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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EJ says
Am I correct in understanding that under the Senate version, a sole proprietor with no W-2 employees would get a 199A deduction of 23% of his Schedule C net income, as long as his Schedule C net income is less than $250,000?
Steve says
That’s almost right… and for the record, I have had to read and re-read this new section about a dozen times to get all the details into focus…
But a sole proprietorship with zero W-2 wages will get to use the 23% deduction if his or her taxable income is less than $250K (or less than $500K if married).
So it’s not the sole proprietorship income… it’s the taxable income on the return with the Schedule C.
Further, and sorry I didn’t do a better job describing this, but the deduction also gets limited by the taxable income. So if someone has $50K of taxable income as discussed in an example above and $100K of qualified business income, you calculate 23% of the $50K and not the $100K
EJ says
Thanks, Steve. So both the House version and the Senate version give a huge tax cut to businesses that file as C corporations. The Senate version, in an attempt at somewhat equal treatment, gives a large tax deduction (up to a point) to businesses that do not file as C corps, The House version, however, gives a tax break only to certain PRIVILEGED categories of non-C-corp businesses (those with lobbyists?), thereby discriminating against many categories of non-C-corp businesses. Sad!
Steve says
I read the House version to give a very similar tax break to pass-through entities. The route they take looks a little different. But the Sec. 199A qualified business income deduction will save pass-through businesses a noticeable amount of money. Also, because the deduction is a percentage of income, the higher the tax rate someone pays, the bigger the impact.
E.g., 23% deduction of income taxed at 10% saves someone $230 of tax on $10,000 of income.
A 23% deduction of income taxed at 38.5% saves someone $886 of tax on $10,000 of income.
EJ says
No, my point was that the House version discriminates against several kinds of businesses, which you describe in another article: https://evergreensmallbusiness.com/pass-through-entity-tax-cut-rules/
Steve says
Agreed…The two bills absolutely treat this pass-through entity deduction differently.
JUles says
Great explanation. Thanks
Ikonos says
Good write up.on the Senate version. However “Specified Service Trade or Business Disqualification” portion needs further clarity. Initially it says traditional white collar professions are disqualified. Next portion says the disqualification does not apply if the taxable income is under $500K (married) threshold. Next portion talks about how the deduction is phased out even if the taxable income is above $500k but under $600k. If they can still get the deduction and the primary disqualification is their taxable income, why even have the conditions about “Specified Service Trade”?
Steve says
You’re right. I didn’t do a great job at wrestling this part of beast to the ground. Let me try to clarify therefore…
The Senate didn’t want to let highly-paid professionals use the new loophole… so the law says in an indirect way that if you’re in one of these professions and your taxable income is above specified thresholds ($250K if single and $500K if married), you lose some or all of the deduction.
And then this extra complexity: If your income crosses one of the thresholds, you don’t lose the entire deduction by tripping over the threshold… rather you lose the deduction over a range of income… for single folks, you lose the deduction as your taxable income goes from $250K to $300K… for married folks, you lose the deduction as your taxable income goes from $500K to $600K.
P.S. I will see if I can tweak the blog post with a deletion or extra word to address the lack of clarity you mention.
MGR says
Thanks for the concise post. Please relook at how partner investment sale ie the ordinary gain is treated for PTPs as pages 38 and 39 (5 A and 5B) on dep. recapture, etc (5B ordinary gain) is business income and receives the benefit of the 23% reduction perhaps also including nol carryovers.
:…qualified publicly traded partnership income means…”
5B
“..any gain recognized by taxpayer upon disposition of its interest.. realized from the .sale or exchange of property other than a capital asset..”
Section 751, In General
Section 751 provides that the amount of any money (or the fair market value of any property), received by a selling partner in exchange for all or a part of his interest in the partnership that is attributable to—
unrealized receivables of the partnership,
substantially appreciated inventory items of the partnership, or
ordinary income depreciation recapture under Sections 1245 or 1250
is considered as an amount realized from the sale or exchange of property other than a capital asset.
Stated in English, this means that if a partner sells his partnership interest, his share of any gain attributable to cash-basis accounts receivables, appreciated inventory, or depreciation recapture results in ordinary income rather than capital gain.
Steve says
I may not understand what you’re getting at… sorry. But if you’re pointing out that there’s more stuff on a K-1 that qualifies that just what’s in boxes 1, 2 and 3, I agree with that.
I tried to make a general statement about Sec. 1231 gains to throw a lasso around all those other gains. But as your comment points out, there’s other stuff that’ll potentially be subject to that 23% deduction.
MGR says
Steve thanks for replying. Being more specific to your examples which were appreciated, I was attempting to get clarification-confirmation relating to your calculation by taking it to the final input associated with a parternship investment sale :
“…A second limitation exists, too… You can’t deduct more than 23% of your taxable income after subtracting your net capital gains.
Say, for example, that you should theoretically get a $23,000 Sec 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, your deduction equals 23% of the net $50,000 ($80,000 taxable income minus $30,000 net capital gains), or $11,500….”
On PTP’s and many non publicly traded partnerships, generally when a partner sales the investment and incur a capital gain, the investor will concurrently recapture Section 751 items as ordinary gain/ordinary income. From your view will the Section 751 recapture to partners be added back to business income before calculating the 23% deduction?
Thanks in advance for your followup.
Steve says
I don’t know. And I think we need to see some guidance from IRS on this. But I thinking we’re going to see new K-1 codes for S corps and partnerships which indicate what the qualified business income and the W-2 wages are for the pass-through entity. If you’re familiar with how the Sec. 199 DPAD stuff appears on a K-1, I’m thinking something like that.
The general theory, I think, is that ordinary income and deductions from a pass-through entity get combined to create the qualified business income… the value against which the 23% is applied.
Justice says
This is a little off topic, but I have read that the Senate bill closes the S corp SE tax “loophole,” ie, both S corp wages and distributions would be subject to SE tax. Is this your understanding, and what if anything would you recommend to prepare for it?
