Late in 2017, Congress passed the Tax Cuts and Jobs Act of 2017, an enormous, complicated 500-page chunk of tax law. Among other things, the new law happens to provide the best small business tax break of the last fifty years: the pass-thru income deduction.
You’ll want to learn and understand how this new deduction works. Understanding the law may be the key to you actually benefiting and starting your tax savings earlier.
Note: This blog post has been updated for the Section 199A final regulations and is current as of January 18, 2019.
Thing #1: First Two Key Terms
You will want to know the correct name for the new law, Section 199A. This small technical detail will help you do any research.
Further, knowing the actual Internal Revenue Code section will let you find and read the the actual law if you’re interested.
One other thing: You want to know that tax law gives this new loophole a name, the “Qualified Business Income” deduction. Knowing that name will also help you with any online research.
Thing #2: Deduction Available Starting January 1, 2018
The pass-through income deduction works for tax years starting on or after January 1, 2018.
You therefore first get the deduction on the return you prepare in 2019 and file for 2018.
A related note while on the subject of effective dates: The Section 199A deduction only works until 2025. In other words, the statute makes the deduction available for eight years.
Thing #3: Pass-through Entities
The deduction works for pass-through entities, which includes sole proprietorships, real estate investors, partnerships, S corporations, trusts and estates, REITs and qualified cooperatives.
The deduction doesn’t work for traditional corporations technically known as “C corporations.”
Thing #4: Pass-through Income Deduction Equals 20 Percent
The Section 199A deduction, tentatively, equals 20 percent of a pass-through entity’s business income.
For example, and keeping the math easy, if a pass-through entity makes $100,000, the deduction tentatively equals $20,000.
I use the adverb “tentatively” a couple of times in the preceding sentences because the law includes a number of limitations on the basic formula.
Thing #5: Taxable Income Usually Limits Actual Deduction
A first limitation that applies to every taxpayer: Tax law limits the Section 199A deduction to no more than 20% of the taxpayer’s taxable income subject to ordinary income tax rates.
A taxpayer with $100,000 of pass-through income might hope for a deduction equal to 20 percent of $100,000, for example.
But if the taxpayer’s taxable income taxed at ordinary income rates equals $50,000, the actual deduction equals 20 percent of that $50,000.
Thing #6: Tax Savings Equals Top Rate Times Deduction
The tax savings the deduction produces equals the deduction times the taxpayer’s top tax rate.
If a taxpayer gets a $10,000 deduction and pays a top rate of 12 percent—probably the typical middle-class top tax rate under the new law—savings equal $1,200.
Thing #7: Foreign Businesses and Real Estate Excluded
The new deduction applies to businesses operated and real estate located “inside” the United States.
Taxpayers don’t get a deduction on pass-through income earned “outside” the United States.
Thing #8: High Income Taxpayers Need Employees or Property
The law requires high-income taxpayers to either pay wages or hold depreciable property in order to get the Section 199A deduction.
A “high-income” taxpayer includes single taxpayers making more than $157,500 and married taxpayers filing joint returns making more than $315,000.
These extra requirements get complicated quickly, but basically the Section 199A deduction can’t be more than the greater of either 50% of W-2 wages or 25% of W-2 wages plus 2.5 percent times depreciable property.
Thing #9: Some Service Businesses Disqualified
The law prohibits a handful of service businesses from taking the pass-through income deduction if the taxpayer enjoys a high income, so over $157,500 if the taxpayer is single and over $315,000 if the taxpayer is married filing a joint return.
The “handful of service businesses” includes most traditional professional service firms (but not engineers and architects), athletes, performing artists, investment managers, investment brokers, and then any “celebrity” that earns appearance fees, endorsement income, or licensing fees.
Thing #10: A “Phase-In” Range for High-income Taxpayer Limitations
The extra requirements that apply to high-income taxpayers and service business owners don’t immediately “kick in” at $157,500 or $315,000 of taxable income.
Rather, complicated little formulas “phase in” the requirement to have wages or property as a single taxpayer’s income rises from $157,500 to $207,500 or as married taxpayers’ incomes rise from $315,000 to $415,000.
Thing #11: Better Bookkeeping a Requirement
Because the new deduction provides big savings and the law is complicated, the follow-up rules from the IRS require taxpayers and their accountants to do better accounting.
The pass-through entity’s accounting system will need to track both the business income the firm earns and then the non-business income the firm earns (non-business income includes things like investment income and capital gains).
For high-income taxpayers, the accounting system will need to track W-2 wages, depreciable property and then for specified service trades and businesses both service income and non-service income.
Note, too, that the K-1s prepared by partnerships, S corporations, trusts and then estates will need to provide more details on all of this sort of stuff to their owners and beneficiaries so these folks can make the Section 199A calculations.
Thing #12: Watch for More Guidance
Since the original law passed, taxpayers and their accountants have received hundreds of pages of additional guidance from Congress and the Internal Revenue Service: a conference report, technical corrections and then recently proposed regulations (August 2018) and final regulations (January 2019).
At this stage, we probably have the information we’re likely to “have” before needing to prepare the 2018 tax returns. But surely the IRS will continue to issue some incremental guidance.
Taxpayers (or their advisers) will need to watch for those…
Additional Resources You Might Find Useful
Section 199A Pass-thru Deduction and the “Principal Asset” Disqualification
Actual complete text of law: Tax Cuts and Jobs Act of 2017
Interested in more articles like this? You can subscribe to our monthly-ish free newsletter using the form that appears below. Note you can unsubscribe anytime.
Scott Bonacker CPA says
I got your email notice about this article – thank you Steve.
The Tax Foundation says that state level tax revenues for most states won’t be affected by this deduction –
There’s no question that the pass-through deduction is significant. The Joint Committee on Taxation estimates that it will cost $414.5 billion over the next ten years. Equally significant, however, is that in the conference report, it is structured as a deduction against taxable income, not adjusted gross income (AGI).
Other tax return items that don’t look to be affected by this include self employment tax and retirement plan contributions based on earned income.
>> The “handful of service businesses” includes most traditional professional service firms (but not engineers and architects).
What about computer/IT consulting/programming, etc?
The Sec. 199A statute references another older chunk of tax law, Sec 1202(e)(3)(A). It says this:
“…any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees…”
So computer/IT consulting pretty clearly fits within the “consulting” category.
Also, if you’re a one person business, it seems pretty tricky to argue against the position that the principal asset of the business is the reputation or skill of the 1 employee doing the work.
But what defines an Engineer? I have a Master of Engineering degree in Computing (from the UK). So, am I not practicing Engineering?
Here’s my educated guess. Architects and engineers who work on construction projects lose out big in the new tax law because they used to get the 9% Sec. 199 deduction (not the new 20% Sec. 199A deduction but the old 9% “domestic manufacturers” deduction.) It looks like their removal from the usual list of professional service businesses flows from that. If that’s so–and again, only an educated guess–I would say construction engineers (so civil engineers basically?) qualify. But other sorts of engineers won’t qualify.
I’m a UX designer with a very technical process to develop a software interface. However, my ‘pass-thru entity’ which I own depends almost entirely on my personal reputation. Thus – I sense that I will not qualify for this deduction.
It makes sense, I guess… my work is indifferent to being employed by a software company.
However, my entity also produces custom hardware products with some relatively expensive equipment (laser, CNC, 3D printer, etc). Sometimes this is used to prototype hardware interfaces for a client, and other times it’s used to manufacture products that I sell.
So… my tax returns are going to be a LOT of fun to figure out.
James, you may need to wait for the regulations to come out to figure out what you feel comfortable doing.
Also, note that some people are able to push their taxable incomes down below the point where the specified service business thing matters. Even if they make a lot more than $157,500 or $315,000.
A giant pension fund contribution, for example, will do the trick for many… as some of the commenters indicate.
Thanks for info. It is very helpful. Do you know if real estate agent belong to professional services providers? I read that the income earned by professional services providers, such as doctors, lawyers, accountants and others wouldn’t qualify for the lower tax rate(20% income tax free).
I would think real estate agents count as “specified service” businesses… so if your taxable income exceeds $157,500 and you’re single or your taxable income exceeds $315,000 and you’re married, you will lose some or all of the deduction.
