Do you own a pass-through entity? You may already know the new tax law provides a gigantic new tax break. The Section 199A pass-through entity deduction.
The deduction counts as really good news. It can shelter the last 20% of the income you earn in a business from income taxes.
But the bad news? Successful service businesses may get disqualified from using the deduction.
Tip: If you’re not yet knowledgeable about the new Section 199A pass-thru entity deduction, stop here. Go read our blog post Pass-thru Income Deduction: Top Twelve Things Every Business Must Know. This blog post assume you know the stuff covered in that other post.
Note: One other thing to mention here. We have updated this blog post’s information for the Section 199A final regulations that appeared in January 2019. Just so you know…
How Service Business Disqualification Works
Disqualification occurs for most high-income “white collar” professionals (doctors, lawyers, accountants, consultants, and so on). Also, successful actors and musicians and athletes get lassoed into the specified service category. And then so do then investment bankers, brokers and advisers.
What counts as “high income?” When a taxpayer’s income rises over $207,500 for a single taxpayer and over $415,000 for a married taxpayer.
Further, the statute includes a vague catchall. That catchall says that any high income business owner also gets disqualified if they earn their income in a
trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners.
And it’s this special form of “fuzzy disqualification” I want to talk about here.
Predictably, the fuzzy disqualification generated a bunch of questions from taxpayers right after the Congress passed the law. For the obvious reason, the disqualification appeared to hit every one person business.
Reputation or Skill Definition
When the IRS published its Section 199A regulations , however, they very narrowly defined the “reputation or skill of 1 or more employees or owners” language. Specifically, they said this disqualification refers only to three situations:
- when someone earns income from endorsing products or services,
- when someone earns income from licensing an individual’s “image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity,” and
- when someone receives income for appearing at “an event or on radio, television, or another media format.”
This useful thought: Tony Nitti, the CPA who pens a popular tax column at Forbes magazine, points out that the regulations essentially require you be a celebrity in order to get disqualified.
In the end, then, unless you can generate income basically just by “renting” your credibility, name or likeness, you shouldn’t need to worry about getting disqualified.
A tangential remark? If you really want more detail on the disqualification rules, you may be interested in my Maximizing Section 199A Deductions e-book monograph.
This 135 page, $150 monograph goes into detail about how the new tax deduction works using dozens of simple examples. It provides brief descriptions of about a dozen tactics taxpayers can use to maximize their Section 199A deductions. And it covers two topics tangentially related to the 199A deduction: Whether a business owner should “unincorporate” and whether S corporations should “revoke” their Subchapter S status
When Celebrity Owns Business
A related thought: so what happens when some celebrity owns a business?
Obviously, in such a case, much of the marketing relies on the celebrity’s star power.
The regulations say in this situation, the celebrity may split the activities into separate business– and then only the skill-or-reputation trade or business gets disqualified.
Here’s the actual example from the final regulations:
L is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to L’s skill and reputation as a chef, L receives an endorsement fee of $500,000 for the use of L’s name on a line of cooking utensils and cookware. L is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, L is also in the trade or business of receiving endorsement income. L’s trade or business consisting of the receipt of the endorsement fee for L’s skill and/or reputation is an SSTB within the meaning of section 199A(d)(2) or paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
Note: The acronym SSTB stands for “specified service trade or business.”
You see the difference the Treasury makes here. A famous celebrity chef can use his personal brand and culinary skills to fill his restaurants with hungry customers. And that restaurant business gets the Section 199A deduction.
But if she or he earns income from endorsements, appearances, brand licenses, well, that trade or business gets disqualified.
Obvious Loophole Closed
And just because we’re already on the subject, let me point out one final thing.
Because the tax attorneys at the Treasury are actually really smart, they closed the obvious loophole. A celebrity can’t contribute their personal brand to a partnership that sells some product or service and escape disqualification.
