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Section 199A Deductions - Pass Thru Tax Breaks

(posted: December 11th, 2018)


Section 199A deduction, also known as the Qualified Business Income Deduction (QBID), arises from the Tax Cuts & Jobs Act of 2017 (TCJA). This is a significant tax break for small business owners but there are rules and limits, of course.

A quick summary is as follows:

Section 199A Qualified Business Income deduction is a deduction from adjusted gross income to arrive at taxable income (what we call a below-the-line deduction, from AGI). This is contrasted with an adjustment to gross income to arrive at adjusted gross income (what we call an above-the-line deduction, for AGI).

Defining Terms

Pass-thru entities and structures include:

  • Sole proprietorship (no entity, Schedule C).
  • Real estate investors (no entity, Schedule E).
  • Disregarded entities (single member LLCs).
  • Multi-member LLCs.
  • Any entity taxed as an S corporation.
  • Trusts and estates, REITs and qualified cooperatives.

Specified Service Trade or Business is defined as:

  • Traditional service professions such as doctors, attorneys, accountants and actuaries.
  • Performing artists who perform on stage or in a studio.
  • Paid athletes.
  • Anyone who works in the financial services or brokerage industry.
  • And now the hammer..."any trade or business where the principal asset is the reputation or skill" of the owner.

Interestingly, removed from the traditional service profession are engineers and architects. But an engineer operating a business based on his or her reputation or skill is still a specified service trade.

Income Limits

  • Based on taxable income including all sources (not just business income).
  • Single is $157,500 completely phased out by $207,500 (adjusted for inflation).
  • Married filling jointly is $315,000 completely phased out by $415,000 (adjusted for inflation).

Calculating The Qualified Business Income Deduction

The basic deduction is 20% of net qualified business income which is huge. If you make $200,000, the deduction is $40,000 times your marginal tax rate of 24% which equals $9,600 in your pocket. Here is the exact code:

Determination of deductible amount for each trade or business. The amount determined under this paragraph with respect to any qualified trade or business is the lesser of:

(A) 20 percent of the taxpayer's qualified business income with respect to the qualified trade or business, or
(B) the greater of:

  • 50 percent of the W-2 wages with respect to the qualified trade or business, or
  • the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.

There are some devils in the details of course. The best way is to show some examples:

Jan makes $100,000 in net business income from her sole proprietorship but also deducts $5,000 for self-employed health insurance, $7,065 for self-employment taxes and $10,000 for SEP IRA. These are not business deductions - they are adjustments on Form 1040 to calculate adjusted gross income. Her deduction is the lesser of 20% of $100,000 (net business income) or 20% of her taxable income, which could be less.

Patrick owns three rentals with net incomes of $20,000 and $5,000, with one losing $8,000 annually. These are aggregated to be $17,000. He would deduct 20% of $17,000.

Patrick has passive losses that carried forward and are "released" because he now has net rental income, those passive losses are taken first. Using the same example above with $10,000 in passive loss carried forward, Patrick's deduction would equal $17,000 less $10,000 or 20% of $7,000.

Judy earns $100,000 but reports $80,000 of taxable income on her tax return due to other deductions such as her itemized deductions. Her Section 199A deduction would be $16,000 since it is limited by the lesser of 20% of $100,000 or $80,000.

Mr. Brown operates an online retailer S corporation which pays $100,000 in W-2 wages and earns $400,000 in net qualified business income. Because he is considered a "high earner" by exceeding the income limits, his deduction is limited to 50% of the W-2 wages or $50,000 which is less than 20% of $400,000.

If Mr. Brown operates as a sole proprietor and earns $500,000 but does not pay any W-2 wages, his deduction is the lesser of 50% of the W-2 wages (or $0 in this example) or 20% of the $500,000. If he paid out $200,000 in wages and had $300,000 in net business income, his Section 199A deduction would be the lesser of 50% of $200,000 or 20% of $300,000. In other words, he would deduct $60,000 ($60,000 is less than $100,000). He would want to create an LLC, tax it as an S corporation and pay W-2 wages to maximize his Section 199A deduction.