Steve says
I don’t think so. The house bill, after some initial confusion, definitely does not close the loophole. And I don’t see anything in the senate bill that proposes taxing income the house has already pretty explicitly decided not to tax.
Fingers crossed on this one, but I don’t think you need to worry about this.
Jeffery Campbell says
“any trade or business that relies on the “reputation or skill of one or more employees.”
Seriously? Why don’t you just say that you can’t use this?
WIlliam Humphrey says
What is the possible policy reason for Subsection (f)(1)(B) of Section 199A which would exclude trusts and estates from the Qualified Business Income Deduction? Most if not all successful, multi-generational, family businesses likely have some form of irrevocable trust as a shareholder.
Steve says
Good question… and one I don’t have a good answer for. (Sort of seems like one thing we voters and citizens lose when legislation speeds through Congress is discussion of why stuff is in the law, what people are thinking, etc.)
BTW, above is not a criticism of the party driving this piece of legislation. Both major parties seem to do this sometimes.
David Ann Arbor says
Thanks for this write up.
Dan WI says
How would real estate investors get the deduction if limited to trade or business income? My understanding is that rentals are not trades or businesses. Are you referring to self-rental arrangements or Real Estate Professionals?.
Steve says
Good question Dan. So you’re right (as you know)… real estate rentals aren’t typically considered a trade or business by tax law.
The proposed Sec. 199A however doesn’t take this approach and instead treats rental income as qualified business income thereby making it eligible for the Sec. 199A deduction.
Steve two, or too says
Where do you find this in the law?
I’ve just read the final Sec 199A and have the sick feeling that a two person partnership holding one commercial building with three tenants would not get the deduction since their activities do not rise to the standard of a Qualified Trade or Business. All they do is collect rent, pay taxes and insurance and make repairs.
I hope you’re right.
Also, Schedule E page 1 owners might also have to cross the QTorB bar.
Steve says
I think the answer to your question comes in the first paragraphs of Sec. 199A:
‘‘(a) IN GENERAL.—In the case of a taxpayer other than a corporation, there shall be allowed as a deduction for any taxable year an amount equal to the sum of—
‘‘(1) the lesser of—
‘‘(A) the combined qualified business income amount of the taxpayer, or
‘‘(B) an amount equal to 20 percent of the excess (if any) of—
‘‘(i) the taxable income of the taxpayer for the taxable year, over
‘‘(ii) the sum of any net capital gain (as defined in section 1(h)), plus the aggregate amount of the qualified cooperative dividends, of the taxpayer for the taxable year, plus
If you then dig down and look at definitions for qualified business income, you get to language that says any trade or business (excepting specified service businesses) counts…
This Tax Advisor article talks about the (legitimate) issue you raise:
https://www.thetaxadviser.com/issues/2013/may/clinic-may2013-story-09.html
But at this point, I think you’re okay.
Steve two, or too says
First thanks for your information. However, it seems to work against you. (Really, I’m not trying to be dick. Feel free to delete this response.”
The Tax Adviser article:
“Implications and Observations
Real estate owners whose properties are profitable must determine whether the income is derived from a nonpassive activity and, if so, whether their activities rise to the level of a trade or business. Only where both conditions are met may the income be outside the scope of the 3.8% tax. A taxpayer owning a building that is triple net leased to long-term tenants might not be able to substantiate an exemption from the net investment income tax on this income stream or on any gain from a sale of the property subject to the triple net lease. On the other hand, a taxpayer significantly involved in the real estate activities may, with proper tax planning and documentation, be able to avoid the 3.8% tax.
The proposed regulations under Sec. 1411 do not provide a definition of “trade or business” for purposes of taxpayers engaged in rental real estate activities and thus potentially subject to the tax on net investment income on income from these activities…..
[Big snip here because I don’t know how much we can copy and paste from Tax Advisor without violating fair use…]
I am uncomfortable with this part of your article: “More specifically, this means your qualified business income includes the bottom-line profits from an active trade or business as shown on . . . the rental income shown on a Schedule E form and in boxes 2 and 3 of a partnership or S corporation K-1,”
I think we have a problem for Sch E p. 1 owners and other owners that even through pass-through partnership entities do little more than collect rent, pay taxes and insurance and have repairs made.
Again, thanks for your response. Have a good holiday!
Steve says
Steve two, I think you raise an important issue. And we all benefit from a robust discussion of the issues. No kidding, thank you for your comments.
But I think you’re going to be okay. Congress appears to have designed this section to give un-incorporated taxpayers a break since they gave C corporations a break. And I think you’ll get a 20% deduction on the rental income shown on your Schedule E.
But you know what? We should all be alert to any guidance the IRS gives us over the next year. It could be, that in the end, I’m wrong in my reading of the law.
Jerry Lucke says
Two things:
I assume Sch F Farmers may qualify for 23% treatment as well, and
Am thinking 1099Patr amounts will use box prev used for DPAD to calculate a 23% pass through deduction; Suggestion is 1099Patr is similar to k-1??
Thanks for your analysis
Steve says
I think that’s right.
LR says
Steve, I am one of 40 S corp shareholders.in a consulting business. Our K1 incomes range from $250,000 to $1,000,000 per owner. We all file married. Does this mean some of our shareholders will get the Sec 199A deduction and others won’t? Or does the provision consider the income for the firm as a whole? Wages may exceed the numbers above, Thanks!
Steve says
Any single shareholder with taxable income of less than $250,000 will get to use the Sec. 199A deduction. Similarly any married taxpayer filing a joint return with taxable income of less than $500,000 will get to use the Sec. 199A deduction.
Phase-out rules apply when a single taxpayer’s income falls between $250K and $300K and when a married taxpayer’s income falls between $500K and $600K.
And above $300K and $600K, taxpayer (or taxpayers) lose the deduction.
Summarizing situation: Some, maybe many, of the shareholders will be able to take the Sec. 199A deduction. 🙂
Mike says
Thank you for the explanation.
