Some bad news, I’m afraid. The new Section 199A qualified business income deduction creates a number of danger zones for taxpayers and their tax accountants.
That maybe sounds surprising. The deduction at first blush seems straightforward. Taxpayers simply add a tax deduction to their return equal to 20% of their “qualified business income,” right?
Oh my gosh, if only the deduction worked that way.
In this long-ish blog post, therefore, let me briefly review the complicated new law. And then let me point out the eleven danger zones that taxpayers and accountants need to watch out for.
A note: The information below reflects IRS guidance through January 23, 2019, which means I’m considering the final regulations. (They appeared on January 18, 2019.)
Quick Description of Qualified Business Income Deduction
As just mentioned, the Section 199A “qualified business income” deduction gives taxpayers a deduction equal to 20% of their qualified business income.
Qualified business income includes the income from a sole proprietorship, partnership, S corporation, rental property (when the activity level rises to that of a trade or business), and then also REIT dividends and income from qualified agricultural and horticultural cooperatives.
Qualified business income excludes W-2 wages, investment income like dividends, interest and capital gains, and then the guaranteed payments a partnership pays partners.
Understanding the Taxable Income Limitation
The Section 199A deduction formula limits or even eliminates the final deduction, however, in a number of situations.
First, the actual deduction can’t be more than 20% of the taxable income after subtracting any capital gains or qualified dividends.
Example: If some taxpayer earns $100,000 in a sole proprietorship but calculates $50,000 of taxable income, the deduction equals 20 percent of $50,000 and not 20 percent of $100,000.
Dealing with Specified Service Trades or Businesses
Another wrinkle: High income taxpayers don’t get the deduction on income earned in a “specified service trade or business” if their taxable income exceeds $207,500 as a single taxpayer or $415,000 as a married taxpayer.
The ”specified service trade or business” label (let’s call them “SSTBs” like the regulations do) includes doctors, dentists, lawyers, accountants, consultants, investment advisers, securities and commodities brokers, athletes, performing artists and then any business where the principal asset of the business is the reputation or skill of one or more “celebrity” owners or employees.
Example: A doctor or lawyer earning $1,000,000 as a partner in a professional services firm gets no Section 199A deduction on that income.
Example: The income that LeBron James earns endorsing shoes or that Aaron Rodgers earns appearing in insurance company ads generates no Section 199A deduction because of the “principal asset” thing.
Wage and Property Based Limitations
Furthermore, every single taxpayer with taxable income over those $207,500 and every married taxpayer with taxable income over $415,000 potentially sees their Section 199A deduction limited.
For these high income taxpayers, the Section 199A deduction can’t exceed the greater of either 50% of the W-2 wages the business pays or 25% of the W-2 wages the business plus 2.5% of the original cost of the depreciable property used in the business.
Example: Suppose someone with $2,000,000 of taxable income earns a $1,000,000 in sole proprietorship that requires no depreciable property. The business owner potentially gets a $200,000 Section 199A deduction (20 percent of the $1,000,000 of qualified business income) but only if the business’s wages equal at least $400,000 (because 50 percent of the $400,000 of W-2 wages equals $200,000).
Example: Suppose someone with a large real estate property but no W-2 employees earns $1,000,000 in rental income and also coincidentally shows $1,000,000 in taxable income. This investor potentially gets a $200,000 Section 199A (20 percent of the $1,000,000 of qualified business income) but only if the original basis of the depreciable property equals $8,000,000 (because 2.5 percent of the $8,000,000 of depreciable property equals $200,000.)
Phase-outs Apply to High-income Taxpayers
Another complexity: Single taxpayers with a taxable income falling between $157,500 and $207,500 and married taxpayers with taxable income falling between $315,000 and $415,000 see their Section 199A deductions phased-out (on a sliding scale) if the qualified business income comes from a “specified service trade or business” or the business falls short in terms of wages or depreciable property.
Note that the phase-out from SSTB status gets calculated first… and then after that the phase-out from insufficient wages or property applies. A taxpayer could, for example, lose half their Section 199A deduction due to SSTB status… and then lose half of the half that remains due to lacking W-2 wages or depreciable property.
And Then Things Get Complicated…
The above very brief discussion highlights how the core formulas work.
And if you’re a tax accountant, you can immediately see that the tax software will make these calculations for you if you just get the right numbers input into the software.