If Mr. Brown instead operates as a specified service trade as defined previously, he would completely phase out the Section 199A deduction by exceeding the income limits of $207,500 and $415,000. This is the specified service trade.

If Mr. Brown was married and operated a specified service trade, and the taxable income considering all income sources (spouse, investments, etc.) exceeded $315,000 but was less than $415,000, there would be a sliding scale of deduction eligibility. Obviously, tax reform doesn't mean tax simplification.

Joe is single and operates an S corp as an accountant. He earns $100,000 in net qualified business income after paying $50,000 in W-2 wages to himself. Joe is clearly a specified service trade but because he earns less than $157,500 total ($150,000 in this example) he can take advantage of the full Section 199A deduction of 20% of $100,000. The question of reasonable salary is not being entertained here, focus on the W-2 to income relationship.

Helen becomes a slumlord and earns $500,000 in rental income. No W-2 since she is operating the properties as an individual (and converting passive income into earned income vis-a-vis a W-2 would be silly). Let's say she purchased the properties for $1,000,000 (unadjusted basis). The math would go like this:

  • 20% x $500,000 is $100,000 (straight calculation).
  • 50% of $0 is $0 (W-2 limit calculation).
  • 2.5% of $1,000,000 is $25,000 (depreciable asset limit calculation).

Section 199A is limited to the lesser of $100,000 as compared to the greater of $0 (W-2) and $25,000 (depreciable assets). So her deduction is $25,000.

Takeaways

  • No entity is penalized under the new tax laws. Some entities and situations might not qualify or be limited in some fashion, but the high-water mark in terms of taxation is the old 2017 tax law.
  • Taxable income becomes a big deal for two reasons. First, $1 over $157,500 or $315,000 starts the specified business disqualification and W-2 limitation (and there is also a depreciation component that we are glossing over in this summary). Second, the Section 199A deduction is limited by 20% of taxable income from all sources (what would be reported on your tax returns).
  • W-2 wages include all W-2 wages, not just those paid to the owner(s). Converting a 1099 contractor to a W-2 employee might be beneficial.
  • It appears that self-employment taxes will still be calculated on the net business income BEFORE the Section 199A deduction since the deduction is taken "below the line" on Form 1040. So you could earn $100,000 and deduct $20,000 under Section 199A, but still pay self-employment taxes on $100,000. This remains unclear, however, and we will await further IRS guidance.
  • S corporations remain a critical tax saving tool for two reasons. First, the usual self-employment tax savings remains intact for all business owners including specified service trades or businesses. Second, a business owner might need to pay W-2 wages to himself to not be limited by income, and only corporations can pay W-2 wages to owners (in other words, an LLC cannot without an S Corp election).

Section 199A Optimization
As you can see, there is some optimization that is necessary for a small business owner to get the most from the Section 199A deduction. On one hand we want to reduce W-2 salaries to shareholders to minimize self-employment taxes. On the other hand, we want to increase W-2 salaries so they do not limit the amount of Section 199A that is deducted.

This seems straightforward since payroll taxes are 15.3% plus some unemployment and other insidious stuff and the Section 199A Qualified Business Income deduction is 20%. However, the 20% Section 199A deduction must be multiplied by the marginal tax rate to obtain the true tax benefit. Even at a 37% marginal tax rate, the additional payroll taxes might exceed the Section 199A deduction benefit. Again, optimization is important.

Section 199A Decision Tree
Remember that taxable income is all income for the household.

Specified Service Trade or Business, if taxable income is:

  • less than $157,500/$315,000 then the 20% deduction is fully available.
  • greater than $157,500/$315,000 but less than $207,500/$415,000 then a partial deduction is available.
  • greater than $207,500/$415,000 then you get no QBID.

All others, if taxable income is:

  • less than $157,500/$315,000 then the 20% deduction is fully available.
  • greater than $157,500/$315,000 but less than $207,500/$415,000 then a partial deduction is available with the W-2 and depreciable asset limit calculations phase in.
  • greater than $207,500/$415,000 then the 20% deduction is compared to the full W-2 and depreciable asset limit calculations.

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