Thank you so much for your quick answer. Does the limit $157,500 for single refer to the business income or the total income (business income + w2 income)? I have a w2 job that is over $157,500 already, Thanks in advance.
The $157,500 or $315 refer to the taxpayer’s taxable income… so W-2s, K-1s, Schedule C and E amounts, interest income, dividends, etc etc. less the deductions.
Thank you for your reply. How to structure the side business in order to save tax for people with $280k w2 wages, and $150k side business income (independent contractor). It seems to me that LLC or S corp is not a good fit anymore in this situation since the 20% tax deduction does not apply. Do you have any suggestions? Thanks in advance.
If your side business has no W-2 wages, it won’t get the Sec. 199A deduction. So keep that in mind. (Maybe re-read the blog post…)
Also, in all the little scenarios I’ve run, it’s pretty hard to come up with a set of numbers that makes the subchapter S corporation thing obsolete. See my earlier response to Samantha McGrath.
Ed Mackin says
I am the majority owner of a S-corp that has 15 employees, and this information on the aspects of the tax law relating to pass-through income is the best and easiest to follow I have read anywhere so far. Thank you!
Thank you Ed. 🙂
Hi Steve, thanks for the info. I have not taken distribution from my S Corp for the 4th quarter. Would it be a good idea for tax saving if I choose to smooth the distributions and retain some of this year’s profit to be distributed next year?
Good question, but it shouldn’t matter. You’ll be taxed on the distributive share and not the distribution.
Steve, you mean I still need pay tax on all profits earned this years, regardless of smoothing the distributions or not? If this is true, what is the benefit of smoothing out distributions?
Brandon, sorry, I don’t understand your question… Maybe you’re using the term “distribution” to refer to what I would call “distributive share?”
It does make sense to smooth distributive share, or your income, because you pay more taxes if your income fluctuates.
Pass-thru entity owners don’t however pay income taxes on distributions (the cash that’s paid out of the distributive share to the owner)… they pay it on the distributive share.
Hope that helps.
Would a sole prop that whose revenue is the interest from making loans be elibigle for the pass thru income deduction?
I’m having trouble figuring out the following clause because I don’t know where the find the “subsection (d)” that is referenced.
“(6) BUSINESS INTEREST INCOME.—For purposes of this subsection, the term ‘business interest income’ means the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business. Such term shall not include investment income (within the meaning of subsection (d)).”
If you’re in the trade or business of lending money, your trade or business’s income should be qualified business income. The statute excludes interest income on stuff like a bank account or bond from the qualified business income.
How is a loan different than a bond?
The article mentions that the tax deduction starts to phase out at income of $315,000 for married couples. For someone who is an employee and has a side business, does the $315,000 limit include both types of income (wages and business income) or just income from the business?
The $315,000 is your taxable income… so what shows on your tax return. You need to lump everything together.
Steve Rowan says
well that’s interesting. I’m looking at Capital gains and wondering if such a pass thru for a trust would qualify.. certainly of interest. so far I’ve not heard that it would be of benefit to the cap gains issue. hope hope hope. The trust sells one of its real estate holdings. A profit is realized against all the deductions…leaving a capital gains payment. Would the pass thru apply to the capital gains?
Items of income and deduction retain their character as they flow through a pass-thru entity. So one won’t use the Sec. 199A deduction against everything that comes out of a trust, partnership, S corporation, etc. It’ll need to be qualified business income.
Something like rental income will count. So will business income.
Interest, dividends, capital gains, etc, won’t.
So if I am working as a business consultant, and my net pass thru income is 350k, do I get a 20% deduction on the first 315k with a phase out after that, or does the phase out % apply to the entire amount? Same idea, if you have net income of 415k, do you lose the entire deduction, or everything over 415k?
You don’t say what your taxable income is so the question can’t be answered definitely… but here’s general rule.
But if your taxable income is $315K or less, you’ll get the 20% on the lesser of the pass-thru income or taxable income treated as ordinary income.
If you’re within the band ($315K to $415K) you basically lose your deduction on a sliding scale.
Someone (CPA) please comment true/false for questions a-d:
exp) I have pass-thru LLC as consultant with no employees thus fall under “handful entities” limited by the 157/315 rule.
exp1) My Schedule C income after expense deductions is 415K.
a) Do I get zero deduction?
b) Do i get 0.20 x 315K=63 K + zero?
c) Do i get 0.20 x 315K=63K + (0.1 x (415-315))= 73k?
d) If “b” is correct then means minimum will always be 63K? then is phased out up to 415k?
Marc, if you earn $415K in your schedule C–and assuming your business isn’t a specified service business–your Sec. 199A deduction equals the lesser of
20% of your qualified business income… (this is Schedule C amount of $415K) so maybe $83K…
Or 50% of your W-2 wages from Schedule C… probably this is zero given the way you ask your question… so you get 50% of zero which is zero.
I.e., because you’re over the $415K tripwire (the $315K plus the $100K phase out) you must have wages.
This is another example where pass-thru entity owners need to set things up correctly as soon as possible in 2018.
BTW, I noted in another comment here that mathematically the optimal percentage to have as “wages” is 28.5714% (roughly) of the business income before wages. E.g., if Marc earns $415K in profits and pays zero wages to anyone else, 28.5714% of $415K is the optima.
SAMANTHA MCGRATH says
Hi Steve, Re: “Thing 5 – where the deduction is limited to 20% of taxable income” I assume this is something we need to be really careful of as most people are just taking 20% of the K-1 or Sch C income into formulas to determine whether or not to revoke S elections in 2018. It seems very hard to project. What are your thoughts on this?
Hi Samantha, First thanks for dropping by… Second, yes, you’re right people need to think about the deduction being lesser of either 20% of the qualified business income or 20% of the taxable income taxed basically as ordinary income. (Many questions from blog readers here and at other posts and on online forums stumble over this.)
Regarding revoking S status, I don’t think I can come up with scenarios (yet) where revocation makes sense. Seems to me that what a taxpayer loses in way of Sec. 199A deduction is only that portion of the W-2 wages paid to S corp shareholder-employee that actually increase the Sec. 199A deduction. E.g., someone has $30K of deductions, a $50K W-2 and $150K of qualified business income on a K-1. They get 20% of $150K, or $30K as Sec. 199A deduction as an S corporation. If they revoke, they get 20% of $170K or $34K as the Sec. 199A deduction. The slightly bigger Sec. 199A deduction saves them money… maybe 24% of $4000? So $960 in tax savings lost?
But in this situation, the S corp saves the person maybe $10K to $12K in FICA…
At least that’s my thinking. But definitely share the scenario you are thinking about. Because surely some people (many people) will need to relook at entity classification.
Given #5, is the maximum possible tax relief for a professional services business owned by a single person:
a) $157,500 x 20%
b) $157,500 x 20% x 50%
…given that you can only use this relief against ordinary income, and your total income can only be $157,500
(assuming the maximum impact is at $157,500 rather than somewhere between that and $207,500)
That’s an interesting, good way to think about it, Max…
So say someone is single and earns $157,500 a year… but he or she also has, say, $24,000 of other income from somewhere (stock dividends)… and then he or she gets just the $24,000 standard deduction that’s new. $157,500+$24000-$24000 equals $157,500… Which means this person then gets Sec. 199A deduction equal to 20% of $157,500… that’s $31,500 of deduction. This person’s marginal rate equals 24%… so the annual savings equal $7560.
But you want to noodle with these numbers, probably, because they can really change. E.g., say single guy actually makes $300,000 in this sole proprietorship that falls within the specified service category. But he does a big pension of $60K and has health insurance equal to $20K and self-employed taxes deduction of $10K so that knocks his AGI down to, say, $210,000. And then he has a big $30K mortgage interest deduction and $10K for state and local taxes and then he also does charitable giving of $12,500. His taxable income also equals $157,500 after all the accounting and so he also gets a $7560 tax savings too.
Thanks, that’s very clear
If they are single they would not get a $24,000 Standard Deduction.
You say the new law “limits the Sec. 199A deduction to no more than 20% of the taxpayer’s taxable income,” Assuming a person is smart about maximizing above-line deductions and itemized deductions, taxable income is very small compared to business income.