Does the deduction get applied after determining taxable income? Otherwise wouldn’t the calculation be circular?
Steve says
It’s not circular… the Sec. 199A deduction doesn’t count in the taxable income number used in the calculations.
Mike says
Will this deduction require that a taxpayer itemize deductions? With the new limits on deduction of state taxes and mortgage interest, some taxpayers may benefit more from taking the increased standard deduction. I’m wondering if the Sec. 199A deduction is taken that way or can a taxpayer that uses the standard deduction take the Sec., 199A deduction as well?
Mike says
Never mind. Found the answer in the conference committee joint explanatory statement. The deduction is not applied in determining AGI but is a deduction from taxable income and is available to itemizers and non-itemizers.
Steve says
You found your answer. And I agree. Statute very clear on this aspect of new law.
J. Feldman says
O.K. —- I have one that will really stump everyone…
A retired couple holding about a dozen Limited partnership interests. This is all passive income, could never have been set up as a tax dodge, and “should” be eligible for the full 199A deduction. Total income (remember there are 12 infome sources here) comes to an AGI of $750K.
Two problems, $750K is over the threshold for 199A, and therefore the deduction is not applicable. Also, the partnerships are old (1960’s), inherited (with no trace of the form 706 for inheritance taxes) and therefore there is NO WAY to find an unadusted basis (only 10-15 years of docs exist) by computing backwards. The partnership assets, when sold, have to be sold at “zero basis”.
Some partnerships yield $5K a year in income to the couple, some are as high as $175K/year. Even if unadjusted basis was computable, it would cost far more to do so than any deduction will yield.
So, by trying to rein in abuse, Congress takes about the most passive, pass-through income possible and does not allow any favorable treatment. Ironically, if tax for the couple could be calculated for each entity (they are all separate entities), tax would be discounted.
Steve says
The situation may not be as bleak as you worry. Starting next year, the partnership K-1s should provide both the W-2 information and unadjusted depreciable assets information needed to make the “limitation” calculations. That may give you some Sec. 199A deduction. (E.g., for wages paid by or allocated to the partnerships or for capital improvements made to the properties.)
BTW, it sounds like the partnerships didn’t do Sec. 754 adjustments at the death of the original partners… but that would possibly help in a situation like this… obviously. Also, your situation shows the future importance of doing good (or better) accounting.
Carl says
I seem to have missed something. You indicate a phaseout applies between 315 and 415k for the specified service trade or business disqualification, but I do not see a discussion of HOW the phaseout is calculated. Say taxable is 365k and Sch c is 400k – how much, if any, deduction would you get?
Steve says
For the precise math, you want to refer to the statute.
But if you’re half way, or 50%, through the phase-out range, you lose 50% of the qualified business income in your Sec. 199A deduction.
Mourad Kattan says
This is the most informative article I have seen on the small business tax deduction, thank you.
Do you think a software training company (offers group classes for MS Office, Adobe etc) with a lot of employees and over 400k of income would qualify for the deduction?
Steve says
Yes, I think it will. You’re not a specified service business. So you just need to look at your taxable income to see if maybe the W-2 wages limitation applies…
Mourad Kattan says
thanks steve, So let’s say it’s 400k of income, and wages are 500k, I’d get an 80k deduction for the pass through deduction?
Steve says
Yes, potentially if you don’t get hit with limitations or qualifications…
Justin says
Hey Steve,
I’m kind of confused after reading some comments regarding pass-through income from professional services. Lets say I am the sole owner/employee of an S corp and the company makes 180K from consulting services. I pay myself 80K for my services. The 20% deduction will be applied to my compensation or distribution?
Steve says
Your wages don’t count. Basically, only the business income shown on your K-1.
Jessica says
I’ve referred to this article several times over the course of the legislative process, thanks for the write up!
This may be a “dumb” question.
Why is everyone up in arms that Senators and the President will benefit from the deduction? I would assume most of them are well above $315,000 in income and therefore would be phased out. What am I missing?
Steve says
Great question! But note that if they have pass-thru entities with W-2 wages or depreciable property AND are not earning the pass-thru income in a disqualified service business, they will get the Sec. 199A deduction too.
Lois B. says
Can you expand on this further? Here’s my understanding: Hypothetically, let’s say an LLC, made up of commercial real estate, shows $1,000,000 net profit, have $0 W2 wages but $10,000,000 in depreciable property. If the members of the LLC are other LLC/Partnerships, then does that LLC get to take a deduction on it’s partnership return before passing down to its’ members? Or does it keep passing through the until the owner of the final LLC is actually an individual?
Regarding Trump and the above question. So, the key for Trump is having personal W2 income less than $315,000, correct? (only looking at Line 7 on the 1040) So like above, if he has, say $1,000,000 on line 17 and those entities have say $10,000,000 in Depreciable property, he could take a $250,000 deduction (2.5% of $10,000,000), correct? Other than the 2.5% depreciable assets total, what would be his other limitations assuming his entities pay $0 W2 wages? If he has schedule C income from a disqualified business, that won’t effect his 199A deduction, correct?
Steve says
Good quesions Lois, good questions…
Regarding your first question, the Sec. 199A deduction appears on an individual’s 1040 return… so what’s going to happen is the information required for the deduction calculation needs to appear on the partnership K-1 that goes to owners so they can “do the calculations” on their return. BTW, this extra accounting will be one thing that people who prepare the entity returns really need to get right.
Second, the taxable-income-based limitations don’t prevent someone from using Sec. 199A. E.g., some billionaire. The limitations only mean (a) that she or he can’t use the deduction for qualified business income from a specified service trade or business and (b) that she or he will need either W-2 wages or depreciable property to support the deduction on the other “non-specified-service” qualified business income on her or his return.
