I’ve got some bad news, unfortunately. The IRS may have destroyed or dramatically reduced your Section 199A deduction. At least if you’re a typical small business owner.
But let’s review the Section 199A deduction’s calculations. And then I can walk you through the nonsensical logic the IRS used to eliminate or dramatically reduce the Section 199A deduction for many small business owners.
I can also point out the two or three possible gambits you may be able to use to sidestep or minimize the IRS’s new rules.
A Quick Review of Section 199A Deduction
The Section 199A deduction gives small business owners a deduction equal to 20 percent of a sole proprietorship’s profits, the profit an S corporation shareholder earns, or the profit a partner earns from a partnership interest.
Let me provide some slightly simplified examples to show how this works…
Example: A sole proprietor who earns $100,000 in self-employment earnings gets a Section 199A deduction equal to 20 percent of the $100,000, or $20,000.
But then this wrinkle: Deductions associated with those self-employment earnings—even if they don’t count as business deductions—reduce the business income that plugs into the Section 199A formula.
Example: A sole proprietor who earns $100,000 in self-employment earnings but deducts $20,000 for self-employed health insurance sees her Section 199A deduction reduced for the health insurance deduction. Why? The $100,000 of business income shrinks to $80,000 after subtracting the $20,000 of health insurance. She therefore gets a Section 199A deduction equal to 20 percent of $80,000, or $16,000.
Example: A partner who earns $100,000 from a partnership but per the partnership agreement pays another $10,000 of business expenses that go un-reimbursed by the partnership sees his Section 199A deduction reduced for those expenses. The $100,000 of business income shrinks to $90,000 after subtracting the $10,000 of unreimbursed expenses. He then gets a Section 199A deduction equal to 20 percent of $90,000, or $18,000.
Note: The deductible part of the self-employment taxes a sole proprietor or partner pays also reduce the “qualified” business income that plugs into the Section 199A calculations. I’m not providing examples of that adjustment. The arithmetic gets too gritty for a blog post.
The above accounting all makes sense. You and I should have no problem with these sorts of bookkeeping tweaks. Some small business expenses don’t appear on the actual form or page that calculates the business’s profit or loss. Yet the expenses still tightly connect to the business.
But S corporations and partnerships? These small businesses get beat up bad by what I can only describe as bookkeeping nonsense.
Partnership and S Corporation Section 199A Deduction Complications
The problem for S corporations and partnerships? Business owners deduct the self-employed health insurance deduction a second time. The accounting gets complicated. But you want to understand it.
How Partners and Partnerships Double-Deduct Health Insurance
Let’s return to the simplified example where a partner earns $100,000 of self-employment earnings from a partnership.
Further assume the partnership pays $20,000 for the partner’s health insurance out of this $100,000.
At first glance, you might suppose the partner’s “net” business income equals $80,000: the $100,000 of business profit minus the $20,000 of health insurance.
But if the partnership provides a $20,000 health insurance benefit, the benefit probably shows up as a guaranteed payment paid by the partnership.
And what’s significant with that accounting treatment? Guaranteed payments don’t count as business income that’s qualified for the Section 199A deduction. In other words, if you start with $100,000 of self-employment earnings and then provide a $20,000 self-employed health insurance “guaranteed payment,” the “qualified” business income drops from $100,000 to $80,000.
But then this wrinkle. When the partner prepares his individual tax return, the $20,000 of health insurance gets deducted a second time from the $80,000, leaving $60,000 of adjusted “qualified” business income:
The Section 199A deduction then equals, probably, 20 percent of the $60,000, or $12,000.
You see what’s happened, right? The IRS says you deduct that same $20,000 self-employed health insurance amount twice.
How S Corporations and their Shareholders Double-Deduct Health Insurance
The IRS’s Section 199A accounting for S corporations works the same black magic. But with more twists. So let me walk you through the accounting using an admittedly worst-case scenario.
Assume for sake of illustration that an S corporation generates $100,000 of profit for some shareholder-employee.
The S corporation needs to break this amount into a chunk it calls wages and another chunk it calls distributive share. For example, perhaps the corporation breaks the $100,000 into $60,000 of wages and $40,000 of distributive share.