Here’s the example from the regulations:
J is a well-known actor. She entered into a partnership with Shoe Company, in which J contributed her likeness and the use of her name to the partnership in exchange for a 50% interest in the capital and profits of the partnership and a guaranteed payment. J’s trade or business consisting of the receipt of the partnership interest and the corresponding distributive share with respect to the partnership interest for J’s likeness and the use of her name is an SSTB within the meaning of paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
This makes a lot of sense if you think about. If you’re a celebrity and you start a business that benefits from your personal brand, that’s okay. But if your only contribution is your personal brand, you don’t get to use the Section 199A deduction.
Question: Doesn’t this only become an issue once you exceed the income limitations?
Yes.
Or more precisely using the language from the statute: The specified service trade or business disqualification becomes an issue as soon as the taxpayer’s taxable income crosses the $157,500 or $315,000 threshold.
If you are a S corp that pays yourself a salary, would taxable income be the aggregate of w-2 and k1 income?
I think you’re asking if the Sec. 199A deduction applies to the W-2 wages a shareholder receives from the S corp and then also the distributive share the shareholder receives… and the answer to that question is “no.”
I.e., suppose shareholder earns $100K in W-2 wages and then receives $200K in distributive share (the value shown in box 1 of the K-1)… in this case, sec. 199A deduction probably equals 20% of the $200K or $40K.
To Clarify, specifically if my 1040 shows 600k in total income, but schedule E income is 300k(from a service business). Does the 300k qualify for the deduction?
Hi John, I think there are some errors in your comment. E.g., I don’t know how you could have a Schedule E form (which reports on rents and royalties) also show service income. Also, you give your total income… but not your taxable income which is the key factor.
But if you mean you have $600K of taxable income and your return includes a Schedule C with $300K of business income, you need W-2 wages to get the Sec. 199A deduction. And the actual deduction will be lesser of 20% of $300K or 50% of your Schedule C’s W-2 wages.
So you might get a $60K Sec. 199A deduction if you have lots of W-2 wages. But if your Schedule C has zero W-2 wages, then you don’t get the Sec. 199A deduction. (And BTW in this case, you probably shouldn’t be a Schedule C business but rather an S corporation.)
So to clarify: are you saying that a doctor, for example, can take the deduction if the income is less than the income threshold? Or are you saying that the fact that the taxpayer is a doctor excludes him or her from income dollar “1”?
Sorry if I wasn’t clear enough… but here are two examples:
Doctor #1 earns $375K in pass-thru income… but he files a married joint tax return… and on that return, he has a $36K pension fund deduction and then takes the new $24K standard deduction. His taxable income therefore equals $315K. And he gets the Sec. 199A deduction. It equals lesser of either 20% of his pass through $375K of pass-thru income (so $75K) or 20% of his taxable income of $315K (so $63K). His Sec. 199A deducton therefore equals $63K
Doctor #2 is also married and files a joint return. She earns $415,000 in a pass-thru entity. She has $24K of other taxable income on her return… and then only has the standard $24K deduction. Her taxable income is therefore is $415,000. Because she’s over the $415K, she doesn’t get the Sec. 199A deduction.
Would Health Medicare Insurance Agency an S Corp be disqualified for 20% business income deduction? Is this profession considered a service? The insurance sold is 90% Medicare Health Plans. The government regulates all Medicare Insurance agents commissions. Agents can not charge for any additional services and all income is commission based.
The officer is taking W-2 salary at $60K annually and the S-corp income is $158K. Would is mean the 20% deduction would be phased -out?
Someone selling insurance (so a one person operation) possibly is subject to the principal asset disqualification issue. Their income, arguably, stems principally from their efforts.
But someone who owns and operates an insurance agency where they and their team earn commissions, that would at first blush seem eligible.
To look at another industry, a real estate agent probably will potentially be subject to disqualification. But the person who owns the real estate brokerage office where the agent works? That person should still be eligible, I think.
