A String Quartet, a Nothing Special Diner, and a Famous Chef Diner Take a Random Walk Through the New Section 199A Pass-Through Deduction

By Elizabeth A. Whitman

Recently, some friends and I formed a string quartet. We all have full-time day jobs, and we don’t expect for the quartet to be a source of income. However, let’s imagine for a moment that our string quartet (which we can refer to as the TCJA Quartet[1]) is asked to provide chamber music for a community event.  We set an open instrument case in front of the group.  As we perform, people drop bills into the case, and at the end of the evening, we are surprised to see that we have collected $100.

What should we do with the $100? Well, the TCJA Quartet hasn’t formed an official legal entity such as a corporation or limited liability company and it doesn’t have a bank account or any expenses. It seems like the best thing to do is just to split the money four ways so each of us receives $25.

The TCJA Quartet is a lot like a “pass-through” under new Section 199A of the Tax Cuts and Jobs Act (the “2017 Tax Law”). Under this law, a “pass-through entity” is any entity which is not taxed as a corporation.  Under the simplest reading of the law, this means that any individual or entity which reports income on Schedule C of Form 1040 (individual tax return) or on Form 1065 (for partnerships and trusts) or Form 1120S (for S corporations) can be a pass-through entity under Section 199A.  What these “pass-throughs” have in common is that they involve business income, but the business itself “passes through” items of income and expense to the business’s owners.[2]

Under Section 199A, it is good to be a “pass-through,” because taxpayers may deduct the twenty percent (20%) of their “qualified business income” (roughly equal to net income) from pass-throughs when computing their tax obligation, provided the taxpayer’s taxable income does not exceed a “threshold amount” of $157,500 ($315,00 for a joint return).

For taxpayer’s whose income exceeds the threshold amount, there is a phase-out period of $50,000 ($100,000 for a joint return), after which the pass-through deduction is the lesser of 20% of qualified business income or the greater of either 1) 50% of the pass-through’s W-2 wages or 2) 25% of W-2 wages plus 25% of the unadjusted basis of “qualified property” immediately after acquisition (roughly equal to the acquisition cost for depreciable property owned by the pass-through).

In case you are not already confused, not all pass-throughs are treated the same under Section 199A. Specifically, pass-throughs which are a “specified service trade or business” completely lose the deduction after the $50,000 (or $100,000) phase-out period.

This limitation for pass-throughs which are a “specified service trade or business” has been widely touted as preventing higher income attorneys, accountants, real estate brokerage, and financial advisors from benefiting from the deduction, but it excludes taxpayers in other fields, as well. Specifically, a pass-through is a “specified service trade or business” if it is engaged in the provision of services in health, law, accounting, performing arts, consulting, athletics, financial services, and brokerages services, or “where the principal asset [of the pass-through] is the reputation or skill of 1 or more of its employees or owners.”

As a result, a pass-through which is, the Nothing Special Diner which is owned and operated by a local family and serves unmemorable omelets, meatloaf, and macaroni and cheese using recipes from a collection of church cookbooks might not see a complete phase-out of its deduction. However, the nearby Famous Chef Diner selling the same menu items, but which is owned by a celebrity chef who lends his/her name to the restaurant and helps formulate recipes might see a phase-out of its deduction. After all, the skill or reputation of the celebrity chef, which is the primary asset or at least a major asset for the Famous Chef Diner, but the Nothing Special Diner does not appear claim the reputation or skill of is owners or employees as a major asset.

Perhaps more paradoxically, a corner bodega owned by local family, which sells fresh-cut flowers might not see a complete phase-out of its pass-through deduction, but a family florist business of no particular fame, which sells floral designs with the same type of flowers, might be subject to the phase-out. That is because the floral design skill of the owners and employees of the florist business might be considered to be the principal asset of that business.

Going back to the TCJA Quartet, even though we aren’t quite ready for our Carnegie Hall debut, because we are providing services in “performing arts,” we likely would be considered a “specified service trade or business,” which would be subject to potential phase-out of the deduction, provided our income from our day jobs exceeded the threshold amount plus the $50,000/$100,000 phase-out amount. We would be subject to this phase-out based upon income, even if we remained unknown.