Jeff says
I’m trying to understand how the 315,000 married limit applies. Let’s say I make 125,000 in taxable income and my wife owns a service based LLC with a gross income of 325,000. However, she pays 150,000 of that in 1099s to subcontactors leaving her 175,000 on taxable income. Does the 315,000 limit apply to my 125,000 plus her 300,000 or my 125,000 plus her 175,000? If it’s the combines 300,000 is the 20% deduction calculated from her 325,000 gross or 175,000 net? Thanks in advance!
Steve says
If your taxable income equals $125,000 and your wife’s taxable income equals $175,000, your joint return shows $300,000 taxable… that means you’re under the $315,000 and so don’t have the limitations or disqualification impact you.
BTW, if you earn $125,000 in a W-2 job and your wife generates $175,000 in taxable profit in something like a Schedule C sole proprietorship, your taxable isn’t $300,000. You will have at least the new $24,000 standard deduction.
Also, you get the 20% on the just the pass-thru income… so maybe her $175,000 from sole proprietorship.
Barry says
So, I’m totally confused. I am a sole practitioner attorney. I am married. My wife doesn’t work. My net income on my Schedule C is less than $200,000. I have income from a family trust of about $20,000 a year and social security of about $31,000. I have a mandatory distribution from my 401k which I put back into it. Do I get a 199A deduction or not? And if so, how is it calculated.
Steve says
Barry, this other post will give you better details on the calculations:
https://evergreensmallbusiness.com/pass-thru-income-deduction-dozen-things-every-business-owner-must-know/
But assuming your 401(k) transactions basically “zero out” or are “sheltered” by your personal deductions, you’ll get a Sec. 199A deduction equal to about $40K as long as your taxable income equals at least $200k.
Sam says
Thanks SO MUCH for this easy-to-read write up….
I’m confused on where the 199A deduction is made.
Some questions based on a practical scenario:
S-Corp business with one member (owner)
Pays payroll to member/owner of $100k on W-2
K-1 income is $75k
Final taxable income on owner’s personal 1040 (line 43) $135k
Assuming the S-Corp is not disqualified by the type if service business (or if this matters based on this income scenario) — what income line is the 199A deduction made?
Steve says
Deduction equals 20% of that $75K… probably.
TacyRay says
We’re selling our retail shop next year. Net proceeds, after broker fees, are expected to be $600k. Since the sale will take place early March or so, total wages for 2018 will only be about $75k.
We are a two person S corp, my husband and I own equal shares. We will file married jointly. How much will we be able to deduct on sec 199A, if any?
Steve says
So your $600K of proceeds will be partly capital gain (probably) and partly (possibly only a little bit) ordinary income. Remember or note that you can only use the Sec. 199A deduction to shelter ordinary income.
In any case, because your taxable income exceeds the $415K threshold, you’ll need W-2 wages to support your Sec. 199A deduction. And your Sec. 199A will basically be lesser of either 20% of your qualified business income (again, this doesn’t include the capital gains) or 50% of your W-2 wages.
TacyRay says
Thank you! I am trying to find a way to put as much of it into a retirement fund as possible. Can I open a solo 401k after the sale of the business assets, since I technically won’t have any employees after the sale? Or does having employees earlier that year count? I’ve looked it up and can’t find anything online regarding this. Rules for previous employees when you have a simple or SEP IRA are very clearly spelled out. Not so with Solo 401ks.
KJ says
Steve,
This is the most helpful Q&A I have seen anywhere on this topic and it’s very timely given the year-end planning. Thank you so much. I’m sure you have given this answer many times already but I’m still not 100% certain, so here goes:
First question: I have a consulting business LLC with no employees and I’m married filing jointly. Let’s say my K1 income is $300,000 for 2018 and that’s 100% of our family income. Do I get the Sec. 199A deduction on the full $300,000 or is my personal service/consulting business K1 income disqualified even below the $315,000 threshold?
Second question: if my consulting business qualifies for the Sec. 199A deduction (in Question 1) and I establish an S corp next year and pay myself $125,000 in W2 wages to lower the FICA burden, and the balance ($175,000) in distributions, then to what portion will the Sec. 199A apply? The full $300,000, $175,000 or $125,000?
Thanks again,
KJ
Steve says
In your first example, you get the Sec. 199A deduction on the lesser of the $300K or your family’s taxable income (less any capital gains in that income) as long as your family’s taxable income is less than $315K.
In your second example, you get the Sec. 199A deduction on the $175K of K-1 income. But it probably still makes sense to operate as an S corporation because you’re not losing the Sec. 199A deduction on the full $125K but only the part that’s left over after your deductions… further, with the S corporation you save FICA and medicare on the $175K.
You probably want to have a local tax accountant help you with the math to get this right… Just an idea.
KJ says
Thanks, Steve. Very helpful. One more follow-up question.
I assumed that if my LLC taxable income became more than $315,000 then I get the full 20% deduction up to $315,000 and then phased out up to $415,000. So my question is if taxable income is $500,000 then do I still get the 20% deductions above but not any deductions for the overage? It’s not zero deduction just because I’m over the threshold, right?
Thanks again.
Steve says
If you’re over $415K and married, you can lose all of the deduction due to a lack of wages… or due to being in a “specified service” trade or business.
Alfred says
Hi Steve
Do you think a Third Party Administration Firm for pensions plan with actuaries not on staff but paid 1099, will be able to utilize that income deductions?
Steve says
I don’t know. Sorry. We really need more guidance from the IRS is order to operate safely here.
What I would worry about with your business model is that it counts as consulting.
Paul H Burgess says
Your article states QBI includes the profit from an active trade or business and then also rental income as long as you operate as a pass-through.
1. What do you mean by “active?” You don’t mean active in the sense of “active vs. passive” income, correct, but rather an operating trade or business?
2. I’m trying to further trying to ascertain where in the law rental income is QBI. I think it is, but can’t get a specific cite to back up the conclusion.
3. In addition, if rentals are QBI, I did not see anything in the law that would require the rentals to be from a “pass-through.”
