The Tax Cuts & Job Act (TCJA) that was signed into law in December 2017 paved the way for the “Sec. 199A deduction.” In layman’s terms, this could result in big tax savings for small businesses and real estate investors.
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 Sec. 199A, here are 10 points related to taking this deduction.
1. It Shelters Pass-Through Income.
The Sec. 199A deduction applies to qualified business income. Most commonly, this includes income from Schedule C sole proprietorships, Schedule E real estate investors and Schedule F farmers and ranchers, as well as the business and rental income reported on a K-1 from a partnership, S corporation, trust or estate. The government may issue guidance around which activities qualify and which ones don’t. However, there’s a wrinkle: the deduction also applies to real estate investment trust dividends, qualified agricultural and horticultural cooperative dividends, and publicly traded partnerships.
2. The Deduction Tentatively Equals 20 Percent.
The actual Sec. 199A deduction tentatively equals 20 percent of qualified business income. As a result, if your business has $1 million of qualified business income, for example, you may get a $200,000 deduction.
3. Taxable Income Limits.
The deduction formula includes several limits. The most important one says the Sec. 199A deduction can’t exceed 20 percent of a taxpayer’s 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 $80,000 of other “ordinary” income, the Sec. 199A deduction can’t exceed 20 percent of the $80,000.
4. Sec. 199A Shelters Domestic Business Income.
Sec. 199A only shelters domestic income. If you operate your business outside the United States, you don’t get to use the deduction to shelter your income from taxes.
5. Service Businesses May Get Excluded.
If your income is from a white-collar professional service business, such as 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 do not get to use the deduction.
6.High-Income Taxpayers Need W-2 Wages and Depreciable Assets.
If you cross these thresholds – $207,500 for a single person or $415,000 for a married person – the business generating the qualified business income needs either W-2 wages or depreciable property in order for you to get the deduction. Again, this part of the deduction formula gets complicated, but above these thresholds, the Sec. 199A deduction can’t exceed the greater of either 50 percent of the business’ W-2 wages, or 25 percent of the business’ W-2 wages plus 2.5 percent of the original purchase price of its depreciable property.
7. There Are Phase-Out Zones for Upper-Income Taxpayers.
For single taxpayers with income ranging from $157,500 to $207,500, and for married taxpayers with income ranging from $315,000 to $415,000 taxable income levels, the deduction gets phased out if your business is a specified service business, or lacks adequate wages and depreciable property. Beneath the phase out range, you get the deduction even without wages or depreciable property, or from a specified service business.
8. The Law Applies Starting With 2018.
The new deduction will first appear on the 2018 tax returns, or January through December 2018.
For more information, articles and resources on tax reform, check out the new Small Business Tax Reform Center.