Let’s say Schedule C income is $150k, other income is $10k, solo 401k deduction is $50k, SE deduction is $10k, health insurance deduction is $5k, and itemized deductions are $15k. Then taxable income is $80k. So the 199A deduction is only $16k (20% of $80k), not $30k (20% of $150k)? So at the 22% bracket, that’s only a tax savings of about $3.5k?
Seems like the level of excitement (or outrage, depending on one’s perspective) about this new deduction far exceeds the modest amount of tax savings!
P.S. So would it make more sense to forgo the solo 401k deduction, thereby increasing the 199A deduction, and put the $50k in a Roth 401k, with tax-free growth and tax-free withdrawals?
EJ, so a deduction like the Sec. 199A one depends on someone’s income. Someone with, as in your example, $80K of taxable income saves maybe $3500 or so. That seems like a lot to me. Without the deduction, this person’s income tax maybe equals $13500 before any credits. After the deduction, they’re down to $10,000. But this is all in the eye of the beholder…
The flip side of this coin, the higher the tax rate and the more qualified and taxable income,the bigger the benefit. With $100K more in qualified business income than in your example, taxpayer gets an additional $4800 of annual tax savings on top of the $3500 you calculated. And the savings numbers keep getting bigger and bigger as rates and income rises.
But the 199A deduction starts phasing out when taxable income exceeds $157,500, so at some level it maxes out, right?
Would it make sense to use a Roth 401k instead of a regular 401k, which would eliminate the solo 401k deduction, which in turn would increase the 199A deduction?
Jay P. says
Sorry, I am quite confused, so this question will likely be very naive:
Somewhere on the site, I read “Sole Proprietorships are excluded from the tax reduction”. Is that correct?
Let’s say currently someone has a website earning them $500K in advertising revenue. Currently run as a Sole Proprietorship. What are the implications? Does that level of income mean that rate reduction does not apply? Should this business consider changing the structure? In that case, Solo-LLC or Solo-S-Corp?
An advertising business probably (or maybe only possibly?) doesn’t get disqualified from using the Sec. 199A deduction. But to take the deduction, assuming your taxable income crosses over the $157,500 or $315,000 thresholds, you’ll need W-2 wages.
So you probably/possibly can use the deduction. But you’ll probably/possibly need W-2 wages.
Tip: Re-read the blog post carefully… especially the stuff about the limitations.
Jay P. says
My Schedule C income will cross $315K threshold. Regarding the W-2 wages. I don’t currently have any other W-2 wages. I only have my Sole Proprietorship. What am I missing? Can I start to pay myself and issue a W-2 to myself?
I’m not the expert by any means but I think Steve is talking about wages paid to your sole proprietorship’s employees. The intent is to reward biz that are creating job. The wage test or limitation is based on 50% of the wages paid by the business, not the taxpayer’s individual wage income.
I’m not sure how wages paid to oneself help or don’t help.
david kolkebeck says
Steve: I run and own a driving school, a sole proprietorship and LLC. I’m the only worker, so I instruct, advertise, maintain a car, everything. Do I qualify for the 20 percent tax deduction for business income? I ask because I can’t be sure my principal asset or business isn’t my skill or reputation; I’m NOT a consultant, that’s for sure.
On a more general note, I can’t get my head around how someone would have $100k in business income and only $50k in ordinary income, meaning the 20 percent deduction would be on the lower amount. Can you explain?
First, your situation does seem like one that might get disqualified due to the role you personally play. So you and your tax advisor need to think carefully about that. (BTW, I could also see that, and no offense meant, that you are *not* the key asset. You have a vehicle or vehicles that are arguably pretty essential. And though you may be a great teacher–you probably are if you’re on top of stuff like this–you probably are not the only person who can teach students to drive. Your situation, in other words, differs from some one-person consultant who’s only real assets are a cellphone and laptop.)
Second, here’s how you move from $100K of qualified business income to $50K of taxable income. Say you have a couple of IRAs or a little pension. That maybe adds up to $10K. Say you buy some health insurance and/or have a health savings account. That maybe adds up to another $10K. You get about a $6K-ish adjustment for your self-employment taxes. And then if you’re married, under the new law, you’ll get a $24K standard deduction. Add this stuff to together, and you take your $100K of sole proprietorship profit down to $50K of taxable income.
david kolkebeck says
Steve: I’m at least temporarily heartened and will consult my tax guy. Many thanks for getting back to me and for taking the time you did to answer so thoroughly.
If an S Corp owner in a “specialized service business” takes a $215,000 salary and $100,000 in distribution and has no other taxable income, does that then equate to a $20,000 deduction?
Yes… and a situation where the S corporation needs to re-examine as soon as possible why such a high salary.
Lots of people think the FICA max represents a sort of “unofficial” safe harbor… If S corp resets salary to $128,400, Sec. 199A roughly increases by 20% of that extra $70K of distributive share.
S Corp owner is a full time physician. Difficult to support lowering the salary relative to national averages
Would it be advantageous for a smaller C corporation with two employees to convert to an S pass-through to take advantage of the pass-through deduction? The C corp does take advantage of paying employee meals as well as a medical expense plan for employees.
Without more details and a bit of analysis, one can’t answer this question… but this suggestion: If you can save payroll taxes with an S corporation, you ought to look at the option of having the C corp make an S election. You will avoid payroll taxes on all of the non-wages profits the business earns. You will probably (through the Sec. 199A deduction) avoid income taxes on 20% of the non-wages profits the business earns.
Forgot about the rule of 5 years before I Can switch back to S…
Suppose Taxpayer receives w2 wages of $175k, and is also member of an LLC that is an active business. K-1 Income from LLC = $125k. Itemized deductions = $65k, Dividends, interest, and cap gains are $0, so taxable income = $175+125-65 = $235k.
I would think 199a deduction would = 125 * 20% = $25k, but then I read this in the conference bill:
“taxpayer’s deduction for qualified business income for the taxable year is equal to the sum of (a) the lesser of the combined qualified business income amount for the taxable year
or an amount equal to 20 percent of the excess of taxpayer’s taxable income over any net capital
gain69 and qualified cooperative dividends, plus (b) the lesser of 20 percent of qualified
cooperative dividends and taxable income (reduced by net capital gain). This sum may not
exceed the taxpayer’s taxable income for the taxable year ”
in a nutshell, sounds to me like deduction would be lesser of QBI, which is $125k, or 20% of taxable income, which is 20% * $235k???
So the taxpayer would actually get a deduction for his/her w2 wages that he/she receives? Seems like it should be limited to 20% of the QBI but I don’t see that in the explanation
( http://docs.house.gov/billsthisweek/20171218/CRPT-115HRPT-466.pdf )
I feel like I’m missing something obvious.
It’s a really complicated law to get a handle on… but what you’ve done is confuse the qualified business income with the qualified business income amount.
The qualified business income amount is (sort of) the qualified business income times 20% … subject to the limitations, etc.
That’s exactly what I’ve done, and your explanation makes perfect sense. I knew there was something simple I was doing wrong. Thanks.
Thank you for this very informative article. I’ve been trying to make sense of the “specified service
business” definition. I am a sole-proprietor remodeling contractor (I remodel houses and perform handy work), making an income of about $60,000 per year for my labor. After business expenses like mileage, supplies, etc. Net income is about $50k. My wife makes about $100k as a teacher with a W2, so in all we have about $150,000 per year income before what will be the standard deduction of $24,000. Under the new law, will I be able to deduct 20% ($10K) of the $50k net income that I earn as a remodeler, in essence reducing our pre-standard deduction income from $150K to $140K? Or is remodeling/contractor labor excluded as a specified service?
If the new law in fact does reduce our taxable income by $10k in addition to the $24k standard deduction, that would be the first really good news for us in terms of the new legislation. Thanks for your help.
MKB, I think you get the Sec. 199A deduction. And I agree with your calculations… you get a deduction equal to 20% of the $50,000, or $10,000.
The actual savings you’ll get run about $2200… 22% (your probable tax rate) times the $10,000.