4. I’m further concluding that the 50% wage limitation does not apply to QBI if the taxable income of the individual is in the $157,500/$315,000 range including the $50/100K phase out provision. Do you have an opinion on that statement?
Nice job!
Steve says
You don’t need a pass-through entity to convert the rental income into pass-thru income. Just as you don’t need to incorporate a sole proprietorship to turn the business income into pass-thru income. (We’ve got a link at bottom of page if you want to grab the law and read through the first paragraphs of Sec. 199A.)
Also once taxable income crosses over the threshold $157,500 or $315,000, the wages and depreciable property limitations absolutely do apply. And by the time you hit $207,500 or $415,000 in taxable income, they may eliminate the Sec. 199A deduction if both values equal 0.
Greg says
I receive 1099’s and have always filed as Sole Proprietor under my SS#. To take advantage of new pass-thru deduction would I need to form an LLC, or okay to file as I have since all my income is 1099?
Steve says
You can get the Sec. 199A deduction without being an LLC or S corporation or partnership.
Greg says
Great. Thank you!
Oola says
Great info but still no concrete answers.
I’m a 20% owner of a service company (LLC) that provides custom software solutions. We’re taxed as an S corp and all owners take an an appropriate W-2 salary.
Let’s assume my W-2 wages are $100000, 1065 income of $500000 and div/inc of $25000.
I think I’d qualify for a 20% deduction of $400000 ($80000) but would be limited to 50% of my W-2, $50000. Sound right?
Steve says
The info in your comment doesn’t really all fit together… E.g., an S corporation doesn’t file a 1065 return… that’s for a partnership.
But based on what you describe, a custom software consulting business, I would guess you fall within “specified service” category and so get disqualified from using the Sec. 199A deduction because you’re over the $207,500 and over the $415,000 threshold.
Oola says
Steve, I was mistaken. K-1… I get a K-1 from the S-Corp.
Anyway, I’m now even more confused. I purposely worded my description to avoid “consulting”. Even with that, it sounds like you think my business would be caught up in the “specified service” exclusion: ‘A business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services’
I’m curious why your response to George’s (Professional Engineering) query would be completely different (is this not consulting)? Would it behoove us to rebrand our business as a professional engineering company?
Steve says
Engineers and architects who work on construction projects in the US get a special break in the new Sec. 199A law. They are treated preferentially…
Jim Brightman, cpa says
Absent further guidance from the IRS, I believe a strong case can be made that the carve out for engineering relates to the field of engineering which includes software engineers. The Sec 199A does not specify that only those who were eligible for DPAD are eligible..
Steve says
I think it won’t apply to software engineers. The exception for engineers and architects seems to me to be “trade-off” for these guys losing their Sec. 199 deduction.
But you are right, we’ll wait to get some guidance.
P.S. Though you’re right, clearly, that Sec. 199A doesn’t reference Sec. 199. (Neither does conference report.) But congress copied language from Sec. 199 for Sec. 199A. And the phrase “engineering and architecture” seems (to me) to look a lot more like a reference to Sec. 199.
Laura Kearney says
I am a digital technology consultant and have my business owned by a single member LLC. My schedule C gross profits are $200,000. My spouse earns $30,000 a year. I’m confused whether or not we will be able to utilize the 20% deduction. Thanks
Steve says
You should be able to use it because your taxable is less than $315K.
Laura Kearney says
Great thanks!
George says
Steve: I am still confused re A199. I will own in 2018 a Professional Engineering business LLC (one member, no employees other than me, no equipment). If total revenue all US is 2.5 Million$, I pay myself 750k$ W-2 income, that would leave 1.75M$ in profit. Can I take 20% deduction of the profit or 350k$ deduction? It would not exceed 50% of W-2 wages paid by LLC. I know you also mentioned total income limits/phaseouts, but would that apply to an Engineering firm?
If one has AGI over 415k$ is the 20 deduction not allowable or does one still get it up to 415k$.
I know AMT could also grab you, but deciding on deferring or taking 800k$ in 2017 vs 2018. Live in HI where tax rate going up by same amount as Fed tax going down, but can deduct on Fed tax the state tax in 2017. If can get unlimited 20% deduction, then better to defer. Need answer quickly!
Steve says
George, so if you’re an engineering firm which has used the old “Domestic production activities deduction”…AKA Sec. 199… yeah, I think you get a $350K deduction. Your business doesn’t fall into the specified service category. You’re not limited by the 50% of W-2 wages thing either. That would be $375K…
So, good news, you save about $140K in taxes with the new Sec. 199A deduction… (You also lost your old Sec. 199 deduction…)
Steve says
George the first answer I gave you is the best I can do. Sorry it’s not clearer. (This law does get complicated.)
But to restate, if you’re an engineer doing US construction work (so like you used to take Sec. 199 deduction on your return) and you pay yourself $750K a year and then earn an additional $1,750,000, you get the lesser of these two calculation results: Either 50% of your $750K in wages…which would be $375K… or 20% of the $1,750,000 from the S corp’s K-1… which would be $350K… You get therefore $350K…
BTW, in your situation with high dollars involved, you really want to get your situation looked at by a local tax accountant. Someone who’s on top of this new law.
Bill says
Steve, I have an easy one. I say that, but here I am having no clue as to the answer.
For round numbers…let’s say I have w2 income of 100,000, 25,000 from a 1099 sole proprietor and my wife makes 60,000 on a W2.
How does the 199A deduction apply? I know my 1099 income usually gets taxed at my tax bracket plus the SE tax.
Steve says
W-2s don’t count as qualified business income. So the Sec. 199A deduction equals 20% of the 1099 contractor profits.
Brian says
If you are an S Corp(sole member/owner) and you pay yourself a W2 and you get your business profits, does it not longer benefit you to pay yourself a w2(other than ss, medicare, etc) if your w2 wage is fairly low compared to your S Corp profits? Could paying yourself a w2 wage that is lower than your profits actually hurt you and give you a lower deduction? Example, say you pay yourself 75k w2 wage and your profits are 400k. Would you have to take the 20% deduction based on your 75k instead of the 400k? So you might as well not pay yourself a w2 anymore???