Note: The attraction of an S corporation is shareholders pay employment taxes only on the part of the profits broken out as wages.
The Section 199A deduction doesn’t apply to the wages an S corporation pays its shareholders. You may already know that. It applies to the leftover “distributive share, “ or $40,000 in this example.
But here’s what happens if this business provides a shareholder with $20,000 of health insurance.
First, the IRS says the S corporation needs to count the $20,000 of health insurance as shareholder wages. That artificially pushes the shareholder wages from $60,000 to $80,000. And it reduces the “qualified” business income from $40,000 to $20,000.
But then the other shoe drops. That $20,000 of self-employed health insurance becomes not just a tax deduction on the shareholder-employee’s individual 1040 tax return. It also reduces the “qualified” business income.
In this example, the remaining $20,000 of “qualified” business income goes to zero.
And that’s how the IRS can eliminate the Section 199A deduction for an S corporation.
Let Me Point You to Source
Just so you have it, here’s the actual language from page 2 of the draft Form 8995 instructions,
To figure the total amount of QBI, the taxpayer must consider all items that are related to the trade or business. This includes, but not limited to, charitable contributions, unreimbursed partnership expenses, business interest expense, deductible part of self-employment tax, self-employment health insurance deduction, and contributions to qualified retirement plans.
Note: The IRS also prescribes the accounting I describe in the preceding paragraphs in Question 33 at the FAQ shown here. Also note that draft version of the Form 8995 instructions appear here.
Is there Anything You Can Do About This?
Sorry, I don’t think you can do much to finesse the accounting on this one. In fact, I have only two or three ideas. And then one crazy suggestion.
The first small idea: If you happen to own both an S corporation and a sole proprietorship, you should take the self-employed health insurance deduction on the Schedule C “sole proprietorship” income. Not on the S corporation income. This tweak will mean you only reduce your Section 199A once for your self-employed health insurance.
A second small, related idea: Take a close look at how you handle any employer-provided Health Savings Account, too. For business owners, an HSA may shrink the Section 199A, too, if the business treats HSA contributions like health insurance. What may work better is for shareholder-employees and partners to contribute to HSAs personally.
The third small tangential idea from the draft instructions language quoted earlier: If your partnership or S corporation makes charitable contributions, you want to stop that practice. Those charitable contributions reduce “qualified” business income, too. You can still make those contributions personally. I think…
But other than those two or three small ideas, I think you or your accountant needs to follow the IRS’s form instructions. Presumably when finalized they will instruct you to deduct the self-employed health insurance deduction twice. And then also deduct anything else tangentially connected to the business.
Form instructions aren’t official IRS guidance. But heaven help you if you ignore them and then get audited. The IRS agent will expect you to comply fully with the form instructions. Even if they appear to conflict with the law.
One Final Crazy Suggestion
So here’s my crazy suggestion: I think you write your senators and house representative a letter that complains about needing to double-deduct the self-employed health insurance when calculating the qualified business income that plugs into your Section 199A calculations. Maybe mention the charitable contribution thing too.
You want to respectfully point out the IRS approach really beats up on small businesses.
A short letter like the one below should convey the insanity with clarity:
Dear Senator/Representative,
As someone who voted for you in your last election, I respectfully request you or your staff review the way the IRS has severely reduced the benefit of the new small business Section 199A deduction.
For many small businesses, the IRS 8995 form instructions either eliminate or severely reduce the Section 199A deduction available if a partnership or S corporation provides health insurance to business owners. Or makes charitable contributions.
This surely cannot be what Congress intended.
Respectfully,
Stephen L. Nelson, CPA
By the way, you can look up representative’s contact information here and your senator’s contact information here.
Your objective in writing such a letter? Get some elected official to add her or his criticism to that from tax accountants about this reduction in the value of the Section 199A deduction.
Additional Information about Section 199A
Need to get a basic overview of how the Section 199A deduction works? Check out this blog post: Pass-through Income Deductions: Top 12 Things Every Business Owner Must Know.
Need more information about how to adjust “qualified” business income for things like self-employed health insurance on your tax return? Section 199A Qualified Business Income Adjustments.