David Samet says
Wow Steve – I am a CPA myself and I really want to thank you for all the input and research you must have done on this section of the new law – which really just came out. I may want to engage you to get input for my various clients (or purchase your new guide). Thank you. David
Does Section #8 mean that sole props only benefit from the pass through deduction if the owner’s taxable income is under the $157k/$315k threshold? I’m assuming a sole prop cannot have W-2 wages.
A sole proprietor with profits large enough that his family income exceeds the thresholds needs some W-2 wages in the business in order to get Sec. 199A deduction.
Can a Sch E owner that rents multiple rental property (passive income) with no w-2 wages also qualify for the 20% income deduction? Or should that Sch E owner consider setting himself up as an LLC to qualify for the deduction?
Your rental income is pass-thru income. You don’t need to be an LLC. Note that you need rental income… if you’ve got losses, this doesn’t work for you … yet.
Are you on the Twitter? I see a link to re-tweet your article, but can’t find a link to follow you.
Dennis Hastings says
Just to try to understand this further. I am a professional , as is my wife, and together we earn quite a bit over the $315,000 amount. We work in the health field. Can I still pay the 20% tax on the $315,000 amount and the full tax on the rest? And is this an advantage? And can I pay w-2 wages to a family member if I need to?
The thing you compare the $315K is your taxable income… and if your taxable income exceeds $315K, you do need W-2 wages in the businesses where the pass-thru comes from… and if you’re a professional in a specified service business you will lose some or all of the Sec. 199A deduction if your taxable income exceeds $315K.
Tim Lee CPA says
I see that partnership or LLC path-through entities that have rental rental (residential or commercial) can have this 20% deduction for partners depending on their income due to 2.5% of capital rule. How about Schedule E of personal tax return? Is it a qualified for 20% deduction? I think passive activity entity still qualified for 20% deduction.
Also I have advised my LLC clients (husband and wife under community property state law to file a Schedule E as a disregarded entity for simplification. Maybe I should start to advised them to file a partnership return (Husband and wife both as partners).
Great questions and issues you raise… but I think your clients get pass-thru income right off of Schedule E. I.e., I would give your clients the same advice.
Hello Steve, I have W2 wages of about $75000. My wife and I also run a home business with taxable income of about $25000. Does this provision in our case reduce our taxable business schedule C income by $5000, thereby dropping our total taxable income by that amount? If so is there a commensurate reduction in the self employment FICA tax that is paid? Thanks!
Brad, you reduce your taxable income by $5K… but this won’t affect your self-employment taxes.
Thank you for you insight and concise answers to the multitude of questions. Information is scant on this so far. Glad to hear that mom and pop Schedule E filers such as myself will be able to get the pass through deduction for Schedule E income. Thank goodness the new law has “simplified” things so much for us… CPA’s are going to come out as big winners this year! 🙂 Can’t wait to send in my postcard.
I agree. Steve has done an exemplary job of answering questions and has been most generous with his time. For anybody looking for the nuts and bolts of the bill, the language with the included House/Senate conference agreements is available here:
Some of it is really clear and helpful, some would appear to require a degree of sorts to understand.
Thanks again to Steve!
I’m trying to understand the rules that will apply to a sole proprietor who earns income in one of the professional services fields where this income exceeds the maximum of $415K (where the new deduction “phases out” for a joint filer). Let’s use an example where the total taxable income is $600K which comes from a combination of income from the sole proprietorship and pension income. There are no employees.
At first glance, its seems like there should be a new 20% deduction on $315K (equal to $63K), some reduced % deduction on the next $100K until the $415K limit is reached (haven’t seen what this rate is, let’s say it’s 10%, or an additional $10K), and then no deduction on the remaining taxable income over $415K ($600K-$415K or $185K). Is this how the term “phase out” will be applied? I ask because some of the language implies that once the $415K limit is reached, there is no deduction allowed at all (even for the first $315K). In other words, for the taxable income of $600K, there is no new deduction at all, with the $63K deduction allowed for the first $315K and some smaller amount for the next $100K completely taken away.
Which scenario is correct? Usually if something is “phased out”, the benefits that accrue up until the “phase out” limit is reached are retained. For example, if someone has a new $1M mortgage under the new rule, they can deduct interest for the first $750K of the mortgage and none of the interest for the remaining $250K. In other words, just because the mortgage amount ($1M) exceeds the new limit ($750K), you still retain the benefit of the interest deductibility from the first $750K and you will not lose the entire deductibility of the mortgage interest.
Using the same logic, it would seem that the $63K of deduction allowed for an income of $315K and the smaller amount for the next $100K would be retained, with higher amounts of income not qualifying for the deduction but not causing the accrued deduction to be lost. I saw an article at another site that implied the marginal tax rate increase from $315K to $415K approached or exceeded 70% which is only possible if the term “phase out” in the context of this new deduction means that it is completely lost above the upper phase out threshold, unlike how that term is usually applied such as in my mortgage example above.
Someone filing a married join return and earning business income in a specified service business loses the Sec. 199A deduction on that income as their taxable income moves from $315K to $415K. So you are not going to get this deduction. Sorry.
Dave our posts are same. My questions a-d pin Steve down so let’s see the answer,
In short we must be able to get 63K (315 x 0.20) for the first 315 K we earn. What Steve seems to be saying is that if i earn 416K I get zero? and 315K I get 63k? If this were true i would simply buy some asset, car, office space, etc to get down to 315K and get my 63K deduction then sell them later. Also what if we have 316K then zero? I am not a CPA but i am smart enough to know the government knows how to avoid obvious loopholes.
The reduction in the deduction phases out on a sliding scale as you move from $315K to $415K.. there isn’t a cliff. E.g., if you’re at $365K so half way, you don’t lose all of your deduction due to no wages… basically you lose half. (I have a big discussion of how this works in the monograph.)
Also, the idea that you’d buy assets and then resell doesn’t work. Or at least not the way described. The gain the next year when you sell jacks your income because of the Sec. 1231 gain treated as ordinary income.
Sid Johnson says
On second look, it appears that the above-the-line deductions are taken care of by the provision that limits the 20% deduction on QBI to 20% of taxable income, if the latter is lower. Taxable income in this case, is prior to the 20% deduction.
If one has a retail business that say made 900k in taxable income and they have some employees and they paid their employees in w2 wages a total of 400k. Does that mean they would get to deduct 50% of the w2 wages off the 900k income? So their new taxable income would be 700k? Basically getting 200k tax free? If so how does the remaining 700k of income get taxed? At the new tax bracket level?
In your situation, if I understand your question and data, you get the lesser of either 20% of the $900K of businesss income, which is $180K… or 50% of the $400K of W-2 wages which is $200K…
So you get $180K as your Sec. 199A deduction.
BTW, if it turns out your taxable income is actually $600K because of other deductions you didn’t mention here, you get 20% of the $600K or $120K.
Ok so that amount is basically tax free then correct? Whether it be the 200k, 180k, or 120k in the examples above? And then what is the remaining amounts taxed at, the new tax brackets?
Also can you explain a little more about this limitation you wrote about below? How would someone go from 100k in pass through income down to 50k in ordinary income rates?
A first limitation that applies to every taxpayer: Tax law limits the Sec. 199A deduction to no more than 20% of the taxpayer’s taxable income subject to ordinary income tax rates.
A taxpayer with $100,000 of pass-thru income might hope for a deduction equal to 20 percent of $100,000, for example.
But if the taxpayer’s taxable income taxed at ordinary income rates equals $50,000, the actual deduction equals 20 percent of that $50,000.
You could move $100K of qualified business income to $50K of taxable income with deductions for self-employed health insurance, pension contributions, an HSA and then personal deductions.
If someone takes the standard deduction $12K or $24K, and does not itemize because they don’t have enough to exceed that, do they still get the 20% “deduction” from Sch E net income for example. I’m in a situation where Sch E generates about $20K of income net of deductions, and I have virtually nothing to itemize so will be taking the $12K.
I think I found the answer to my own question. Page 39 of the conference report:
“Deduction against taxable income
The conference agreement clarifies that the 20-percent deduction
is not allowed in computing adjusted gross income, and instead is allowed as a deduction reducing taxable income. Thus, for example, the provision does not affect limitations based on adjusted gross income. SIMILARLY THE CONFERENCE AGREEMENT CLARIFIES THAT THE DEDUCTION IS AVAILABLE TO BOTH NON-ITEMIZERS AND ITEMIZERS.”