The phase-out also would apply to any US income of The Really Terrible Orchestra[3] (yes, it really exists), an amateur orchestra which prides itself in its mediocrity, but which now travels and the members of which possibly, might have significant income as a result. The same phase-out potentially could be applied to a pass-through providing piano lessons, soccer coaching, or home health services, but paradoxically not to pass-throughs providing painting lessons, math team coaching, or babysitting services.

Section 199A is nine-pages long and contains cross references to existing Internal Revenue Code sections, some of which are better “fits” into the concepts in Section 199A than others. The IRS has not, to date, issued any guidance on how it expects to interpret any part of Section 199A, and it’s a fair guess that it likely will be well over a year (and probably longer) before the IRS is able to complete the regulatory process to give clarity on exactly how Section 199A will work for specific taxpayer situations.

Until then, taxpayers may be able to maximize the likelihood that they will benefit from the pass-through deduction by doing the following:

  1. Confirm that they have a business structured as a pass-through. Although it seems clear that taxpayers filing corporate tax returns on Form 1020 and individuals whose only income is W-2 wages do not qualify as pass-throughs, it is not as clear whether an individual who is what some call a 1099 employee [4] will be able to take the pass-through deduction. The safest course of action for individuals is to consider operating under a true “pass-through,” such as an S corporation or limited liability company. [5]
  2. Take opportunities of retirement savings and other “above the line” deductions, which reduce taxable income. To avoid the phase-out of the pass-through deduction, taxpayers whose business might be considered a “specified service business” will benefit by keeping their taxable income as low as possible. At this time, it appears that pre-tax deposits into retirement funds and other “above the line” deductions may help those taxpayers keep their income below the threshold amounts for the phase-out. Even taxpayers who are not in a “specified service business” may benefit from this strategy so that they are assured of having the flat 20% deduction available to them, rather than having to compute and compare W-2 wages and qualified property.
  3. Do a quarterly review of their tax situations. All taxpayers should, on a quarterly basis, look at their anticipated taxable income and deductions and try to fine-tune their withholding or make quarterly payments if necessary to assure they are making appropriate tax payments. Taxpayers who might be eligible for the pass-through deduction additionally should evaluate what business expenses, retirement account deposits, and other strategies might be appropriate to maximize the likelihood they will be eligible for the deduction at the end of the year.

As for the TCJA Quartet example, each of us will have a huge $25 income for our efforts. Assuming the TCJA Quartet is a “trade or business,” it would be considered a special services business due to our performing arts focus. It is possible, however, that the four of us would each receive different tax treatment of our $25.

If, for example, the first violinist was single and had taxable income of $100,000, she could deduct the full 20% (or $5) under the pass-through deduction, so she would pay taxes on only $20 of her quartet income. On the other hand, if the second violinist filed a joint return and together with her spouse had taxable income of $365,000, then she would be subject to a partial phase-out of the pass-through deduction (50% reduction to be exact), so her pass-through deduction would be only $2.50, and she would pay taxes on $22.50 of her quartet income. If the cellist also filed a joint tax return and she and her spouse have taxable income of $420,000, above the phase-out period; she would pay taxes on the entire $25.00 of her quartet income.  And as for the violist, I’ll be polite and save the viola joke for a later article.

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[1]  Named after the newly-passed Tax Cuts and Jobs Act

[2]  Insert explanation of why sole proprietorship wasn’t traditionally a pass-through, and why a SMLLC is disregarded entity.

[3] http://thereallyterribleorchestra.com/wordpress/

[4]  An individual who works as an independent contractor form whom form W-2 need not be filed but who also is not considered to be engaged in a trade or business, if such an individual can exist.

[5] Noting that single member limited liability companies are disregarded entities under the tax law, but like multi-member limited liability companies, do not pay their own taxes, but instead, taxes are paid by the owners of the limited liability company.  Limited liability companies can elect to be taxes as an S corporation, but that election is subject to strict time deadlines.

© 2018 by Elizabeth A. Whitman

For more information, please contact Elizabeth A. Whitman at (301) 664-7713 or eawhitman@mirskylawgroup.com

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