Using Cost Segregation to Maximize the I.R.C. § 199A Pass-Through Deduction

The Tax Cut and Jobs Act (“TCJA”) provides a new deduction for partnerships, LLCs, S corporations and sole proprietorships (in other words, pass-through entities). This deduction can be as much as 20% of Qualified Business Income (“QBI”), which is equivalent to net profit. The benefit will be significant for the owners of most pass-through entities. The interplay of the depreciation and cost segregation rules can result in larger I.R.C. § 199A deductions--allowing taxpayers to maximize their I.R.C. § 199A deductions.

The Pass-through Deduction is the lesser of 20% of the taxpayer’s QBI or ordinary taxable income. I.R.C. § 199A(c) defines QBI as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” Qualified items of income, gain, deduction and loss are those items that are connected with a trade or business that is operated in the United States and are generally included or allowed when a business determines its taxable income for the year.

A Qualified Trade or Business is any trade or business that is not a “Specified Service Trade or Business” or the trade or business of performing services as an employee

Section 199A defines the term “Specified Service Trade or Business (“SSTB”)” as:

  • Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners.
  • Banking, insurance, financing, leasing, investing, or similar business,
  • Farming business (including the business of raising or harvesting trees),
  • Business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A,
  • Business of operating a hotel, motel, restaurant, or similar business.
  • Business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

An exception based on income-based applies for owners of a SSTB. If income is below a certain threshold limitation an owner of a SSTB may still take the pass-through deduction.

For 2018, that amount is $207,500 (or $415,000, for MFJ) to be eligible for a partial deduction and $157,500 (or $315,000, for MFJ) to be eligible for the full deduction. Form W-2 Limitation and Taxable Income Exception

A taxpayer may only deduct 20% of QBI up to a certain limit. This limit is the greater of:

  1. 50% of the wages paid by the qualified trade or business, or
  2. The sum of 25% of the wages paid by the qualified trade or business, plus 2.5% of the original unadjusted basis immediately after acquisition of all qualified property.

There is a taxable income exception to the above-stated limitation.

For 2018, the threshold amount is $157,500 (or $315,000 if married filing joint). Additionally, the taxpayer is afforded an additional $50,000 (or $100,000 if married filing joint) to phase-in the deduction.

Proposed Regulations to I.R.C. § 199A

Recently the Department of Treasury and the IRS have issued the proposed regulations to I.R.C. § 199A. There are 6 sections to the proposed regulations. The first section provides general guidance on calculating the deduction. The second section provides the rules for determining W-2 wages and the unadjusted basis immediately after acquisition (“UBIA”) of qualified property. The third section provides guidance as to determining QBI, qualified real estate investment trust (“REIT”) dividends, and qualified publicly traded partnership (“PTP”) income. The fourth section provides the rules for aggregation of multiple businesses. The fifth section provides guidance as to SSTBs. Finally, the sixth section provides additional special rules such as reporting requirements for pass-through entities and special allocation rules for non-grantor trusts.

Cost Segregation & I.R.C. § 1245 Property

A Cost Segregation analysis allows a taxpayer who owns real estate to reclassify certain assets as I.R.C. § 1245 property with shorter useful lives for depreciation purposes, rather than the longer useful life for I.R.C. § 1250 property. This property may then be depreciated over a shorter period of time--five, seven or fifteen years--while I.R.C. § 1250 property is depreciated at 39 years for nonresidential property and 27.5 for residential property.

The value of utilizing this technique is to take advantage of the immediate cash flow generated from tax savings, particularly the tax savings attributable to the catch-up adjustment that is often available in the year the cost segregation study is completed. Basic time value of money principles makes this advantageous for the taxpayer.

Using Cost Segregation to Qualify for the Pass-Through Deduction

The Cost Segregation analysis will create accelerated depreciation deductions, thereby lowering the businesses net income or QBI. This will allow certain taxpayers to meet the W-2 limitation or SSTB exceptions, thereby allowing the taxpayer to utilize the full or partial deduction, where he otherwise would have been prevented from doing so. This provides the taxpayer with immediate cash flow while generating tax savings.

I.R.C. § 481 Treatment under the I.R.C. § 199A Regulations

In general, I.R.C. § 481 provides rules for the treatment of certain items that may be duplicated or omitted when a taxpayer chooses to change accounting methods. The general rule provides that the taxpayer has 1 year to report a net negative adjustment and 4 years to report a net positive adjustment. However, the proposed section 199A regulations state that any section 481 adjustments, either negative or positive, arising after tax year 2017, will constitute QBI in that year for purposes of I.R.C. § 199A. Therefore, a taxpayer who is in this situation can benefit greatly by performing a Cost Segregation analysis to accelerate depreciation deductions.

Unadjusted Basis and Cost Segregation

The second part of the W-2 limitation, discussed above, provides for the sum of 25% of the wages paid by the qualified trade or business, plus 2.5% of the original unadjusted basis immediately after acquisition of all qualified property. The important part here is that the original unadjusted basis is used when computing the amount. This means that taxpayers who utilize a Cost Segregation analysis on their purchased property need not worry that it will negatively impact their ability to utilize the pass-through deduction. Therefore, a capital intensive taxpayer who utilizes a Cost Segregation analysis may benefit from both the new pass-through deduction and the cash flow influx from accelerating depreciation deductions with Cost Segregation.

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