PS says
Hello Steve, very valuable information on sec 199A.
I do have one question: ( this is assuming the business is a qualified business and the shareholders have income less than the threshholds of 315,000 for MFJ)
So I understand the 20% deduction on qualified business income after reasonable compensation… My question is on the limitation for the 50 % and 25% wage limitation is the limitation based on wages of employees and the shareholders of the company.
So in the case of an S corp with 200,000 net income after wages and wages of 70,000 ( including shareholder wages of 50,000 for two equal shareholders), and no assets, no capital gains or investment income, the calculation is as follows:
20% of net income=$ 40,000
Subject to wage limitations
50% of wage is =$ 35000
So deduction is limited to $ 35,000, correct. We do include shareholder wages for this calculation,correct?
Also, this calculation has to be done for each shareholder, so essentially in each shareholder ‘s case, it will be
Shareholder’s share of 20% of net income=$ 20,000
Subject to wage limitations
Share holder’s share of 50% of wage is =$ 35000 or $ 17,500
So deduction for each equal shareholder is $ 17,500.
Thanks in advance….
Steve says
PS, that’s right. You’ve got it.
Stanton Elseroad says
I’m not sure this paragraph is accurate:
“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 Sec. 199 deduction just mentioned.)”
Are you inferring that service businesses can get the deduction if their taxable income is >$415k by making a S Corp? Or are you inferring nonservice industries need an S Corp?
I interpreted that part of the bill differently. I believe > $415k service industry is excluded and all nonservice businesses are unlimited. https://www.physicianonfire.com/tax-reform-physicians
Steve says
Not sure I understand question, but that $415K tripwire, for married taxpayers, means that you won’t get Sec. 199A deduction for a specified service business… and it means for any other business that either the 50% of W-2 wages or the 25% of W-2 wages plus 2.5% of depreciable property determine your tentative deduction.
Big Question says
Okay, thx for any free awesome advice 😀 Don’t trust the IRS to ask them and business accountant an idiot, but the numbers add up LOL
Spouse has a solo medical practice with 12 employees. S-Corp . Total net is under $315K, I have no income. Pays self $144K on W-2 and S-Corp reported profit is about 100K this year and probably same in 2018 as business is pretty steady. Should she stop paying herself the salary at the end of 2017 ????? to maximize the deduction or ???? THANK YOU
Steve says
You can’t/shouldn’t adjust salary to max Sec. 199A benefit. S corp needs to pay what’s reasonable.
P.S. You’ll get a $20K Sec. 199A deduction per your numbers… that’s pretty dang good.
Big Question says
Okay .. that actually make sense. Thank you sir.
PS says
Thanks a lot , much appreciated!
Fred says
I am trying to determine optimal business structure for new specified service business in 2018. No employees. Deciding between S election or sole proprietor. If I elect S Corp taxation w-2 wages to me 200,000 (though much flexibility here)
Married filing joint
Gross business income 485,000
Expenses 50,000
Net 435,000
Individual defined benefit plan contribution 212,000
Solo 401k contribution (total of employer/ee) 29,000
By my calculations:
QBI S Corp = 435,000 – 200,000 – 212,000 – 29,000 = (6000) form 1120S
NO DEDUCTION
QBI sole proprietor = 435,000 schedule C
Potential deduction 87,000
Would be limited by taxable income but 212,000 + 29,000 deducted on 1040 as adjustment so taxable income including 24,000 standard deduction is 435,000- 212,000-29,000-24,000 = 170,000 so no limitation, thus
DEDUCTION 87,000
Is there something I’m missing?
Steve says
You’re correct, I think. I.e., neither the specified service disqualification or the W-2 wages requirement matters to you… because with your big pension contribution, you push your taxable income below $315K…
Fred says
Seems a strange twist that structuring the same business as an S Corp vs Sole prop would be so disadvantageous, especially when all advice I have received suggested S Corp was the better route in the past (due to lower Self Emloyment tax)..
At the 32% marginal rate that $87,000 would be worth almost $28,000.
Thank you
Rick Leipzig says
Steve,
As tax practitioner, I have been following this SEC 199A and your GREAT web site. As to the Alternative Minimum Tax, another author says:
Q: What about the individual alternative minimum tax? Can you take the 20% of QBI deduction against AMT taxable income?
A: Based on my reading, you certainly can. Section 199A(f)(2) provides that when computing alternative minimum taxable income, you determine qualified business income” without taking into consideration any AMT adjustments or preferences as provided in Sections 55 -59. To me, this simply means that QBI is the same for AMT as it is for regular tax, and thus, the 20% deduction is computed the same way. And since the determination of alternative minimum taxable income starts with taxable income, and the amended Code provides no specific add-back to AMTI for the 20% deduction, I say we’re good to go.
Maybe the AMT issue will have to wait for the IRS interpretation?
Steve says
I think your interpretation (which I think comes from the Tax Geek column in Forbes) makes sense.
The other thing I wonder about–and your comment shows me I need to think about the AMT angle more–is whether we can look at what the 199 did with regard to the Sec. 199 deduction and AMT…
Good question, Rick… good question.
Steve says
If someone has a Schedule C, wouldn’t the net income be consider compensation not subject to 20%
Steve says
No, it’s qualified business income. E.g., if your Schedule C shows $100,000 of profit, that’s qualified business income… and potentially the proprietor gets a 20% of $100,000, or $20,000, Sec. 199A deduction.
What you may be thinking of or have heard about are S corps and partnerships. S corps don’t count wages paid to shareholder-employees in qualified business income. And partnerships don’t count guaranteed payments paid to partners in qualified business income.