I agree with that assessment.
Unfortunately, however, coming up with the right numbers to enter? That’s going to be tougher than most folks realized.
Hidden in the nearly three-hundred pages of regulations, all sorts of little traps and gotchas appear. And those of us who are unwary (or maybe just bleary-eyed at the end of tax season) will trip up.
Let me share the danger zones I already see, therefore. And if you see or know of more, please, please post a comment that adds your insight.
Danger Zone #1: Misclassifying Non-SSTBs as SSTBs
A first trap to stay alert to? As noted, the new law excludes businesses that fall into that “specified service trade or business” or SSTB category.
But what folks need to be alert to? The IRS defines some of these categories narrowly and some of the categories broadly. And three quick examples illustrate this.
First, consider the consultants. Lots of people (software engineers, programmers, independent contractors doing all sorts of project work, and so on) consider themselves consultants. One might assume that these folks, should their incomes rise high enough, get excluded. But probably that won’t be the case. The Section 199A regulations only call someone a “consultant” when she or he provides advice and counsel or when she or he does political lobbying. But then note this too: Even if you don’t consider yourself a consultant, if you’re providing planning or giving advice? Hey, you’re probably an consultant.
A second example: That language about a business becoming an SSTB if the principal asset of the firm is the reputation or skill of an owner? You might assume that applies to any super-successful one-person business. But not true. The “principal asset” test applies only to celebrities when they earn money via endorsements, appearance fees or licensing income.
A third example: Partly due to the “principal asset” thing just mentioned and also partly because of the law’s reference to brokers, many people wondered about real estate brokers and agents as well as insurance brokers and agents. These folks understandably worried these “brokers” and “agents” would lose the Section 199A deduction. However, that didn’t end up being the case. The “principal asset” thing only applies when income comes from celebrity endorsements, appearance fees and brand or image licensing income. And then real estate and insurance brokers and agents get specifically excluded from the SSTB category.
The upshot of all this then? You and I need to be careful we don’t exclude someone from the deduction too quickly. Maybe based on the name of their entity. (“Steve’s consulting business”) Or based on how the taxpayer describes their business. (A realtor who describes herself as an investment adviser because she sells rental properties.)
And this similar mistake: Don’t assume your business or client’s business isn’t an SSTB without checking…
Danger Zone #2: Misclassifying SSTBs as Non-SSTBs
Another trap also connects SSTB classification… That trap? Missing that some business activity is an SSTB and so does not generate a Section 199A deduction.
The rules are pretty clear on this one as briefly mentioned earlier.
So let me share where I’m seeing people confused. People get confused between the job someone does and the products and services the business delivers.
For example, consider the case where someone who is not a physician or who maybe is a physician but who doesn’t work as a physician owns an interest in clinic or hospital. This person might assume because she or he is not a physician or not working as a physician that they get to take the Section 199A deduction.
But that’s not the case. If the business operates in a specified service trade or business, the income from the trade or business potentially gets disqualified.
Example: We had a physician (not a client) call our offices recently. She earned $1,000,000 a year and explained she only provided a few hours of physician-type services a month. Her assumption and hope was she got the deduction. She did not. The $1,000,000 of income flowed from a surgical center.
Danger Zone #3: Including Non-qualified Business Income
Here’s another thing to watch out for–especially when a taxpayer’s bookkeeping and accounting are crude.
Several types of business income don’t count as qualified business income. The wages an S corporation pays to its shareholder-employees, for example, don’t count. Neither do guaranteed payments made to the partners in a partnership.
Note: The above two categories should be easy to spot and exclude.
But section 707(a) payments to a partner for “services rendered to the partnership” also don’t count. (These may be harder to spot.)
And payments made or income earned by someone because some business artificially reclassifies the individual as an independent contractor or partner don’t count either.
Example: Last year, Joe the employee earned $100,000 as an employee. Thinking ahead, Joe and his employer this year treat Joe as an independent contractor earning that same $100,000. The plan is, Joe will get the Section 199A deduction via this reclassification. But the law prohibits this smoke-and-mirrors approach.
Note: In our firm, we’ve tried to expand our entity organizer so clients disclose these “Section 199A” relevant situations.
