President Trump’s 2017 tax cut created a new deduction pursuant to Internal Revenue Code Section 199A (199A Deduction) for the owners of certain businesses that operate as a sole proprietorship, partnership (including a limited liability company), or S corporation.
Subject to certain limitations, the 199A Deduction is equal to twenty percent (20%) of the owner’s allocable share of the business’ net income. Importantly, the 199A Deduction will be claimed on the owner’s individual income tax return as a deduction after the calculation of adjusted gross income, but is not an itemized deduction.
Eligibility for the 199A Deduction depends upon the type of business operated by the owner, and there are two general categories of businesses. The first category consists of any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, financial science or any business where the principal asset is the reputation or skill of its employees or owners (Restricted Businesses). The second category consists of all other businesses (Non-Restricted Businesses).
Owners of Non-Restricted Businesses are entitled to claim the 199A Deduction regardless of their taxable income (subject to certain limitations).
Owners of Restricted Businesses (which includes physicians), however, can fully benefit from the 199A Deduction only if their taxable income is below $157,500 for single filers and $315,000 for joint filers. For taxable income levels between $157,500 and $207,500 for single filers, and between $315,000 and $415,000 for joint filers, the 199A Deduction is phased-out. Once taxable income levels reach $207,500 for single filers and $415,000 for joint filers, the 199A Deduction is completely denied.
Assume, for example, a physician operates a medical practice through an S corporation. The physician’s allocable share of the corporation’s net income is $150,000 and the taxable income on the physician’s joint return that the physician files with his or her spouse is $450,000. Because the physician’s taxable income on the joint return is greater than $415,000, the physician is not entitled to any 199A Deduction.
Assume the same facts as above, except that the taxable income on the physician’s joint return is $310,000. Because the physician’s taxable income on the joint return is less than $315,000, the physician is entitled to a 199A Deduction in the amount of $30,000 (20% of $150,000). If the physician’s taxable income is between $315,000 and $415,000, the physician would be entitled to a reduced 199A Deduction.
The amount of business net income for which the 199A Deduction is available does not include reasonable compensation paid by the business to the owner of the business, nor does it include guaranteed payments paid by a partnership to a partner. Thus, in the second example above where the physician claims a $30,000 199A Deduction, the deduction is based on the amount of business income listed on his Schedule K-1 from the S corporation, and the physician does not receive any 199A Deduction with respect to the amount of compensation reported to him on Form W-2 from the S corporation.
Remember, owners of an S corporation are required to pay themselves reasonable compensation for their services, and cannot simply report all of their earnings on Schedule K-1.
Until regulations are issued, owners of Restricted Businesses, such as physicians whose income fall below the income thresholds, will not know if it will be advantageous for them to convert their S corporations to limited liability companies (LLCs), because owners of LLCs, unlike owners of S Corporations, do not receive any W-2 income.
Also, because of the denial of the 199A Deduction for high-income owners of a Restricted Business, such owners may want to consider moving their non-clinical functions to a related company to claim a 199A Deduction. Assume, for example, a medical practice operates as a limited liability company (taxed as a partnership), and none of the LLC’s owners are entitled to a 199A Deduction from the company.
But, suppose the medical practice spins off all personnel and assets related to administration, secretarial services, IT support, billing, document storage, property management and other similar functions into a newly-formed limited liability company (Newco), the ownership of which mirrors the ownership of the medical practice. Further, suppose the medical practice (which now only contains the physicians and other clinicians) contracts with Newco to obtain all of the non-medical services that are now provided by Newco.
Assuming that the amounts paid by the medical practice to Newco are consistent with the fee a medical practice would pay in an arm’s-length relationship with an unrelated management company providing such services, then the medical practice would have separated the profit it earns solely from providing medical services (which will be retained in the medical practice) from the profit earned with respect to the provision of non-medical services (which will be retained in Newco).
Since the services provided by Newco are not included in the types of services that constitute a Restricted Business for purposes of the 199A Deduction, the business income reported by Newco on Schedule K-1 to the physicians should qualify for the 199A Deduction (subject to certain limitations).
While the business income from the medical practice still would not qualify for the 199A Deduction, the restructuring (if respected by the Internal Revenue Service (IRS)) would separate the “good” income from the “bad” income (“good” and “bad” in terms of the 199A Deduction) and allow the physicians to claim a 199A Deduction that would not otherwise be available to them.
As noted above, however, this type of restructuring would accomplish the goal of securing a 199A Deduction only if respected by the IRS. The IRS could assert that the restructuring lacks a non-tax business purpose, and was effectuated solely to claim a 199A Deduction. It is also important to realize that, at this point, the only guidance we have regarding the 199A Deduction is the newly-created statute itself. Perhaps additional guidance will be forthcoming in the form of Treasury regulations or other IRS authority.
Douglas T. Coats
410-576-4002 • firstname.lastname@example.org