BTW, regarding your numbers, remember that the qualified business income plugs into the formula but doesn’t really determine whether a business is subject to disqualification. Disqualification is based on the taxable income. A taxpayer with a $60K W-2 and a K-1 with $158K would get at least some Sec. 199A deduction no matter what… and might get a full Sec. 199A deduction.
As a CPA, I could sell my practice and the real asset I’m selling is my client list. I feel that this is the principal asset of the firm. Thoughts?
Julie, so I get your argument and see your point. But just as one CPA to another, it sort of seems to me like the argument suffers from a couple of weaknesses…
First, and biggest, statute specifically puts an accounting firm on the “specified service trade or business” list of services. So that’s pretty explicit. And I would think that even if your CPA firm isn’t a “traditional” CPA firm, probably if it’s even only “sort of” a CPA firm, you’d be hard pressed to convince an auditor, appeals officer or judge you weren’t scooped up into that category.
Second, though a CPA firm’s goodwill (including the client list) possesses substantial value, I wonder how easy it would be to say that goodwill clearly counts as *the* principal asset. I could easily fall down the rabbit hole on this topic, but if you look at CPA firm profitability (see blog post I did at link below) and then look at profitability levels for firms of different sizes, I think one can pretty easily argue that most of the profit comes from the skill or reputation of the CPA firm owner.
https://evergreensmallbusiness.com/small-cpa-firm-profitability/
I am one partner of 4 (I own 25%, with 1 other partner who is also employed by the company, and 2 who are passive investors) in a company that imports and distributes foodstuffs. the companyt has 5 other employees. I receive a salary and W2 bonus from the company, along with a K1 distribution.
A few things are not clear to me and I am hoping you can clarify:
1: Is the W2 wages number pro-rated according to my shareholding (for example, if the company’s total W2 wages are $1 million, is the applicable number 50% of that (so $500,000), or as I am a 25% partner is the applicable number 50% of 25% of $1 million – so $125,000? (or is it a different ratio?).
2: Am I correct in thinking that the actual deduction amount is limited to 50% of W2 wages, rather than the amount of money the deduction is applied to – for example, if W2 wages are $1 million, then the deduction is 20% of K1 income up to a maximum deduction of 50% of W2 wages – so $500,000 in my example.
Or is the deduction limit applied to K1 Income up to a maximum of 50% of W2 income – so a maximum deduction of 20% of 50% of W2 wages – so a maximum deduction of $100,000 in my example..
Thanks in advance
Hi David, I don’t understand your question… possibly because we’re using different definitions for terms.
But if you own 25% of an entity, your share of the W-2 wages equals 25%. Probably. (The rules for partnerships look to be a little more flexible than for S corporations.)
You should not, BTW, be paying partners salaries. Rather you should pay them guaranteed payments. (But maybe that’s what you’re really doing.)
Your Sec. 199A deduction probably equals 20% of the value shown in box 1 of your K-1 as long as that value isn’t greater than 50% of your share of the W-2 wages.
For what it’s worth, you should confer with your CPA and have them help you re-evaluate your whole compensation arrangement so it doesn’t needlessly reduce your Sec. 199A deduction.
HI Steve
Thanks for the reply – in an attempt to clarify:
The company is a Subchapter S.Corp.
I am employed by the corporation and receive a salary plus bonus (as does one other partner). We each own 25% of the company, with the other 50% owned by passive investors.
If I understand you correctly:(using example numbers)
If total W2 wages are $2 million my share is $500k – so 50% is $250k
I can deduct 20% of the value shown in box 1 of my K1 as long as that number does not exceed $250k – so a maximum deduction of $50k (20% of $250k).
Is that correct?
Many articles I have read seem to suggest that the actual deduction amount could not exceed 20% of wages – so in my scenario I could deduct 20% on a K1 box 1 amount up to $1.25million (which would be $250k – or 50% of W2 wages). From your answer I understand this is not correct?
