Timing is everything: 199A deduction may determine date you sell pass-through entity assets

December 12, 2018|Shane Wheeler

Choose your closing date carefully when selling pass-through entity assets, as the transaction timing can affect how the 199A deduction impacts your tax situation.

For ease of administration, it has become common for transactions to close on the first or last day of the year. An oft-used method of tax deference involved delaying a transaction until the first of the following year, potentially providing tax deference until April of the second year (tax on a January 1, 2018 sale is not due until April 15, 2019). However, there may now be a significant reason to structure a sale to close on the last day of the year.

The IRS recently released proposed regulations surrounding Section 199A, as amended under the Tax Cuts and Jobs Act (TCJA), detailing the new 20% deduction for qualified business income (the “199A deduction”).

In an admittedly oversimplified explanation, the 199A deduction provides taxpayers meeting certain thresholds or limits with a deduction equivalent to 20% of their business income, excluding capital gain income. For taxpayers with taxable income over $315,000, the 199A deduction is limited to 50% of the wages paid by the taxpayer’s business or 2.5% of the adjusted basis of the assets of the business. For those taxpayers with taxable income high enough to be impacted by the wage limitation, timing on the sale of a pass-through interest could mean significant tax savings.

What qualifies for the 199A deduction?

When a pass-through entity sells its assets, there are several assets that can result in ordinary income, rather than capital gain. Those assets generating ordinary income include, but are not limited to, the following:

  1. Any depreciation recapture (excluding most depreciation recapture on real estate);
  2. Appreciated finished goods in the inventory of the business; and
  3. Cash basis receivables.

Subject to the thresholds and limitations of the 199A deduction, any and all ordinary income described in the foregoing paragraph will be eligible for the 199A deduction. If we look back to the limitations outlined above, the 199A deduction can be limited to 50% of wages paid by the pass-through when a taxpayer’s taxable income is greater than $315,000. If the taxpayer sells the assets of their pass-through entity on January 1, the taxpayer will have one day’s worth of wages to utilize when computing the 50% limit. This is opposed to 365 days’ worth of wages had the transaction been closed one day earlier, on December 31.

While this important distinction will not apply in all scenarios, business owners and tax practitioners must now look carefully at each sale of a business to determine the importance of choosing a specific closing date.

It is important to note here that, like an asset sale, the sale of LLC units or partnership units can, and often does, result in ordinary income. Unfortunately, the IRS has yet to clarify whether the ordinary income generated from the sale of partnership/LLC units would be eligible for the 199A deduction.

If you are considering an ownership change in your entity and would like guidance regarding the material discussed in this article and other important considerations, please contact us or reach out to Shane Wheeler, CPA, JD, supervisor, at 920-455-4280.

Shane Wheeler, CPA, JD, is a supervisor with Schenck who focuses primarily on tax planning, compliance, and business consulting for closely held businesses and individuals. He is a member of the firm’s Manufacturing & Distribution and Real Estate & Construction teams.

Tags: Tax