SO, apparently you can take the $12k/$24k standard deduction, AND still get a ‘deduction’ of 20% of the Sch E income elsewhere. I guess it does not count as a normal itemized deduction, it is different class of deduction.
Yeah, I agree. And that accounting treatment is in the law.
Yes, you’ll get the Sec. 199A deduction in that case.
This is a great article. I’m still unsure how the W-2 limits work. I’m the sole owner of an S Corp with about $1M EBITDA. I have employees and pay significant W-2 wages to them. I don’t currently pay myself W-2 wages, but I could. Assuming my business is the only income I have is my deduction limited to 50% of the wages I pay my employees or the wages I pay to myself?
Thanks in advance for your help
Your Sec. 199A deduction is basically the smallest one of these values:
20% of your S corp K-1 box 1
50% of your S corp wages
20% of your taxable income taxed at ordinary income tax rates.
I have a question on your above posts. What is this exactly?
20% of your taxable income taxed at ordinary income tax rates.
Is there a line for this on your returns?
The taxable income based limitation is actually taxable income less capital gains. But that’s a tricky concept for non-tax-accountants because with business income that means you are quickly into a discussion of Sec. 1231 gains and losses. I.e., if I say “taxable income less capital gains” you need to know how Sec. 1231 gains and losses work. And that some of the Sec. 1231 stuff is potentially capital gains.
Sorry for the confusion. You can probably think about the number as taxable income except for capital gains… and then know that this number is a little fuzzy.
So if my only source of income were my S-Corp, I would pay 50% through payroll and 50% distribution and would get to deduct 20% of 50% or 10%. Am I thinking about the right? I get that in the real world it is much more complicated with payroll taxes, deferred income, other tax planning strategies, but just trying to understand this part.
Yes, that’s right.
Mark G says
I’ve read a lot of sites about pass-thru income and that tax changes; this is the best by far.
My question relates to Taxable Income and the 20% deduction. I am in an excluding category, so the $315,00 joint cap is my threshold.
An hypothetical example will be best to ask this…
Taxable income WITHOUT Qualified Business Income = $150,000,
Qualified Business Income = $200,000,
Is my taxable income 350,000 (150,000 + 200,000) or is it 310,000 (150,000 + 200,000 – 40,000)? The 40,000 is the deduction from the QBI * 20%.
So, the question is, can I use the 20% deduction from QBI to reduce my taxable income and help keep me below the 315,000? I read somewhere a few days ago that Mnuchin specifically said that the 20% deduction would not be excluded from taxable income. But I cannot find info to confirm or refute that.
You can’t use the Sec. 199A deduction to drive your income below the thresholds… you need to use itemized deductions or stuff like a pension, self-employed health insurance, etc.
I’m a high income author, with income from advances on new books and royalty income on book sales going back thirty years. I own a subchapter S corporation with my wife, who is a professional photographer. We each take a good salary from the company and each own half. Will my pass-through qualify for the pass-through deduction and if not, what can I do to restructure it to make it qualify? Can I split the company into several pass-throughs to get my income below the $315k level? (It is currently $1 – 2 million). (In other words, could I create a separate pass through for each book I write?) Can I put my copyrights into a new pass-through and treat royalty income on long-ago books as passive income, different from the advances paid to me on submission of my work? I also own investment real estate–should I put that in a new pass-through?
Thank you for the advice.
Doug, it’s your taxable income that needs to be below $415K in order to not worry about wages and not worry about specified service business disqualification. Because your income exceeds $415K you have to worry about W-2 wages (which you may have covered with salaries you and wife draw)… and then you need to be alert to the “specified service” trade or business thing… I think that question is pretty difficult to answer now. (The ink they used to write the law is barely dry.) But what you need to be able to say is neither you nor your reputation are the principal assets of the business.
BTW, I get the copyright argument thing. (Next time you’re at amazon.com, search on my name “Stephen L. Nelson.”) But I’d sure want some IRS guidance before recommending authors say they aren’t “specified service” trades or businesses at least with regard to some of the “mature” royalty streams from backlist titles.
P.S. Your royalties (and my royalties) on old books aren’t passive. If our heirs inherit the copyrights and get the income, they will get to treat as passive income. But we can’t.
David P says
I am a physician who is selling his practice, so next year I will receive a fixed salary per day that I work. I anticipate total salary to be about $225K (married return with wife not employed) but will also have proceeds from sale of about $120K that will be nongoodwill amount. I am thinking of converting to S-corp in view of new tax law.
1. As an S-corp will income be offset by expenses such as malpractice insurance?
2. Do I pay myself a salary and take the rest as a distribution?
3. If the salary were, say, 100K, and the total income after expense offset (assuming that I can do so as mentioned in #1 above) before paying out salary was $300K, would the 199A deduction be $60K (20% of 300K), $20K (20% of 100k), $40K (20% of 300K – 100K salary), or something else?
4. How does self-employment tax or FICA work in this setting? Do I pay only on the 100K salary, or on some other amount?
5. Are the proceeds from the sale of the practice counted towards the income of the S-corp, or should I just have them paid to me outside of the S-Corp and then form it once the sale is completed?
Thanks for al the help. Great website!
Lots of questions there David. But I would say you want to make the investment and consult a local tax accountant. Also, if you can, get the help before the deal is signed so if there’s room to dial down your tax burden with a tweak here or there, you can do that.
Robert W. Olson Jr., says
1. Yes, income is “net” income in a corporation, just as a sole proprietorship.
2. Yes, you pay yourself a salary (subject to payroll taxes) and distributions (not subject to payroll taxes).
3. The answer depends on what is a “reasonable” salary for you. If $100K is “reasonable,” you take the 20% deduction on the remaining $200,000, or $40K.
4. Yes, for an S corporation. But the elephant is the room is … can a SOLE PROPRIETORSHIP filing a Schedule C pay $100K in salary (subject to self-employment taxes) and the balance as “profits” (NOT subject to self-employment taxes)? If YES, then the biggest (only) tax reason to be an S corporation vs. sole proprietor is gone. I just started looking for the answer.
5. If the sale already closed, the question is moot, since the purchase agreement should set forth the tax allocation. If it hasn’t closed, you better talk to your attorney and CPA ASAP about tweaking the allocation. It doesn’t matter if you are a sole proprietor or S corporation for sale proceeds, those will all be treated as pass-through, and they will push up your “taxable income” for the year of closing.
Just as an FYI, I assume when the word “income” is used, i.e. Sch. E income, it is referring to NET income – NOT gross income (or revenues.) It’s been my experience that many people confuse the terms “income” with “revenues” when they really mean “what is left after all the expenses are deducted.”
Steve – appreciate your work! I would just suggest adding the word “net income” or “after expenses” when applicable to avoid yet further new tax bill confusion. Happy Holidays!
Hi Steve – thank you for the thought provoking article.
I am a part-time accountant providing services. Is my income ineligible for the 20% haircut regardless of my income?
Greg, if you’re single and your taxable income is less than $157,500 you get the deduction. (If you’re married, your income needs to be less than $315K to get the deduction if you’re an accountant.)
My wife and I own 3 income producing properties (including 1 in a jointly held LLC), plus an additional 1-family rental property that shows a loss, another that my wife co-owns with 2 partners in an LLC, and another 2-family that we use for ourselves and a tenant; that’s 5-1/3 altogether. In addition, I work part time as a real estate agent, making another $15,000 to $20,000. My wife does not earn any 1099 or W-2 income. The combined income for all of these businesses falls below $315K, probably more like $250K when you factor in all the depreciation and expenses.
First question: Am I eligible for the Sec. 199A 20% deduction?
Second (and this is not a political question): Why do I keep reading that the president has 500 pass-thru entities and stands to benefit enormously from this section of the tax code when the deduction benefit is capped at $415K in income? One would assume that the combined income for 500 pass-thru businesses far exceeds $415K. As a property owner with multiple pass-thru businesses, I am finding all of this a little confusing.
Thank you for providing so much incredibly helpful information!