We have the ability to adjust W2 numbers by paying bonuses through payroll, so will be looking to maximize the deductible amount by doing that.
To complicate matters further – I am a passive investor in two other Subchapter S Corps!
Thanks again
David
Hello Steve,
Can you help me with this.
I’m one of the shareholders in the S Corporation, and the S corporation had only a commercial building will be sold and closing by the end of this month Jan. 31, 2018. Can I just get my shares of money and get out of the S corporation and pay tax for the IRS? How many % tax rate do I have to pay on my portion and I’m married filing joint return? Can the shareholders split the S Corporation to go their separate way? Thank you.
Huong
Hi Huong, your question isn’t really a Sec. 199A question… but to give you a general answer, you will get taxed on your pro rata share of the profit…
Regarding whether or not the S corp will disburse funds, that’s really up to the S corporation though maybe controlled to some degree by the S corporation shareholder’s agreement.
Regarding the tax rate, that’s something you won’t be able to determine until you get K-1 for S corp and see what “flavors” of income or loss flow out of the S corporation. (The person who may be able to help you with this is your tax accountant or the S corp’s tax accountant.)
Hi Steve,
I own multiple chiropractic offices with 7 doctors providing the care, along with 20 plus support staff. Both my wife and I see patients part time, and provide management. Our taxable income is above the threshold. Fair market value for the operation is substantial. Any way to use the deduction as “the” principal asset is the practice itself? Also, we sell a significant amount of vitamins and durable medical supplies(30% of total revenue).
Thanks,
John
The chiropractic care revenue surely falls into the “disqualified” specified service category… meaning you won’t be able to take Sec. 199A deduction on that. (Well, unless you take measures to push your taxable income down below threshold. E.g., a giant pension deduction or big tax deductions from other activities outside of the clinics.)
The vitamins and medical supplies stuff? I think that’ll probably generate a Sec. 199A deduction.
Also, remember that other qualified business income may generate Sec. 199A deductions. E.g., if your clinics rent office space owed by you and your wife, the accounting in end may show those real estate properties generate income that leads to a deduction.
Hi Steve
Can you clarify the following point for me:
Is the actual deduction amount limited to 50% of W2 wages.
or
Is the amount of pass-through income the 20% deduction can be applied to limited to 50% of W2 wages. (meaning the actual deduction amount is
Thanks again
Hi Steve,
Your posts are great – I am buying you book!!
Question.
I have Schedule C income of $200,000 – I do not pay wages, I only have a computer as an asset.
Total married, household income is less than $300,000.
Can I still take the 20% bus income deduction ?
Or should I start paying myself a wage?
You should get the Sec. 199A deduction. But you should probably also be sure you shouldn’t be an S corporation.
With S corp, you might be able to save $9K in FICA and maybe $7K with the Sec. 199A deduction.
Without the S corp, you save $0 in FICA and maybe $10K with the Sec. 199A deduction (roughly).
A couple of blog posts to help you learn more about S corps:
https://evergreensmallbusiness.com/s-corporation-shareholder-salaries-sec-199a-deduction/
https://evergreensmallbusiness.com/million-dollar-s-corporation-mistake/
Hi Steve!
What if you have a high income taxpayer that has “management company” (that only receives fees from his other companies for supervising) which would be a disqualified specified service S Corp?and a “regular” S Corp with $500K of wages (none to him), net assets of $2,000,000 and net income of $1,000,000— he owns 50% of each company – his taxable income is $750,000.00 – is his pass thru deduction—- $500KX.25X.50= 62,500 plus 2.5% of 2,000,000= 50,000 or total of 112,500? And in the case of the S Corp that he owns that is a disqualified specified service S Corp- it really doesnt play here- or better said – only the entities that someone has that qualify are counted—- a disqualified entity’s net income isnt subtracted? correct? Thanks so much if you answer this!!
