By Jason Watson (Google+)
Posted November 23, 2018
Section 199A deduction also known as the Qualified Business Income deduction arises from the Tax Cuts & Jobs Act of 2017. This is a significant tax break for small business owners but there are rules and limits of course.
Section 199, without the A, is the section covering Domestic Production Activities Deduction. Section 199A is seemingly modeled after this (or at least a portion was ripped off by legislators) since the mathematics and reporting is similar between Section 199A and Section 199. Recall that Domestic Production Activities Deduction was reported on Form 8903 and eventually deducted on line 35 of Form 1040.
However, it appears that Section 199A Qualified Business Income deduction is a deduction from gross income on Line 9 on Page 2 of the new Form 1040.
Here is a sample of the new Form 1040 with both numbered and lettered schedules-
It would appear that the new Form 1040 is way more complicated than it needs to be. In the interest of “postcard” tax returns, the IRS has made it more complicated. Why not simply have a three-page Form 1040? Many states have four or even five pages. We digress…
As with any major revision to the tax code, there will be modifications and interpretations which will change how Section 199A can be used for pass-through businesses. Stay tuned to updates. For now, please read our Section 199A articles and blog posts-
Sidebar: The old Section 199 for Domestic Production Activities still remains in a limited form for specified agricultural or horticultural corporations. See 2018’s instructions for Form 8903 if you cannot get enough.
Pass-through entities and structures include-
- Sole proprietorships (no entity, Schedule C).
- Real estate investors (no entity, Schedule E).
- Disregarded entities (single-member LLCs).
- Any entity taxed as an S corporation.
- Trusts and estates, REITs and qualified cooperatives.
Specified Service Trade or Business (SSTB) is defined as-
- Traditional service professions such as doctors, attorneys, accountants, actuaries and consultants.
- Performing artists who perform on stage or in a studio.
- 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. Why didn’t they just start with this since everything else would have been moot. Oh well…
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 might still be a specified service trade or business. In other words, reputation or skill might trump the fact that engineers and architects were purposely left off the list. Every consultant is suddenly going to reclassify themselves as an engineer; software consultant is now a software engineer. Watson Business Engineers has a nice ring to it. Hmm….
Sit on the ledge, sure, but don’t jump off a bridge just yet. The specified service trade or business problem only comes up when your taxable income exceeds the limits. So, a financial advisor making $150,000 might still enjoy the Section 199A deduction. Keep reading!
- Based on taxable income including all sources (not just business income). Also limited to 20% of taxable income.
See Line 43 of 2017’s Form 1040 to assess your 2018 taxable income using 2017 as a proxy, adjusting for itemized deductions and exemptions (or lack thereof).
- Single is $157,500 completely phased out by $207,500 (adjusted for inflation).
- Married filing jointly is $315,000 completely phased out by $415,000 (adjusted for inflation).
Calculating the Qualified Business Income Deduction
The basic Section 199A pass-through 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. Who says Obamacare isn’t affordable now?
Here is the exact code-
(2) 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-
(i) 50 percent of the W-2 wages with respect to the qualified trade or business, or
(ii) 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-
- Wilma 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 a SEP IRA. These are not business deductions- they are adjustments on Form 1040 to calculate adjusted gross income. Her deduction is the lessor of 20% of $100,000 (net business income) or 20% of her taxable income, which could be less (see Pebbles below). This might change as the IRS clarifies.
- Barney 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.
- Barney has passive losses that carried forward and are “released” because he now has net rental income, those passive losses are taken first. With using the same example above with $10,000 in passive loss carried forward, Barney’s deduction would equal $17,000 less $10,000 or 20% of $7,000.
- Pebbles earns $100,000 from her pass-through business 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 limited by the lessor of 20% of $100,000 or $80,000.
- Mr. Slate 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 or $50,000 which is less than 20% of $400,000.
- If Mr. Slate instead operates as a sole proprietor and earns $500,000 but does not pay any W-2 wages, his deduction is the lessor 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 lessor 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, even in Canada). He would want to create an LLC, tax it as an S corporation and pay out W-2 wages to maximize his Section 199A deduction.
- If Mr. Slate instead operates as a specified service trade as defined previously, he would completely phase out of the Section 199A deduction by exceeding the income limit of $207,500 and $415,000. This is the specified service trade “gotchya.”
- If Mr. Slate 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. Silly rabbit, tax reform doesn’t mean tax simplification.
- Fred… yes, we can’t neglect Fred… is single and operates an S Corp as an accountant. Days of busting up rocks for Mr. Slate are in the rear-view mirror. He earns $100,000 in net qualified business income after paying $50,000 in W-2 wages to himself.
He is a 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.
- Betty 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 a $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 lessor of $100,000 as compared to the greater of $0 (W-2) and $25,000 (depreciable assets).
Section 199A Takeaways
No entity is penalized under the new tax law. 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 crummy 2017 tax law.
Taxable income becomes a big deal for two reasons! First, $1 over $157,500 or $315,000 starts the specified service 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 separately in Line 9 on Page 2 on Form 1040. Therefore, 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 or herself 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 Pass-Thru 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 tax benefit. Again, optimization is important.
We go over the math in a later chapter with examples of qualified business income, W-2 salaries paid, the Section 199A pass-through calculation and the net benefit of an S Corp as compared to non-S Corp situations (spoiler alert: the optimal salary for Section 199A as a percentage of net business income before salary is 28% or $28,000 salary paid on $100,000 business income).
Section 199A Deduction 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 (single) / $315,000 (married) then the 20% deduction for your pass-through entity is fully available.
- If taxable income is greater than $157,500 / $315,000 but less than $207,500 / $415,000 then a partial deduction is available. The phase-in of the limit is linear.
- If taxable income is greater than $207,500 / $415,000 then you are hosed. Sorry.
- If taxable income is less than $157,500 / $315,000 then the 20% deduction is fully available.
- If taxable income is 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.
- If taxable income is greater than $207,500 / $415,000 then the 20% deduction is compared to the full W-2 and depreciable asset limit calculations (see Betty above).
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