First question answer: Yes.
Second question answer: Taxpayers don’t necessarily lose the Sec. 199A deduction just because their income rises about $415K… that only happens for “specified service businesses”… what happens for every other type of business is the business needs W-2 wages and depreciable property to support the deduction.
I run an editorial business that makes over $450k a year. Married filing jointly.
I use contractors, not employees. Just have one manager as an employee.
I think I could argue that I am a sales and marketing business, as that is the aspect I handle.
Any chance of getting the 20% deduction?
It’s very frustrating that the marginal rate over the next $100k is sky high if you lose that deduction.
You don’t say specifically what type of editorial business you run or what your entity classification is (S corp… vs. partnership… vs sole proprietorship, etc) , but you’re probably going to get at least a little bit of benefit. And you may be able to get a full benefit. (It’ll depend on your taxable income… and whether your business escapes disqualification… it sounds like it might)…)
I am no tax guy. Just happen to be a limited partner in a E & C co. that works mainly in the industrial arena. Above you talk about these type businesses losing out but referred to a civil engineer in a positive way. I’m cornfused. Could you please give me an brief overview of +’s & -‘s for a LP and my company type in light of the new tax law?
I can’t really do that without knowing what your tax returns look like. This is really a subject you need to discuss with the company’s tax adviser.
Harry Campbell says
Thanks for the post Steve, read through all the comments too and I think I finally understand ‘my situation’.
1. So if my wife makes $60k at her w2 job and I have an llc as s corp in a non-excluded biz category and married, pay myself a salary of $70k and make $200k in qualified business income, minus let’s say the $24k std deduction, I would get to deduct 20% of my $200k biz income right? No need to worry about limitations/etc… Since $60k+$70k+$200k-$24k = $306k and that’s below the $315k limitation.
So I get to take a 20% deduction on $200k = $40k deduction right?
2. Now assuming #1 is correct, let’s say I make $400k in qualified business income in 2018. So now I’m at $506k in taxable income right? So now I’m limited by the W-2 wage limitations right? So I can only take the lesser of my 50% of my w2 ($35k) or 20% of the $400k biz income ($80k) – which means I can only take the $35k right?
Basically it sounds like you want to stay under $315k taxable right lol?
So good question–and let me say that you probably want to consult your accountant to get details totally nailed down–but with numbers like yours you get a Sec. 199A deduction equal to lesser of 20% of your qualified business income of $200K (so a $40K deduction)… or 20% of your taxable income of $306K (calculated as $60K+$70K+$200K-$24K) so $61,200.
Note: You don’t need to worry about wages in your situation because your taxable income is less than $315K. But if taxable ended up being more than $315K, then your $70K of wages might limit the deduction to 50% of the $70K… or $35K.
Bill Moore says
Great article !
Would recruiting firms be eligible to take the 20% deduction (subject to the income limitations)? I and a co-owner have an S Corp with 8 employees (both co-owners included in that figure). We each have low 6 figure W-2 income and have K-1 income of $100k – $150k each and work in the business (40hrs/week +) Our company makes permanent placements only. We’re not a staffing company and don’t place contractors or temps.
After reading the conference report this weekend, I think you guys probably will get the Sec. 199A deduction. But I’d check with your tax accountant and keep alert to additional guidance from IRS.
Mike Hamblin, CPA says
It is obvious by reading the comments, people are either not consulting their CPA’s or tax consultants. Great job on the replies. So I noticed on one of the limitations that it is base up a percentage of the cost of the properties. Can you comment or have any idea how the percentage is applied on properties that were purchased via a 1031 exchange? I am hoping you will say it is based on the original purchase price regardless of the 1031 basis but based on my experience it is probably not.
I think it probably will be based on the original purchase price.
E.g., just to look at simpler case where someone bought a $10,000,000 30 years ago, I think they get 2.5 percent of $10,000,000…
Diane Offutt says
My question is as follows: Accounting Firm, earns $100K, partnership 2 partners, no employees so no W2 wages paid. Net profit after expenses $60K
Retirement Income $110K.
Adjustments FOR AGI $4,590 SE and $6,000 Med Premium
Total AGI $159,410
Deductions (mortgage, contributions, state taxes) $30K = $129,410 Taxable Income
Taxpayers filing MFJ
My interpretation of this 20% exclusion on flow-through entities: Since the Partnership is under the $310K I could deduct 20% of the partnership net profit, which is 20% of the partnership net income of $60K or $12K from taxable income.
Am I correct in my interpretation? And the Partnership being an accounting firm, is the deduction even allowed?
Diane Offutt says
I just sent what I believe is my interpretation on this pass-thru 20% exclusion, but now, reading your blog for the 5th time, I believe I was incorrect in my interpretation.
I believe now, that in my example of $60K net profit from partnership, $110K from retirement income, less adjustments for AGI $4,950 1/2 SE and $6,000 medical premiums = Total AGI of $159,410. Then going further to calculate TAXABLE income, subtract mortgage interest, contributions, state income taxes, property taxes all totaling $30K brings me to $129,410 Taxable income.
My 20% of pass-thru income would be limited to $60K net profit of partnership, less adjustments for AGI 4,950 and 6,000 and itemized deductions of 30K = $19,050 pass-thru income multiplied by the 20% = $3,810 would be the exclusion amount. NOT what I originally thought which was 20% of the $60K or $12K exclusion.
Am I now correct in my interpretation of this most convoluted area of the tax act?
Diane Offutt says
Darn…I should have read a few more of your great examples. Bottom line I will take the lesser of my QBI of $60K (20% x $60K = $12K) OR in my example above 20% of Taxable Income of $129,410 (20% X $129,410 = $25,882). Sooooooo the lesser amount would be the $12K. I believe the adjustments FOR AGI are already considered in the “taxable income”.
Hopefully I have this correct now. Please let me. Thank you Steve.
Just saw these comments… but you have it in the end. $12K.
Diane Offutt says
Thank you Steve. Not only for your response, but for a great article.
Sorry to add another scenario, but am trying to find out if I am doing this right. I am a single person with 50% share in an S Corp. We have two owners and 8 total employees (including owners). I have w2 wages of $95K, and estimated QBI of $150K. So would I be able to get the 20% deduction on $150K? That 30K deduction is no where near my 25% of w2 wages that we pay. Not sure if there is anything else that would prevent me from receiving the deduction. We use a PEO for payroll if that matters. Do I still get it even though my total income is near $250k for single filer?
Your income matters for two potential reasons… one, because it makes you have W-2 wages to “support” your Sec. 199A deduction…you’re good there though.
A second reason? Your S corp needs to not be a specified service business… if it is and your taxable income is over $157,500, you’ll lose some or all the deduction
Great job putting all this information together so quickly. I think the examples you provided in your write up are really helpful.
I would appreciate your thoughts on this situation. All employees are in a C Corp and they provide services to a partnership. The partnership has no employees of its own and the ownership of the partnership and C Corp is the same. Would this employee cost count as W-2 expense for the Partnership?
We don’t have regulations yet for Sec. 199A… but I think you can probably use the Sec. 199 regulations (I.e., the “domestic production activity income” deduction regulations) and follow their “common paymaster” methods to say, essentially, that the C corp pays employees but some of that payroll is really for partnership.
How abought a physician S Corp group that pays its docs $100k as S Corp dividends and 200k more as w2 income/salary? What is the deduction assuming married with non working spouse?
The S corporation dividends aren’t really dividends… they are surely distributions and “hint” that box 1 on the K-1 shows a $100K-ish distributive share.
But say that box 1 on the K-1 does show a $100K distributive share. In your example, the Sec. 199A deduction equals $20,000. And physician probably saves $4800 (24% top tax rate times $20,000).
Yes your right, distributions. but no deduction on the w2 part right?
Right, no deduction on the W-2. Only the K-1 amount.
S-corp, non service . Single owner – 1 employee (the owner) … $140k w2 … $1,140,000 mm profit .. therefore S-corp passes thru 1 million profit.
In this example, is this owner disqualified due to to high of income?