If you’re trying to optimize Section 199A deductions for a partnership, peek at this blog post: Salvaging Partnership Section 199A Deductions.
language from page 2 of the draft Form 8995 instructions,
and contributions to qualified retirement plans.
Does this mean an S-Cor owner with a qualified plan would have to include the contributions in plan for the QBI or am I reading it incorrectly? Please, provide clarification for Sec 404 for what would have to be included.
The employer pension deduction (so the match) appears on 1120S return and so isn’t an adjustment for the “net” QBI on the 1040 return. I don’t think anyone needs to worry about that.
And I don’t think right now we worry about anything other than what’s in the draft instructions…
But channeling the “logic” of the IRS, one can come up with other crummy little arguments for all sorts of adjustments. E.g, saying, well, if the employee elective deferral money comes from the S corporation, maybe taxpayers should have to adjust for that too…
Or one might argue some sole proprietorship using her or his business profits to fund an IRA needs to adjust for that since the IRA deduction vaguely connects to the business income…
But again, right now, I think we only worry about the stuff specifically mentioned in that quoted language…
With your permission, I am posting here a question in reference to a last year post, “S Corporation Home Office Deduction Revisited”, since the original post is closed for comments.
We have a 1 person S-Corp, running out of a home office, however we rent the house, not own it, as it was stated at the top of the post. My assumption that your Reimbursement Arrangement proposal would be similar, if not identical in our case.
My question is motivated by the brief comment made at the bottom of the post, regarding the case of rented home used by a sole proprietorship. You stated that it would work differently. My understanding is that it’s due to the fact of the sole proprietorship, not the rental. However, still would appreciate a clarification.
Thank you.
Alex, yup, the S corp home office deduction works similarly for a renter. The renter includes a percentage of the rent in her or his home office deduction though.
In comparison, the homeowner includes a percentage of the mortgage interest, property taxes, and depreciation in her or his home office deduction.
Hi Steve,
This is somewhat off topic, but your contact us instructions indicated leaving a message on the open blog post is what you prefer.
It’s somewhat on topic because it does relate to treatment of health insurance payments.
I noticed that in your 5 minute payroll monograph (thank you for that and all the other monographs you’ve put out. Extremely helpful!) you complete forms 941 and W2 by including the base wages paid + health insurance paid by the employer. To make it concrete on form 941 if you get 10K in wages in the quarter and 2K in insurance costs paid, then you’d record $12k in line 2 “Wages, Tips, and other compensation.”. If this arrangement repeated all year long, then by the time you filed the annual W-2 it would record $48K (12K for each quarter) in Box 1 and then Box 12 would have $8k annotated with code DD.
I’m confused because in all the guidance I see everywhere else and in the IRS pubs, it indicates that Box 1 should exclude any pretax benefits. In the example above it seems the recommendation would be $40k in box 1 and then $8k recorded in Box 12 using code DD.
Can you help me understand this discrepancy? It seems like in this post above you may be hinting at a difference in how specifically an S corp treats these payments vs another structure. Is that right or is it something else?
As frequently happens, I believe I found my own answer. In the IRS pub:
https://www.irs.gov/pub/irs-pdf/iw2w3.pdf
Box 1—Wages, tips, other compensation. Show the
total taxable wages, tips, and other compensation that you
paid to your employee during the year. However, do not
include elective deferrals (such as employee contributions
to a section 401(k) or 403(b) plan) except section 501(c)
(18) contributions. Include the following.
5. The cost of accident and health insurance
premiums for 2%-or-more shareholder-employees paid by
an S corporation.
I was also unsure of how to treat my HSA contributions. It seems that it’s either includable which means Box 1 3 and 5, or if it’s excludable, which a contribution paid directly by the employer seems to be, then it’s only recorded in Box 12 with code W.
Hi Fred,
So you have located the right answer, though the actual source is IRS notice 2008-1. But essentially, the IRS says add health insurance paid on behalf of shareholder-employees to box 1 of the W-2. The calculations to determinate whether the self-employed health insurance deduction works get made on the person’s 1040.
Also, the wages aren’t subject to payroll taxes… thus they don’t get added to Social Security wages or Medicare wages.