Danger Zone #4: Counting W-2 Wages for Other than Common-law Employees and Corporate Officers
Another similar sort of bookkeeping problem. Per the regulations, when you do need to look at the W-2 wages a business pays, only wages paid to common-law employees and corporate officers matter.
This means surely that some businesses and their accountants will incorrectly include non-common-law employees–like statutory employees–in their W-2 amounts.
Does this mean the tax accountants will need to look at individual W-2s? Gosh, for some small businesses, I think so… I think so.
Danger Zone #5: Counting Depreciable Property that Firm No Longer Holds or Uses
A simple goof seems very likely when calculating the Section 199A deduction for small firms when the depreciable assets figure into the calculations and yet (unfortunately) the fixed assets records appear sketchy.
The law says fixed assets count for Section 199A deduction purposes through the last full year of depreciation or ten years, whichever lasts longer. Some asset depreciated over five years gets counted for ten years, for example. Some bit of real estate depreciated over 39 years gets counted for 39 years.
But in all these cases, the assets included in the Section 199A calculation still need to be used during the year and available for use at the end of the year. Those two assumptions seem problematic for many small firms who pay little attention to their fixed assets records.
In our practice, for example, we commonly see ten-year-old personal computers listed on fixed assets reports. In the past, we haven’t worried too much about those old fully depreciated assets. Or whether the asset still exists. And who cared in past whether some old asset was actually used and could be used at year-end. But now we will all need to. Yikes.
Danger Zone #6: Failing to Disaggregate Trades or Businesses Combined in a Single Entity
A weird part of the Section 199A deduction? The formula generally looks at individual trades or businesses. And that gets tricky. Especially when an individual entity (like an S corporation or partnership) includes more than one trade or business.
So, how do you spot individual trades or businesses? Well, probably an individual trade or business has its own separate identity. An individual trade or business according to the final regulations needs to maintain separate books and financial records. Ideally, an individual trade or business uses its own employees and (or?) resources.
This all matters for purposes of making the calculations. An S corporation that does a bit of consulting and a bit of manufacturing counts tentatively as two trades or businesses: a consultancy and a manufacturer, for example.
This odd wrinkle will surely get overlooked for many smaller firms. And that error may cause a firm to overstate the Section 199A deduction. A consulting business embedded in a larger multiple-activity entity along with several other trades or businesses, for example, may not produce Section 199A deductions for some owners due to the SSTB rules. Ugh.
The worst part of all this? The typical small businesses books may (without malice or forethought) hide this reality from the tax accountant simply by taking shortcuts in the accounting!
Our thought here? We all need to look more carefully at how the financial records and books are maintained… and then ask lots of questions.
Danger Zone #7: Failing to Aggregate Different Trades or Businesses
Sort of similar to the disaggregation thing, taxpayers and their accountants also want to stay alert to the possibility that in some cases, they may or should aggregate different trades or businesses.
Aggregation may allow a taxpayer to legally “hide” an SSTB that wouldn’t otherwise generate a Section 199A deduction inside another larger non-SSTB entity that does generate a Section 199A deduction.
The new regulations include “de minimis” provisions which say that you may ignore a very insignificant amount of SSTB activity and just combine it with the non-SSTB activity. The “de minimis” thresholds, however, depend on the size of the operation.
Or, another distinct possibility: You might want to combine trades or businesses showing large W-2 wages or depreciable asset book values with other trades or businesses showing small W-2 wages or depreciable asset book values in order to generate Section 199A deductions on all of the combined activities income.
The general rule says that if a set of non-SSTB trades or businesses share common owners and then share resources, customers or a supply chain that you may be able to elect to aggregate the trades or businesses.
Danger Zone #8: Letting Minor SSTB Activity Destroy Deduction for Non-SSTB Activity
A giant malpractice risk to watch out for? Okay this is scary… If an individual trade or business includes both SSTB activity and non-SSTB activity, note that the SSTB activity can cause the trade or business to entirely lose its Section 199A deduction.
For firms with less than $25 million in revenues, for example, having an individual trade or business generate 10 percent or more of its revenue performing a specified service will cause the entire trade or business to be treated as a specified service trade or business. And that classification will cause high-income taxpayers to lose their Section 199A deduction.
Taxpayers and their accountants have an excuse for not avoiding this outcome for 2018. The final regulations which made this Section 199A “cliff” official only appeared in January of 2019.