If not, would it make more sense for the W2 to be 400k~ (thereby qualifying for the 50% of wages restriction = 200k~ = 20% of 1mm) .. which would allow this company to take this 20% deduction
Hi Kevin, so Sec. 199A deduction equals lesser of 20% of the $1M… or $200K… or 50% of the $140K in wages… or $70K. Wages therefore are limiting your Sec. 199A deduction.
You’re right that need to bump your wages to bump your Sec. 199A deduction. This ignores your payroll tax burden, but if all you want to do is “max” your Sec. 199A deduction, you set salary to 28.5714% of profit. Roughly $325K in your example…
In my example, paying out at $325k w2s would make the pass thru 814k (20% of that is 162k) and 50% of the 325 also = 162k. So it would be the same deduction.
Is the only way to get that 162k deduction higher, by making more as a company (and as a w2). Does the 28.5714% profit work across the board at any income level above the phase out?
Lastly, maybe I am being naive, but shouldn’t the 20% deduction more than offset any increased payroll taxes. From what I have gathered in the past, 2.9% is what you are losing out on payroll via S-corp divided vs w2. 2.9% is far less than a 20% deduction off say 37% marginal rate. Am I missing something? Shouldn’t anyone at that income level be trying to max the deduction vs save on payroll taxes?
divided = dividend
>”Does the 28.5714% profit work across the board at any income level above the phase out?”
Yes, but it’s a little approximate because it ignores employer payroll taxes on the wages and then any pension match from employer. But making that simplification, here’s how one calculates that number. Start with this equation:
50% of W-2 wages = 20% of (Business Income before wages – W-2 Wages)
Then “solve” for W-2 wages. The wages should equal 28.5714%.
Note that business income before wages in your example equals $1,140,000. So you solve this equation:
.5 * “W-2 wages” = .2 * ($1,140,000 – “W-2 wages”)
A little bit of high school algebra and pretty soon you get
W-2 wages = 28.5714% of business income before wages
>”Am I missing something? Shouldn’t anyone at that income level be trying to max the deduction vs save on payroll taxes?”
I don’t think you’re missing anything. But remember the first rule of fight club.
Still confused and read all. If i have an LLC pass-thru as a consultant with no employees and i earn 315k on bottom schedule C (after expenses) and my wife earned 18 K and rental propeties 40K so my total taxable income is 315+18+40=373K then I will pay taxes on instead 315-0.20(315) +18+40= 310K (instead of 373K right?
In short we will always get a 63K deduction for first 315K taxable income earned? meaning the actual deduction since 315K falls in 35% (current rate) – 20%=28% bracket for first 315 k instead of old 35?
If you’re $58K “into” the $100K phase-out band… I.e., $373K is $58K more than $315K… you won’t lose all of your Sec. 199A deduction because you lack W-2 wages. Rather, you lose 58% of the deduction.
BTW, your real option may be make an S election for the LLC. Pay a reasonable wage. That’ll save you payroll taxes. And let you get some wages for the Sec. 199A deduction.
Here’s a blog post that explains…
what if you have a non service business and a service business, what happens to the duduction and limitations
I don’t think we know yet for sure. But I would anticipate the ultimate regulations work for Sec. 199A like they did for Sec. 199.
In a nutshell, if this happened, the deduction applies to the nonservice part of the business.
BTW, this sort of hidden bookkeeping requirement is why people want to learn as much as possible about how this deduction works before the year starts.
This is the best article with relevant information I have read since the law has passed. Here is my question. I am a CPA with 1 part time employee and income of $100,000. Since I fit into the “professional service” category, do I still get the 20% deduction on the K1 pass thru income since I make less than $157,000?
Yes, you do. The deduction equals 20% of your box 1 K-1 value.
N. Lucy Reddy says
Hello I have a question! sole proprietor physician, $400k income qualify for pay through ? Employee payroll $10-20k is it too low, also $55 k in sep ira thank you
You don’t provide your filing status, your taxable income, nor your personal deductions. But if your total income before deductions equals $400K… and then you deduct from that $55K for a SEP… and maybe another $20K for the self-employed taxes… and then you only take the new standard deduction of $24K, your taxable income might be $300K-ish. That taxable income for a married filing joint return means you don’t need to worry about W-2 wages nor about the fact that you’re in a specified service trade or business.
I am an accounting consultant (I have a single member LLC with an EIN) working now for 3 months as a W-2 Employee with Social Security taxes being withheld.
It appears from Schedule C Part 1 line that I could put W-2 income paid to me on the Scedule C.
If I have less than $315,000 Income in total from all sources, Can I get the the 20% deduction of the Schedule C income?
Thanks for your help
The trade or business of “being an employee” is excluded… so, if I understand what you’re asking, sorry, that doesn’t work.
BTW, if you were a 1099 contractor rather than a W-2 employee, I think the Sec. 199A deduction might be available to you.
Phenomenal article and more importantly the comment stream! Thank you! I read on another site that within the conference report this 199A deduction is structured against “taxable income” not “adjusted gross income”. And that makes a difference depending on where you live. The author went on to say that this is super important because only six states use “taxable income” as their starting point, the rest use AGI. The six states are Colorado, Michigan, Minnesota, North Dakota, South Carolina, and Vermont. I am a resident of Colorado, so what does that mean? Thanks!
Hi Jay, so the Sec. 199A is not an adjustment taxpayer uses to calculate AGI. Rather, the deduction works like the standard deduction to adjust the AGI to the taxable income number. And this approach means the deduction doesn’t work the way one might first guess. I’m not sure, though, what the author you read was referring to. Seems like both adjustments taxpayers use to calculate AGI and adjustments (or deductions) taxpayers use to further reduce AGI down to taxable income number impact taxable income.
Steve Fishman says
On pg. 7 of your Section 199A ebook you say: “Someone who pays the 10% tax rate saves about $200 in tax for every $10,000 of Sec. 199A tax deduction added to the tax return, for example.”
Isn’t the savings $1,000 for every $10,000? 10% x $10,000 = $1,000
Yes, sorry. I meant to say that someone with $10,000 of pass-thru income (paying the 10% tax rate) saves $200. Etc. Ugh. I will fix on the next update we do.
Reading this has been very helpful, but surely you have a nice flow chart for making the calculation that you can share with those of use who are less code nerds and more pragmatic.
My husband and I are real estate appraisers filing jointly on a 1004 with a schedule C, line 12 on the 1040, “ Business Income” for 2016 was $65,000. We fall below the individual and joint income limits even though we have an excluded business. So, should I anticipate a 20% deduction from line 12 of the 1004, if everything remained the same for tax year 2017? Would this leer amount end up affecting (lowering) our self employment and social security taxes?
Final question, we paid 22% of our adjusted gross income in taxes for 2016, is this a reasonable amount, in your opinion?
Thank you so much!
Hi Shirley, so you will benefit from the new Sec 199A deduction. And the actual deduction will equal the lesser of either 20% of your Schedule C profit or 20% of your taxable income. Probably the deduction will equal 20% of your taxable income.
The Sec. 199A doesn’t reduce your self-employment taxes and those add up to about 15%-ish, sort of, of your business profits. (This is reason for that 22% in taxes figure.)
How do we go about calculating when there is more than one pass-through entity for a taxpayer? For example, I have income from an S corp with wages but I also have income from a Partnership with no wages and maybe a loss from another S corp with wages.
The qualified business income amount is calculated for each business. The statute, for example, uses this language, “…the sum of the amounts determined under paragraph (2) for each qualified trade or business carried on by the taxpayer.”
In your example, I think you calculate a Sec. 199A deduction for the profitable S corp… then for the partnership (but that deduction might equal zero if partnership wages and depreciable property both equal zero AND your taxable income is over the phase-out range)… then for the unprofitable S corp (which will be a negative sec. 199A number).
You then add up the qualified business income amounts… a positive number from the first profitable S corp… a zero from the partnership.. and a negative number from the unprofitable S corp.
Thank you for the robust dialogue regarding the new pass through income deduction.
One area I have not seen discussed much…will the deduction affect AMT?
AMT basically starts with AGI (for standard deduction takers) or AGI minus itemized deductions (for those who itemize) , correct? It doesn’t start with taxable income..
So if a taxpayer is still subject to AMT (even after the increased AMT deduction and higher phase-out limit), the new pass through income deduction will be of no benefit to the taxpayer, regardless of income?
