State responses to the new IRC Sec. 199A pass-through deduction differ. The IRC Sec. 199A deduction can be taken by individuals, trusts, and estates with income from:
- S corporations, and
- sole proprietorships.
The deduction is also known as the qualified business income deduction or QBID.
Smart tax planning requires understanding these differences, maximizing the IRC Sec. 199A deduction where available, and weighing the benefits in deciding on the best entity structure.
What Is the IRC Sec. 199A Deduction?
The Internal Revenue Code (IRC) Section 199A pass-through deduction allows eligible taxpayers to lower their taxable income. Eligible taxpayers include owners of pass-through entities (PTEs) such as:
- trusts, and
The Tax Cuts and Jobs Act of 2017 (TCJA) decreased the corporate income tax rate to 21%. Enacted at the same time, IRC Sec. 199A attempts to equalize the tax rates of business entities by providing a special deduction to owners of PTEs.
Both provisions are in effect for tax years 2018 through 2025.
How is the Deduction Computed?
The deduction is generally the lesser of:
- combined qualified business income; or
- 20% of the taxable income minus the taxpayer’s net capital gain.
Who Can Take the IRC Sec. 199A Deduction?
Because of the pass-through income and loss treatment of S corporations and partnerships, PTEs are not taxpayers and cannot take the deduction. Rather, PTEs distribute K-1s to shareholders or partners showing their share of:
- qualified business income;
- W-2 wages;
- unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business;
- qualified real estate investment trust (REIT) dividends; and
- qualified publicly traded partnership (PTP) income.
Each shareholder or partner then determines their deduction and reports that amount on their respective tax returns.
What Tax Planning Opportunities Does the Deduction Present?
Various tax planning opportunities arise from the new deduction, such as:
- determining how best to structure payments made by a partnership to a partner to constitute qualified business income for the recipient;
- making special allocations of W-2 wage expense where allowed;
- determining whether an acquisition of a partnership interest or the purchase of the partnership assets is more favorable; and
- delaying the disposition of assets with UBIA.
How Are the States Responding to the IRC Sec. 199A Deduction?
For individual taxpayers, the IRC Sec. 199A deduction is not included in determining federal adjusted gross income (AGI). It is a “below-the-line” deduction and so is taken after determining federal AGI.
Most states use federal adjusted gross income or federal gross income as the starting point to calculate state personal income tax. Because the federal deduction is taken after that point, most states do not require any adjustment.
States that use federal taxable income as the starting point for calculating personal income tax require an addback of the IRC Sec. 199A deduction if they do not allow the federal deduction. However, states using federal taxable income as the starting point and conforming to the TCJA do not require an addback of the deduction. Yet, if the state decouples from IRC Sec. 199A, the deduction must be added back.
If a state conforms to the TCJA generally or to IRC Sec. 199A specifically, but has a starting point before the deduction is taken on the federal return, the deduction may be subtracted on the state return.
The deduction is available to all taxpayers whether they claim itemized deductions or claim the standard deduction.
The deduction does not have a significant impact on entity-level taxes because the deduction is computed at the partner or shareholder level.
What Are Some State Reactions?
- California’s IRC conformity provision specifically excludes the federal IRC Sec. 199A deduction. So California does not require an addition or allow a subtraction adjustment because personal income tax is based on federal AGI.
- Colorado does not require an adjustment because it incorporates the federal deduction and personal income tax is based on federal taxable income.
- Idaho uses the federal AGI, in practice, as the true starting point in determining Idaho taxable income. So Idaho allows a subtraction adjustment because it adopts the federal deduction.
- Iowa allows a percentage of the federal deduction beginning in tax year 2019. So an adjustment will be required.
- South Carolina requires an addback because its IRC conformity specifically excludes the federal provisions regarding the federal deduction and its starting point for calculating taxable personal income is federal taxable income.
- Virginia’s IRC conformity provision specifically excludes the federal deduction and Virginia’s starting point is federal AGI. So Virginia does not require an addition or allow a subtraction adjustment.
- Wisconsin does not require an addition or allow a subtraction adjustment because its IRC conformity provision specifically excludes the federal deduction and Wisconsin’s starting point is federal AGI.
By Tralawney Trueblood, J.D., M.B.A.