to depreciation recapture or Section 1231 gain treated as long-term capital gain.

Given the overall context and purpose of the statute, it would make sense to provide that, say, an ordinary loss of $1,000 on a truck used in the business would be in the mix that determines the overall measure of business income.

But what about a $1,000,000 gain on the sale of a building used in the business which may be subject to favorable long-term capital gain treatment? Did Congress intend to include such income in the measure of business income subject to the 20% deduction, even though already subject to reduced tax as a long-term capital gain?

It is a fair question but as the authors read the new statute and its legislative history, it would appear that such gain would be included as business income subject to a 20% deduction under the basic rule of Section 199A(a)(1).

But the taxpayer’s deduction is the lesser of the general rule, or the “if less rule” that focuses on 20% of taxable income as reduced by “net capital gain (as defined in section 1(h)).” The authors believe our $1,000,000 long-term capital gain on the sale of a building used in the business would be a limiting factor; i.e., a reduction of taxable income for purposes of the if less rule of Section 199A(a)(1)(B).

This is a brief illustration, admittedly simplified to illustrate the math. Assume the taxpayer has a business Schedule C in the Form 1040 breaking even but it is a year in which the taxpayer also has interest income equal to the standard deduction, so taxable income is $1,000,000 before considering the Section 199A deduction. Under Section 199A(a)(1)(A), we compute such deduction as 20% of $1,000,000 (the Section 1231 gain on sale of business asset) or $200,000. Under the “if less rule” of Section 199A(a)(1)(B), the computation would be taxable income of $1,000,000 less the net capital gain of $1,000,000 times 20%, such that the deduction is zero, and our taxpayer apparently does lose out on any benefit from Section 199A.

But what if the taxpayer also had an additional $1,000,000 of interest income, such that taxable income is $2,000,000 with the $1,000,000 of Section 1231 gain before considering the 20% of business income deduction. Under Section 199A(a)(1)(A), we compute such deduction as 20% of $1,000,000 or $200,000. Under the “if less rule” of Section 199A(a)(1)(B), the computation would focus on taxable income of $2,000,000 less the net capital gain of $1,000,000 times 20%, such that the “if less” limitation should not apply. So despite the “if less” rule’s incorporating a capital gain adjustment, there are some scenarios where the long-term capital gain appears to also yield a 20% of business income deduction.

Planning point:  There are some scenarios in which taxpayers with large amounts of nonbusiness income may be better off under the 20% of business income concept because they may more easily avoid the limitation focused on taxable income.

We turn to discussing in some more detail the capital gains aspects. We note that it may be important in these calculations whether the taxpayer’s other income emphasizes qualified dividends.

“Net capital gains” are expressly mentioned in this part of the “if less” statute but not Section 199A(a)(1)(A) looking to qualified business income. Both rules incorporate a 20% factor. Yet “gain” is mentioned in the more detailed definition of qualified business income at Section 199A(c)(1). Capital losses are not mentioned but seemingly a net capital loss for the year deductible to the extent of $3,000 would simply reduce the taxable income figure. “Loss” is also mentioned in Section 199A(c)(1).

The term “net capital gains” is defined in Section 1222(11) as net long-term capital gains over net short-term capital losses. But the language within the if less rule refers not to Section 1222(11) but rather the definition in Section 1(h), which would appear to say the term means net long-term capital gains over short-term capital losses plus qualified dividends. ((The legislative history confirms but does not expand on the reference to Section 1(h). See Conf. Rep., p. 219, footnote 60, which is the Senate Report which was with modifications followed in conference.))

It would appear that even dividends can affect our if less limitation results in a unique manner, unlike other income. ((See Sec. 1(h)(11) which reads: “Dividends taxed as net capital gains. For purposes of this subsection, the term `net capital gain” means net capital gain (determined without regard to this paragraph) increased by qualified dividend income.” So investing for, say, tax-advantaged dividends versus interest income may need to consider in such analysis the potential difference such investments may have on the 20% of business income deduction.   Qualified dividends are a plus and minus in the if-less limitation computation, whereas net short-term capital gains in excess of long-term capital losses and interest income would just increase taxable income, and muni-bond interest would not increase taxable income. New Section 199A may well impact basic investment strategy.

There’s a second sentence (the last sentence) in Section 199A(a) which says the result of the first sentence cannot exceed the taxable income as reduced by the net capital gain as so defined.

Following are notes from the legislative history concerning gains and losses

“Qualified business income is determined for each qualified trade or business of the taxpayer. For any taxable year, qualified business income means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. The determination of qualified items of income, gain, deduction, and loss takes into account these items only to the extent included or allowed in the determination of taxable income for the year.” ((Conf. Rep., p. 214, which here is the Senate report which with modifications was followed in conference.))

“Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States.” ((Conf., Rep., p. 215; footnote omitted.))

The legislative history here goes on to talk of the “Treatment of investment income,” which is introduced with a sentence saying, “Qualified items do not include specified investment-related income, deductions, or loss.” It goes on to specifically say qualified items of income, gain, etc. that do not qualify for the 20% deduction include “any item taken into account in determining net long-term capital gain or net long-term capital loss.” Later in the paragraph, it mentions as qualifying income gains on sale of inventory. Still later in the list, the discussion goes on to mention exceptions; i.e., property used in the trade or business, or supplies regularly used or consumed in the trade or business..” ((See items #1 and #4 in “Treatment of investment income,” page 215.))

One of the debates on this topic would be whether in the above paragraph, the reference to net long-term capital gain should include gains on the sales of business assets if after applying the rules, the taxpayer ends up with net long term capital gain - tax favored income because of Section 1231. We would stress that the heading here is “investment income” and within the same paragraph there is an expressed exception for property used in a trade or business. Also, the overall context is one of encouraging business.