So if I understand you, taxpayer earns consulting income from two clients who also happen be businesses she or he owns, one a disqualified and one a qualified business…further that taxpayer’s income exceeds $207,500 if single or $415,000 if married.
In this situation, taxpayer doesn’t get Sec. 199A deduction for the consulting or “management services” business or for “disqualified” specified service trade or business… but she or he should get from the “qualified” business.
BTW, this situation may be one where taxpayer wants to rearrange the management company since that actually decreases his Sec. 199A deduction. I.e., not taking a management fee from the qualified business possibly saves him taxes.
Hello,
Would IT/ computer software development be excluded right from the get go? Or would it be considered engineering?
It’s definitely not engineering. (Engineering means engineering related to construction projects in the U.S)
But it may not be excluded in the end. We’ll need to wait and see what regulations look like.
BTW, I would guess a one-person IT consultant or developer will get disqualified but on the principal asset language.
Hello, Steve
Do the limitations with W-2’s ect phase out BEGIN at $157,000 and the deduction completely phases out at the limit regardless of the W-2 calcs? And below that threshold I assume there is no phase out nor a need for a calculation of the W-2’s? Thanks.
Hi Bob, this subsequent post answers your question:
Sec. 199A Deduction Phase-out Calculations
I have a question I own a S corp company that I am paid W2 wages through. I also pay a management fee to another S corp the management company shows income the other company does not. If I have wages from the company with no income will I be able to get the credit on the income from the management company
Not sure I understand your question… but it appears you have two S corporation interests both S corps with W-2 wages but only one S corp with qualified business income… and then you’re wondering whether you get to lump everything together which means the W-2 wages from both companies get plugged into calculations. Maybe because the the first profitable S corporation doesn’t have enough W-2 wages to support a full Sec. 199A deduction?
I don’t think we know the answer for that sort of question yet. We want to wait for some additional guidance from the IRS (ideally in the form of regulations with lots and lots of examples.) But I would guess you do not get to do that.
Great discussion. My situation is a follows:
I am a consultant who receives $182,000 in Schedule C income. My wife and I also receive social security and pension income of another $175,000 combined. My taxable income will likely be over the $315,000 due to the cap of $10,000 SALT deductions (I’m in CA). Does this mean that I do not qualify for the Section 199A deduction?
No… not all of it. Your deduction won’t be 20% of the $182K though… it’ll be roughly 70% phased out.
I”ll be giving you guys a call. This has become to complicated. Thanks for the response.
I am an independent contractor insurance agent. 100% commission, income exceeds limits. Is this eligible for the 199a deductions?
If you’re married and your taxable income (so income after all your business expenses, deductions for AGI, and itemized deductions) is over $415K, you possibly won’t.
Or, if you’re single and your taxable income is over $207,500, you possibly won’t.
A key element of your situation is that you’re paid by commission. That per the conference report makes a difference. The question is whether IRS will say you, Bill, are the principal asset.
How about an auto repair shop? I would think reputation is majorly important here.
Hi Sandy, I don’t know the specifics of the business you’re thinking about, but I would think a repair shop would be able to use the Sec. 199A deduction.
My logic goes like this: If an auto repair shop’s taxable income rises to the level where potentially the business needs to look at the specified service trade or business issue, the income probably isn’t flowing from a single person’s reputation or skill. Probably the income flows from a brand (like with an auto repair franchise) or from strong business model and clever process.
E.g,. the situation isn’t one that resembles the skill or reputation of JK Rowling, Eddie Van Halen or his band, or Dave Chapelle.
Thank you for the blog Steve,
I met with you when I went out on my own- Single member LLC as a licensed Engineer completing design work on new commercial construction. Seems like my company is qualified as engineering, but may be disqualified as a single-member principal asset. For the asset test, I couldn’t practice my profession without my computer and engineering software. My dad always said, when in doubt, take the deduction. I’d love to hear your thoughts too. Thanks!
I think you might get Sec. 199A deduction… even if your taxable income is over phase-out range.