As a small business owner, tax deductions are always welcome. But, deductions aren’t static. Deductions change over time, and some go away completely. Or, in the case of the Section 199A deduction, new deductions are added.
The Tax Cuts and Jobs Act (TCJA) that was signed into law in December 2017 was part of a major tax reform that paved the way for the Section 199A deduction. This part of the reform could result in big tax savings for small businesses and real estate investors.
Before diving into the specifics of Section 199A, let’s get a high-level view of what this deduction does and who it’s for. Then, we’ll cover the 10 major points that make up this tax deduction.
What is the Section 199A deduction?
Section 199A is a qualified business income (QBI) deduction. With this deduction, selecting types of domestic businesses can deduct roughly 20% of their QBI, along with 20% of their publicly traded partnership income (PTP) and real estate investment trust (REIT) income. The deduction is limited to 20% of taxable income, less net capital gains. Net capital gains refers to (capital gains less capital losses).
But, this deduction isn’t for everyone. There are income limitations as well as business limitations. First off, you need to file a joint return with no more than $315,000 in taxable income or a single return with a cap of $157,500 in taxable income for the tax year. According to the IRS provision for Section 199A, the deduction is gradually phased out for joint return taxable income between $315,000 and $415,000. For other filers, the deduction is phased out for returns with taxable income between $157,500 and $207,500.
Businesses must also be domestic, meaning located within and taxed by the United States. And, businesses must be a sole proprietorship, partnership, S corporation, trust or estate to qualify.
10 key points pertaining to Section 199A
It’s always good to check with your CPA or tax professional who can explain this deduction and help you review its impact on your business. To help you grasp Section 199A, here are 10 points related to taking this deduction.
1. It shelters pass-through income
The Section 199A deduction covers pass-through entities. Pass-through entities may file a business tax return, but tax is not assessed on the entity. Instead, the business profits and losses are taxed on the personal tax returns of the owners or partners.
For example, assume that a partnership generates $1 million in earnings. As a pass-through entity, the partnership profits are added to income on each partner’s personal tax return.
But the Section 199A deduction applies to qualified business income, not to all pass-through income. Most commonly, this includes income from Schedule C for sole proprietorships, Schedule E for real estate investors, and Schedule F for farmers and ranchers, as well as the business and rental income from a partnership, S corporation, trust or estate. The government may issue guidance around which activities qualify and which ones don’t.
Further confusing matters, the QBI deduction also applies to additional qualified items of income, such as real estate investment trust dividends, qualified agricultural and horticultural cooperative dividends, and publicly traded partnership income.
2. The deduction tentatively equals 20%
The actual Section 199A deduction equals 20% of qualified business income, and you may need to make an adjustment to the total. If your business has $1 million of qualified business income, for example, you may get a $200,000 deduction.
As laid out before, the actual calculations can be much more complicated when doing a deep dive, with PTP income and REIT dividends being factored in. But, the total will still come out to roughly 20% of income, no higher, but it may be lower depending on your numbers. It’s simply a matter of where that full 20% comes from: your total QBI or a mixture of other income types.
3. There are taxable income limits
The deduction formula includes several limits. The most important one says that the Section 199A deduction can’t exceed 20% of taxable income taxed at ordinary income rates.
For example, if your taxable income equals $100,000 but that amount includes $20,000 of capital gains and no capital losses, the Section 199A deduction can’t exceed 20% of the $80,000 ($100,000 taxable income less $20,000 capital gains).
4. Section 199A covers domestic business income
Section 199A only covers domestic income. If you operate your business outside the United States, you don’t get to use the deduction to reduce your taxable income. The Section 199A deduction only applies to domestic income generated in the United States.Foreign income that’s not taxed will not be considered in the deduction. There’s no grey area or wiggle room here.
5. Service businesses may get excluded
If your income is from a white-collar professional service — like if you’re an athlete, performer, or investment professional — you may find your deduction limited or eliminated.
The rules can quickly get complicated. If a single taxpayer enjoys more than $207,500 in taxable income, or a married taxpayer enjoys more than a $415,000 in taxable income, you don’t get to use the deduction at all.
As always, when in doubt, contact your accountant or financial advisor.
6. High-income taxpayers need W-2 wages and depreciable assets
According to the IRS provision for Section 199A, for eligible taxpayers with total taxable income in 2018 over $207,500 ($415,000 for married filing joint returns), the deduction for QBI may be limited by the amount of W-2 wages paid by the qualified trade or business, and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business.
Again, this part of the deduction formula gets complicated, but above these thresholds, the Section 199A deduction can’t exceed the greater of either 50% of the business’s W-2 wages, or the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property, according to this article.
7. There are phase-out zones for upper-income taxpayers
For single taxpayers with taxable income ranging from $157,500 to $207,500, and for married taxpayers with income ranging from $315,000 to $415,000 in taxable income, the deduction gets phased out.
Beneath the phase out range, you get the deduction even without wages or depreciable property, or from a specified service trade or business (SSTB). Essentially, if you’re not in the phase out range previously mentioned, the rules of point 6 above don’t apply and you can get the deduction as stated.
8. Section 199A has a safe harbor for rent
An initial concern when Section 199A first took effect was whether or not rental properties would be counted as QBI. It’s official: Any kind of rental real estate income that comes from a tangible property will be covered as business income. These amounts will still be subject to the same threshold amounts as those listed before for both single and joint filers.
9. QBI loss is carried over
Whether you have one business or several, your QBI is your total income. That means if you have multiple businesses and one does really poorly, it’s weighed against your other businesses. This makes it possible to have a negative QBI, in which case you have to carryover the loss into the following year.
For example, if you have one business where your QBI was $25,000 and another business where it was –a $30,000 loss, then your overall QBI is technically –a $5,000 loss. This will then be carried into the following year, where your total QBI will have to overcome the -$5,000 loss to get into the positive.
This can reduce your deduction for both the current tax year as well as the following one.
10. Specified service trades or businesses are complicated
A specified service trade or business (SSTB) is defined by the IRS as, “a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, or dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.”
If a business qualifies as an SSTB, it’s not able to take advantage of the Section 199A deduction. But if a business only earns some income through SSTB activities, like consulting, they may still qualify for the deduction. If their income is below the threshold, they can still get the deduction. If their income is within the phase-in range, meaning at or below the earned income cap previously mentioned, they may still qualify, depending on their taxable income in comparison to their SSTB earnings.
If your business does some SSTB business, you’ll want to keep the gross receipts to determine what percentage of your business falls within SSTB territory. If your total SSTB-related income is less than 10% of your gross revenue, you could still qualify for the deduction.
Getting the most out of Section 199A
There’s no getting around the fact that Section 199A is complicated. But, like all things tax-related, it’s much more manageable if you take your time and check every available tax resource. It’s especially manageable if you have a tax professional at your side. (They do this stuff for a living, after all.)
For the right small businesses, Section 199A can be a hearty deduction that lowers your taxable income by a substantial amount. For everyone else, it’s just a bunch of confusing tax jargon. In either event, speak to your tax or financial advisor, and see if this deduction is for you.