The Tax Cuts and Jobs Act added a new business deduction to tax law: the Section 199A Qualified Business Income Deduction.
In a nutshell, the Section 199A Qualified Business Income tax cut gives the owners of pass-through businesses like sole proprietors, partnerships, S corporations and then some real estate investors a deduction equal to 20% of qualified business income.
This deduction will produce big savings for many pass-through entities and real estate investors. But the deduction comes with some tricky calculations and complicated limitations. To understand and begin planning for the deduction, therefore, you need to dig into the details.
Note: This blog post has been updated for the Section 199A final regulations that appeared over the 2019 Martin Luther King Jr. holiday weekend.
What is Section 199A Qualified Business Income?
The qualified business income talked about in Section 199A—that’s the new section of law that creates the deduction—includes the profit from an active trade or business including rental income as long as you operate as a pass-through entity.
More specifically, this means your qualified business income includes the bottom-line profits from an active trade or business as shown on the Schedule C form and in box 1 of a partnership or S corporation K-1, possibly the rental income shown on a Schedule E form and in boxes 2 and 3 of a partnership or S corporation K-1, and then not the capital gains but rather the Sec. 1231 gains and losses taxed as ordinary income or loss that may occur when a business sells assets used in the business.
Note: For more information about when real estate investors get to use the Section 199A deduction, see our Section 199A Rental Property Trade or Business Definition post.
As noted in the opening paragraphs, to calculate the deduction, you add up all this stuff and then multiply the total by 20%.
If you have $100,000 of qualified business income, for example, you potentially get a $20,000 deduction.
If you have a $1,000,000 of qualified business income, you potentially get a $200,000 deduction.
A technical point: Qualified business income also includes REIT dividends (including REIT dividends from mutual funds) and qualified agricultural and horticultural cooperative dividends. This logically makes sense since REITs (real estate investment trusts) and qualified cooperatives are also pass-though entities.
What is not Section 199A Qualified Business Income
Two types of income you might at first think “count” as qualified business income don’t count…
First of all, the Section 199A qualified business income amount does not include reasonable compensation paid to S corporation shareholders nor does it include guaranteed payments paid to partners.
For example, if you own and operate an S corporation making $150,000 before your shareholder-employee salary and then you pay yourself $50,000 in wages, you get the 20% deduction (potentially) on that leftover $100,000 of profits.
The situation works the same way if you’re a partner receiving a guaranteed payment from the partnership. If your share of partnership profits equal $150,000 and you receive $50,000 as a guaranteed payment, you get the 20% deduction only on the remaining $100,000 chunk of the profits.
And a second type of income also doesn’t count for purposes of Section 199A: Qualified business income does not include foreign earned income.
If your business operates outside the United States, for example, you don’t get to use the Section 199A deduction.
Note: This domestic business requirement matches the old Section 199 “Domestic Production Activities Income” logic and language.
Limitations on Section 199A Deduction
The Section 199A qualified business income deduction gets limited in a couple of situations.
A first limitation applies if you’re single and earn more than $157,500 or you’re married and earn more than $315,000. In this case, you can’t deduct more than the greater value of either 50% of your W-2 wages or the sum of 25% of your wages plus 2.5% of your depreciable property.
For example, say you have $1,000,000 of qualified business income and you’re potentially entitled to a $200,000 deduction. If your business’s wages equal $300,000 and you hold no depreciable property, you can only deduct $150,000 because 50% of $300,000 equals $150,000.
By the way, this wages-based limitation will mean that high income sole proprietors, partnerships and real estate investors without W-2 employees will miss out on the deduction unless they form an S corporation. (Again, this logic sort of matches the old Section 199 deduction just mentioned.)
Further, this housekeeping point: You count as wages only amounts your business timely reports to the Social Security Administration.
A second limitation exists, too… You can’t deduct more than 20% of your taxable income after subtracting your net capital gains and qualified dividend income but before deducting the Section 199A deduction.
Say, for example, that you should theoretically get a $20,000 Section 199A qualified business income deduction based on the qualified business income flowing out of a pass-through entity. If due to deductions your taxable income actually equals $80,000 and this $80,000 includes $30,000 of net capital gains and qualified dividends, your deduction equals 20% of the net $50,000 ($80,000 taxable income minus $30,000 of net capital gains and qualified dividends), or $10,000.
Specified Service Trade or Business Disqualification
Not every pass-through entity gets to use the Section 199A Qualified Business Income deduction.
The law, for example, disqualifies “specified service trades and businesses” including most of the traditional white collar professions (medicine, law, accounting, actuarial science, financial services and consulting) and then also performing artists and athletics. The law also includes a vague catchall for any trade or business that relies on the “reputation or skill of one or more employees” but that really means the income a celebrity earns from being a celebrity: appearance fees, endorsement income, and licensing fees.
Note: Another blog post that appears here, Sec. 199A Pass-thru Entity Deduction and Principal Asset Disqualification, discusses that “vague catchall” in a bit more detail.
Professional service firms with high-income owners, therefore, potentially don’t get to use the Section 199A deduction.
I say “potentially” because this disqualification doesn’t apply if you operate a specified service business and your taxable income falls under
$$157,500 ($315,000 if you’re married).
Furthermore, if your taxable income exceeds these thresholds ($157,500 or $315,000 in taxable income), the Section 199A deduction doesn’t immediately zero out. The deduction phases out as you move from $157,500 to $207,500 in taxable income if you’re single (or from $315,000 to $415.000 if you’re married).
Note: We’ve got a detailed discussion of how the phase-out formulas work in another post: Section 199A phase-out calculations.
Four Other Things to Know
Let me also cover three other things you want to know…
First, the Section 199A qualified business income deduction starts in 2018 and ends after 2025. The deduction, in other words, only works for the next few years…
Second, the deduction reduces your income subject to federal income taxes. But not self-employment taxes or alternative minimum taxes.
Third, some of the adjustments that appear on your 1040 tax return also reduce the qualified business income that “flows out” of the trades or businesses a taxpayer owns interests in: the self-employed health insurance deduction, the self-employment tax deduction, and the profit-sharing portion of any pension fund contributions.
Fourth, here’s the best current version of the actual law: Final version of Tax Cuts and Jobs Act.
Need More Information?
We’ve got an instantly downloadable monograph for tax practitioners who need to be able to confidently and comfortably help taxpayers with the new law. If you’re interested in our “Maximizing Section 199A Deductions” monograph, just click the button below:
If you’re still doing your research or need more information about our monograph because this is the first you’ve heard about it, more information is available here: Maximizing Sec. 199A Deductions monograph.
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