Lori says
Thanks for the info Steve! Please clarify one thing for me. A married farmer, filing jointly, has a net income of $200,000. He has gross income from his grain sale to the local farmer’s coop, of which he is a member, of $850,000. Can he deduct 20% of his grain sale to the coop from his net income? Also, if he had $850,000.00 gross income from his grain sold to an independent elevator, not a coop, would the 20% deduction apply? Thanks!
Steve says
The Sec. 199A deduction tentatively equals 20% of the business income earned (revenues minus expenses). But then there are some rules. One important rule being that the deduction can’t be more than 20% of your taxable income. If your taxable income equals $200K, for example, the deduction can’t exceed 20% of your taxable income. In general.
BTW, there are special rules for qualified agricultural cooperatives so if the local farmer’s coop falls into that classification, things work a little differently.
But I think you need to think about it being 20% of the net income (the profit) and not 20% of the gross revenue.
Melissa Rawsky says
Great info above!
Question regarding what may be a gray area on what constitutes a service biz that won’t qualify for the deduction once they start hitting phase-out levels…
Say someone has a dance school S-corp, sole shareholder, and has been renting space for that activity.
My assumption #1: This is a service biz where the rep is based on the owner/dancers, and will eventually phase out.
The owner decides to start an event center biz in a building where they will rent out space for business meetings, artists, etc., and also events like weddings. The dance school’s activity will be moving to this new space.
My assumption #2: If the owner puts all of this under one S-corp, it will be subject to the phase-out because of the dance school activity.
My question #1: Is the activity at the new building a qualified biz that will NOT be phased out of the 20% QBI deduction? The new owner is not an event planner, but will be involved in determining how the space is used and may plan some special events there. There may be an event planner hired eventually, but I think for the most part it is outside planners choosing to bring their events there who coordinate things.
My question #2: If the answer to #1 is yes, then does it make sense to have the new biz be a separate S-corp, and qualify for full QBI deduction, and have the dance school “rent” its space from the event center, as it will NOT qualify for full QBI if exceeding the threshold?
Thanks so much!
Steve says
I think the dance school doesn’t fall into the specified service business… A dancer? Yup, that could get disqualified… but a dance school? I don’t think so (based on the conference report.)
This answer, I think, means you don’t need to worry about the “specified service business” disqualification at all.
P.S. If you did need to worry, I assume the new statute’s regulations will eventually look like those that supported a similar deduction, Sec. 199. With that deduction, the taxpayer needed to break down the income and deductions so as to calculate profits where the deduction applied and when it didn’t.
J Williams says
I am confused about the application of Sec 199A to rent income. The 20% exlcusion applies to real estate investors. Is this any real esate investor or does the investor need to qualify as a real estate professional as defined in Sec 469?
The examples on page #19 of your manual would lead me to believe that any real estate investment would qualify. In otther words, does rental income qualify as trade or business income
Steve says
I believe any real estate investor will get to use the Sec. 199A deduction.
Kathleen Pender did a great overview of this for the San Francisco Chronicle (and quoted me a handful of times) here:
https://www.sfchronicle.com/business/networth/article/How-real-estate-investors-can-cash-in-under-new-12491965.php
You might find this interesting.
Mark Murphy says
I have a fairly large partnership of which all four partners make over $415,000. (The four partners all make ~ $500,000). The entity has payroll in excess of $1,oo0,000, however they use employee leasing/professional employer organization. The employees are really their employees, yet I’m concerned the wages may not count since paid by PEOand not directly under our EIN. Any guidance on W-2 wages being allowed when employee leasing situation?
Steve says
Not yet… but look at Sec. 199 and its treatment of wages. I think that’ll show you how this will also work.
Jim Hamilton says
Good question. I spoke with the Vice President of Federal Government affairs at NAPEO regarding the W-2 wages and Sect 199a treatment for PEO clients. He told me that the law language does not specify that only the wage paying EIN as the party eligible for the deduction. He does not believe that was the intention and that company wages paid, even via a PEO or staffing arrangement could be used for the deduction calculation. A position paper is due on this next week and we will post news about this on our website staffmarket.com once the position paper is released.
Steve says
That makes sense. I am not surprised. (This approach matches what Sec.199 (the old “domestic production activities deduction” law) did.)
A. Christensen says
If I am a partner in a partnership and my share of Qualified Business Income is $25,000 and I am entitled to a Sec. 199A deduction of $5,000 would my basis in my partnership interest still increase by $25,000 or would it only increase by $20,000?
Thank you.
Steve says
The deduction appears on your 1040 return and not on the partnership return. So it doesn’t reduce your partnership distributive share, doesn’t reduce your partnership capital account, and doesn’t reduce your basis in the partnership.
Another way to say the same thing: This isn’t a business or production of income deduction like “rent” or “supplies expense.” This deduction is really just the way Congress says, “hey, pass-thru business owner? You don’t have to pay income taxes on that last 20% (roughly) of income.”
Jason Leher says
I am an S Corp I take a decent salary 60K and my signifigant other 20K plus about 60K in rental Income annually meaning rental on equipment personally owned leased to corp. then year end profits could be 100-350k. will the new tax bill on corporate tax reduction and pass through income actually help us? after corporate deductiosn, section 179 and depreciations, taxable totals including salary will be about 400K for my wife and I.
To me looks like we get lwft behind on any breaks.
Steve says
To make the math more straightforward, say your taxable income actually equals exactly $415K (so not very different from your example but through the phase-out range).
At that taxable income level (and we need to assume the $415K doesn’t include any capital gains), your business can’t be a specified service trade or business (so not a law firm or accounting firm, not a doctor’s clinic, etc)… and as long as that’s true, you tentatively get a deduction equal to 20% of your qualified business income (so amounts shown on Schedule E and Schedule E page 2… but not amounts on your W-2s)
However this complexity… whatever that “tentative amount is? It can’t be more than the greater of:
50% of your W-2 wages inside the S corporation and other business interests
or
25% of your W-2 wages plus 2.5% of your depreciable property’s original basis
Jonathan says
Hi, Steve. I love your Q&A on this website. I have left/sent a couple voicemails/emails to you directly (and with Matt) about setting up a call to potentially engage your firm to provide me accounting/consulting services. I have not gotten any response to those messages. If you are potentially accepting new clients I would appreciate it if you would respond or let me know you are not. Thanks.