In general, the new Tax Cuts and Jobs Act maintained the long-term capital gain rules, such that depending on the taxpayer’s bracket on the tax schedule, the federal tax rates on just the long-term capital gain may be zero, 15% or 20%. The rates have basically stayed the same but the range of incomes where different capital gains rates apply has changed.

Following are the long-term capital gain rates in 2018 (the amounts are subject to annual adjustments.)

Married filing joint: zero long-term capital gains tax up to taxable income of $77,200; 15% on such gains when taxable income is $77,200 to $479,000, and 20% on such gains when taxable income exceeds $479,000. In 2017, the 15% tax rate begins at $76,550 and the 20% rate begins at $470,700.

Single returns: zero long-term capital gains tax up to taxable income of $38,600, 15% on such gains when taxable income is $38,600 to $425,800, and 20% on such gains when taxable income exceeds $425,800. In 2017, the 15% tax rate begins at $37,950 and the 20% rate begins at $418,400.

A 25% rate may reach part of the gain on buildings (unrecaptured Section 1250 gain) but not land. ((See Sec. 1(h)(1)(E); 2017 Form 1040 Schedule D, line 19, and page D-12, 13 of the 2017 instructions to Schedule D.)) Tax consequences may be affected by the minimum tax.

If our interpretation prevails, then one might have the sale of business realty where part of the gain is ordinary income under the depreciation recapture rules, part of the gain is subject to the 25% tax, and part of the gain is subject to the usual long-term capital gain treatment, yet all the gain from the sale would be subject to Section 199A. If one argues that gain taxed at the favorable 20% capital gains rate or even the 25% rate that can apply to part of the gain on the sale of a building should not qualify under Section 199A because it is already tax-advantaged, it would apparently lead to treating the depreciation recapture portion of the gain as subject to the 20% of business income deduction, whereas the rest of the income from the same sale of the same asset did not qualify. There’s nothing in the statute or legislative history suggesting one breaks down one transaction into a portion that is subject to Section 199A and a portion that is not.

We believe the better view is that the 20% of business income concept does reach gains on sales of business assets, even the portion that may qualify as long-term capital gain.

Planning point: A possible planning aspect and an issue of interpretation or IRS regulation is whether pre-2018 appreciation is fully subject to the benefits of the new Section 199A, whether or not the asset was even a business asset when the new law was introduced. For example, assume land is used in business and its sale in 2018 results in a $1,000,000 gain but there was no appreciation in 2018. Is the entire $1,000,000 gain subject to the benefits of the new 20% of business income deduction rule, assuming such gain isn’t excluded from being business income for purposes of Section 199A just because it is already beneficially taxed?

We believe post-2017 gain or loss for purposes of Section 199A does not have to distinguish the portion of the gain that may relate to pre-enactment years, which suggests that when justified there may even be an incentive to convert assets from personal to business use. Conspicuous by its absence is any rule in the new law or its legislative history saying we distinguish the portion of “gain” that may relate to appreciation in years prior to enactment of the new statute. Compare Section 1374 which does have such a concept in so far as reaching appreciation relating to a C corporation’s years that is realized in certain periods following conversion to S corporation status. In general, this would be very complex and we would be surprised if the IRS introduces such a concept by way of regulations or rulings.

A detailed discussion of measuring gain/loss on the disposition of business assets is beyond our scope, but the measurement details can be complicated. In measuring gain or loss within a business context, there may arise any number of different issues, including those relating to basis upon converting a declined-in-value asset from personal to business use, or converting an asset whose value has increased from personal to business use via a sole proprietorship or as a contribution to a partnership or S corporation. ((See, e.g., IRS Pub. 551, Basis of Assets, Rev. Dec. 2016, p. 10.))

Taxpayers may be looking at more and more taxable transactions involving property because the 2017 Tax Act amended the like-kind exchange rules to generally provide that after 2017, they apply only to exchanges of realty not held primarily for sale. ((Conf. Rep., p. 396; see p. 72, 73, 394-396; see also p. 223.  The new rules focus on exchanges completed after 2017 with exceptions if the disposed of property was disposed of prior to 2017 or the property received was received prior to 2017. Conf. Rep., p. 396, 397.))

To summarize, we believe Section 199A, the 20% of business income deduction rule, reaches business income beginning in 2018 looking to income or gains realized or losses sustained after 2017, and we believe this generally as to ordinary income or tax-advantaged gains. If there were say Section 1231 loss from the sale of equipment or say a business building, such loss would appear to reduce the base for computing the 20% of business income deduction. We also believe that even tax-advantaged gain should qualify as gain subject to the benefits of the 20% of business income deduction because the statute basically focuses on business income realized in the taxable year. ((See generally Conf. Rep., p. 223.))  We believe that, e.g., the entire loss sustained on the sale of a business asset after 2017 reduces the benefits under Section 199A even though all or part of the loss relates to pre-enactment years.

We would caveat that there are complexities and possible issues as to how the IRS will interpret the new statute and the stances it will take in rulings and regulations on these important details.

We noted previously legislative history from the Conference Committee, and portions of it has general anti-abuse message.

“The Secretary is required to provide guidance applying rules similar to the rules of section 179(d)(2) to address acquisitions of property from a related party, as well as in a sale-leaseback or other transaction as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital. Similarly, the Secretary shall provide guidance prescribing rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital.” ((Conf. Rep. p. 223.)

This article will be concluded in the December issue of Main Street Practitioner.

Part 1