I think the answer you’re looking for is this: The Sec. 199A deduction is not an AMT preference item. So it won’t directly impact AMT.
Am I understanding the 199A calculation correctly?
Let’s say we have a high income individual with $4M of W-2 income and fully owns an S-Corp.
S-Corp has $6M in W-2 wages (including his $4M) and no assets.
QBI of $800K
I understand the 199A calculation to have 2 parts.
(a) Lesser of 20% of QBI ($160K) or 50% of wages ($3M) which would be $160K.
(b) 25% of W-2 income ($1.5M) + 2.5% of assets (0)
The deduction is the greater of (a) or (b) and in this case it would be (b) at $1.5M.
Does that seem correct to you?
Thanks for the effort you make to explain this law.
The Sec. 199A deduction equals tentatively $160K, calculated as 20% of that $800K.
W-2 wages or W-2 wages and depreciable assets only limit the $160K… they don’t increase it.
You want (if possible) to tweak your salary. That’s way too high…
Steve – Great feedback you provide. I’m surprised revoking the S-Election is not more discussed. Maybe I’m missing something…
If a high-income (>415K) specified service business retains profit, thus not subjecting the owner to double-tax,, I see opportunity under the C-Corp. The C-Corp can deduct the state and local taxes fully, while under S-Corp is getting walloped under the state tax itemized limitation. It has to watch out for the difference in tax rates, but I think it off-sets.
Would appreciate your thoughts…
I talk about this in the Maximizing Sec. 199A Deductions monograph (pages 42 to 44), focusing on the situation where the entity does get the Sec. 199A deduction.
In situations where business owners get a Sec. 199A deduction, the S corp crushes the S corp in every tax bracket.
However, for taxpayers who don’t get the Sec. 199A for whatever reasons, in some brackets, the S corporation and C corporation tax burdens (at least in my calculations) seemed pretty close. The S corp still wins (at least in my examples). But only by a nose.
The upshot to all this? I think the “upshot” is that you’re right. Someone who doesn’t get the full Sec. 199A deduction needs to do the math.
Shelli S says
I purchased your Maximizing the Sec 199A Deduction information and it did not directly answer the question I am coming across. If you have an almond farmer who sells all of his crop to a co op, and so his retain income reported on his 1099PATR is $ 9,000,000, I understand that his qualified business income would be 20% of this amount or $ 1,800,000.00, even is his net income is say 2,000,000.00. Where the confusion comes in is the farmers are being told by the co ops and also other CPA firms in town that their deduction from their taxable income would be the 1,800,000.00, but unless I am reading it incorrectly, because they are over the $ 315,000.00 taxable income limit for a joint return, this amount would have to be further limited to the greater of either the 50 percent of wages paid on their schedule F or 25 % of wages paid plus 2 1/2 % of the capital assets. So if they may still get the entire 1.8 million but if their wages paid were say only 1,5 million and they have 5 million in assets, they would be limited to $ 750,000 for a deduction ( 50% of wages, higher of the two calculations) a higher deduction than the non co op seller who would be limited to 20 percent of the net of $ 2,000,000 or $400,000, but not the 1.8 million they are being told they will get. I am misunderstanding the rule and do co op distributions not have to meet the additional wage limitation even if their taxable income is in the millions?
I think the other coops and other CPAs are right. Sorry. The confusion, I think, stems from wording of Sec. 199A(b)(1).
Read that chunk really carefully and you’ll probably see why people like me and your local folks think you get 20% of the QBI subject to those wage and depreciable asset constraints PLUS 20% of REIT and qualified cooperative dividends.
Mark Thompson says
Steve, I am an independent IT consultant, doing business as a single-owner LLC. No employees. Married, filing jointly. My wife earns about $35k per year, and my income from my business is about $250k, so we are below the $315k threshold.
The text of 199a states that the pass-through deduction is 20% of the lesser of (a) business income, or (b) 50% of W2 wages.
I have never placed myself on a W2. So, right now, I have no W2 wages. According to my reading of 199A, my pass-through deduction is 20% of the lesser (a) or (b), which means 20% of (b), which means 20% of $0, which means my pass-through deduction would be $0.
Does this mean that I have to “put myself on the payroll” and process a W2 income for myself, in order to be able to take the pass-through deduction?
Maybe take another read through Sec. 199A… the limitations only apply (only start to apply) once a married taxpayer’s taxable income trips over that $315K limit.
In your case, therefore, your Sec. 199A deduction will equal the lesser of 20% of your sole proprietorship profits or 20% of your household taxable income.
BTW, you should probably not be a sole proprietorship, but rather an S corporation. This change in entity classification would mean a smaller Sec. 199A deduction but the FICA and Medicare tax savings from the S election more than compensate for that.
Mike P says
I own a real estate brokerage LLC, which is deemed a service related business. If bottom line income is $700,000 or so, would we still receive a 20% deduction on the initial $315,000 ($63,000) or would we receive $0.
If you earn $700,000 in specified service business and your taxable income is over $415,000 and you’re married, you don’t get the Sec. 199A deduction.
By the way, I’m not sure you’re a specified service business. You may not be.
Steve, I have a small LLC of 2 years filing as a partnership, but just bought out my partner’s 40% share 12/31/17. I think in 2018 I’ll have to file as single member LLC (?) since I own 100% myself. I do file MFJ and I won’t be hitting $315k, but I don’t have any w-2 wages. I pay contractors via 1099. Do I need to start doing something differently to ensure I can benefit from this new deduction?
EDIT: my LLC does not have w-2 wages. I have another full time job where I receive a w-2, as does my wife.
If you’re married and your taxable income is less than $315K, you don’t need to have W-2 wages “inside” the entity to qualify for the Sec. 199A deduction.
BTW, if you anticipate substantial income from the single member LLC in 2018, you ought to consider making an S election for the LLC.
Here’s a blog post that can start your learning: https://evergreensmallbusiness.com/million-dollar-s-corporation-mistake/
Thanks for the article! My operations for this company are still rather small at less than $50,000 in revenue, but strong with roughly a 40% profit margin. So far, I’ve gotten back all the money I put in (only $3500!), expanding about 4-5 times in size, and have no debt. 2018 will be the year of dollar growth though as I amp up marketing and a few new products.
PS. My company is a service business, but it’s more so an entertainment category, where we run games for birthday parties, corporate events, festivals, and the like. I don’t think this excludes me based on what you’ve described, I do not operate the events, rather contracted hands.
Jim B says
Yikes, never been more confused. So here’s my scenario. Wife has a small health-related service practice organized as a single-member LLC (disregarded entity). I am her only employee. Until now we have paid the bulk of the businesses earnings as W-2 wages to the two of us. Leaving just enough Schedule C income to cover the Self-Employed Health Insurance deduction. Our annual total W-2 plus Sched C income is well under the $315k limit. How can we make use of the pass-through deduction? Pay less W-2 wages? Are there limits to that?
Because wages don’t count as qualified business income, and cutting your wages bumps up your qualified business income, what you want to try and do is dial down your wages.
That pushes up your qualified business income. And that means a bigger Sec. 199A deduction.
Obviously, you need to think about whether this works. (There is a requirement that if you work in the business, you’re supposed to be paid wages.)
I have a self-directed IRA that receives pass-thru income that is subject to UBIT (unrelated business Income tax) inside the IRA. The business activity is residential housing construction., and the income is reported to my IRA on Line 1 of the K-1.
Section 199A refers to trusts as being eligible for the 20% deduction, and an IRA is a trust….
So,does an IRA qualify for the 20% Section 199A deduction on its taxable pass-thru business income?
I don’t think so. UBIT is the tax an exempt organization (your IRA, in this case, but usually a nonprofit) pays when it earns untaxed business income. That’s not what the Sec. 199A deduction lessons the tax on.
I have a small (gross about $40K annually) side business where I file Schedule C income but I’m not structured as an LLC (or anything else; I’m just a sole proprietor). Does that matter in terms of my eligibility for the 20% deduction, or do I need to formally structures as an LLC (or some other entity)?
You don’t need to be an LLC to get the Sec. 199A deduction. It works for a sole proprietorship.