Steve says
Hi Jonathan, gosh, sorry, please feel free to try again. We had a serious mail server issue which just rippled through our workflow over the last week and a half. But we’d be delighted to talk with you. Here’s Matt’s number: 425-881-7350.
P.S. Matt is the right person to start with. His day begins 9am pacific time.
Jonathan says
OK. I left Matt a voice mail message last week without a response. If you could let him know I plan to call tomorrow at 9 AM and to check his Ringcentral voicemail if we do not connect at that time I’d appreciate it. Thanks.
Jonathan says
Steve, I left another message for Matt. Please have him call me or email me (you have my email since your form requires it even though it is not listed in this message). Thanks.
Cathy says
Thanks all for the education. Opinion on family limited partnership providing me $65,000 K-1 income (Box 2 Net Rental Real Estate Income)? 1970’s my father acquired fractional shares in California LPs which each own a commercial rental property. He is deceased. Five years ago my mother transferred limited partner shares in four of the LPs to an Ohio family limited partnership with her as General and me and my siblings as Limited. Sibling’s activity is passive with no management of the underlying real estate LPs nor the holding family LP. The family LP receives K-1s from the underlying LPs and provides K-1 for my portion. My total income does not meet any caps mentioned herein. (1) Does this apply with the deduction passed through both entities to my K-1 and Federal taxable amount? (2) Is there anything I should be aware to request from accountants who do the K-1s at either level in order to have the Sec 1099A deduction? Accountant on few original LPs is elderly but still does K-1 in tax season as extra income so might not be up on this. As a limited, typically not in contact with either partnership accounting tax process. Any request I should make to General Partners? (3) My mother retains a couple of the 1970s LPs. One currently selling the underling commercial rental property. Does this in any way relate to the payout she will receive when that LP ends?
Steve says
You raise a number of issues in your comment–more than one of which requires a long answer. But here’s the quick answer you want or need most: You should get the Sec. 199A deduction on the pass-thru net rental income.
BTW, the elderly accountant does need, potentially, to do more work on the partnership returns that kick out the K-1s. But that’s his responsibility and the partnership’s responsibility… not yours (unless you’re the tax matters partner). If you think he can’t handle the returns, you should broach subject with him.
Ranbir K. Sharma says
Hi Steve, I am not sure if someone has asked this question. I am 100% owner of a private physician’s office which is structured as a PLLC and is an S-Corp. As I understand it, section 199A potentially disqualifies me to take the 20% deduction from the PLLC. I am confused because from the discussion above it seems that the “potential disqualification” will not apply if my taxable income for a married couple is less than $315 K ? or is it $500K? Please clarify my misunderstanding. Any input will be appreciated,
Ranbir
Steve says
You want to look at the blog post on how the phase-out calculations work. I think you’re using numbers from one of the “draft” versions of the bill.
Here’s link to that post: Sec. 199A Deduction phase-out calculations
Jay says
Hi Steve,
I’m a little confused about the rules of the wages not being allowed to be added back to business income. Say I am a sole proprietor that makes 100k a year. I pull out 100k as distributions to myself. From your article it sounds like I would be allowed a deduction of 20% or 20,000 on my personal return.
Now say the business were formed as an S-Corporation and made the same profit of 100k before paying the owner/officer salary of 100k. The net profit of the business would be zero after paying the officer salary and the shareholder would not be allowed a deduction.
As you can see the only thing that changed was the structure of the company. It would make sense to me that if Officer salaries have to be added back, so do distributions from sole proprietors.
Steve says
Officer wages aren’t added back. The law is very specific.
Pass-thru entities need to understand the law’s mechanics and then look at any opportunities available for optimizing.
You might find this related post helpful: https://evergreensmallbusiness.com/s-corporation-shareholder-salaries-sec-199a-deduction/
Dani says
I have operated as a sole proprietor for 5 years, but was advised last year prior to the passage of the tax law to convert to an LLC electing s-corp taxation. My 1099 income as a CRNA has been around 225K yearly. I’m married filing jointly with no income from my spouse, though I do have about 15K W-2 income from the Army Reserves. My question is whether it benefits me at this point to elect S-corp taxation or maintain my tax status as a sole proprietor. I’ve tried to consult local tax advisors but nobody will meet with me until after tax season and it will be too late to make a change in tax election by that point. A reasonable salary for my profession wouldn’t be less than 120K. Would I generally see a greater tax savings at this point as an s-corp, or with the new pass-thru deduction, would it be a wash if I can take the deduction on my entire income?
Steve says
Determining whether an S corporation makes sense or not in light of the new Sec. 199A requires more info that you provide in your comment. But see if these comments help you…
First, you can make a late S election. So probably you should get help from a professional after tax season. Make sure the CPA knows both S corp tax law and Sec. 199A. BTW more info here: S election timing.
Second, in general you save more money by using S corp when you save FICA. We’ve got a blog post here that explains: S corporation shareholder salaries and Sec. 199A deduction. Also, we have a lot of information on this issue in our S corporation salaries monograph.
Third, you may want to rethink or get some help thinking more about your reasonable salary number. I can believe $120K is good number. But it may also be high. Check out this blog post that discusses S corporation salary safe harbors including billionaire Warren Buffet’s $100,000 salary.
Fourth, remember or note that the Sec. 199A deduction equals the lesser of your pass-thru income or your taxable income. Accordingly, you won’t get the 20% deduction on your entire income. In effect, this means that S corp wages you shelter with pension contributions, itemized deductions, self-employed health insurance and so on don’t reduce your Sec. 199A deduction.
Dani says
Steve, thank you for your reply. This was helpful.