But going forward into the future, taxpayers and their accountants need to explore whether minor SSTB activity will zero out a firm’s entire Section 199A deduction. When that outcome appears likely, people need to look at the possibility of breaking a single trade or business into multiple trades or businesses.
Danger Zone #9: Missing Reality of Limits Applying at Individual Level
One error of omission will be easy to make at the end of tax season as we’re all trying to finish up the last of the turned-in-late returns. That potential bungle? Not providing adequately granular information on K-1s.
Here’s how this error might creep into a return: One might understandably assume that a small business with modest profits surely doesn’t need to report granular income, W-2 wages or depreciable assets information to owners. This assumption might flow from another assumption. That assumption being that a modest profit operation won’t have its Section 199A limited by the SSTB, W-2 or depreciable property limitations.
A risk exists here, however. What a business and its tax accountant often can’t know is whether one or more of the owners of the modest profits operation enjoys a high taxable income.
A K-1 that shows, say, $10,000 of apparently qualified business income may need to provide rich detail on income, wages and fixed assets as well as SSTB status if it goes to a minority investor with a $1,000,000 of taxable income.
Our firm’s thought here? We need to be quick to extend Section 199A-impacted returns if the bookkeeping is bad and we’re not doing all the pass-through entity owners tax returns.
Danger Zone #10: Ignoring Whether Rental Properties Count as Section 162 Trade or Business
A CPA friend pointed out a danger zone related to the Section 199A deduction whenever the taxpayer holds rental property.
Taxpayers and tax accountants will probably need to always determine whether rental property investments count as a Section 162 trade or business. And this will be true even if that rental property doesn’t currently generate positive qualified business income.
Two reasons explain this requirement.
First, if a rental property does count as a Section 162 trade or business (because the taxpayer shows regularity and continuity in their investing and is motivated by profit) the rental property may impact the current year’s Section 199A calculations by creating negative qualified business income.
Example: A real estate investor owns a rental property that loses $20,000 annually and also a sole proprietorship that earns $80,000 annually. Whether or not the taxpayer’s qualified business income equals $80,000 (just the sole proprietorship’s income) or $60,000 (the sole proprietorship’s profits less the rental property loss) depends on whether or not the real estate investment activity rises to the level of a Section 162 trade or business.
Note: We did a longer post here about this topic: Section 199A Rental Property Trade or Business Definition.
A second reason exists for determining whether or not a rental property investment counts as a Section 162 trade or business: Even if the taxpayer enjoys no other qualified business income, the taxpayer needs to determine any current negative qualified business income so that she or he can carry forward that negative QBI and use it to reduce future positive qualified business income.
Example: A real estate investor loses $5,000 a year for ten years on a rental investment. The taxpayer includes no other qualified business income amounts in his income. In year eleven, the investor begins to earn $10,000 a year of profit and wants to take the Section 199A deduction to dial down the income taxes. That may be correct assuming in year eleven, the taxpayer’s rental property activity rises to the level of a trade or business… but if it does, what about the previous ten years of rental activity? If during those ownership years, the taxpayer’s activity rose to the level of a Section 162 trade or business, the losses from those years presumably create a negative qualified business income carry forward. And that carry forward goes into the current year’s Section 199A calculation.
Danger Zone #11: Banking on the Rental Real Estate Safe Harbor
One other danger zone related to rental property investments: The rental real estate safe harbor. But let me explain.
Simultaneous with the final regulations, the Treasury and IRS issued a safe harbor rule for real estate investors. That sounds good. The safe harbor should have made it possible for people to easily determine whether their real estate investing rises to the level of a trade or business.
On its face, this safe harbor rule works simply. It says a real estate investor gets to consider his or her rental activity a “trade or business” if the owner and his or her team of vendors, employees and helpers spend at least 250 hours a year on specific activities.
But this safe harbor is tricky. Really tricky. It comes with strict eligibility rules and burdensome paperwork requirements. Further, and most disappointingly, it seems to undermine the original qualification rules that allowed rental property investors to take the Section 199A deduction if they simply operated their rental activity with a profit motive and then displayed regularity and continuity in their investing.
Bottomline? The safe harbor rule probably doesn’t really help most small beginning real estate investors. And it spews confusion about the alternative rule discussed in the “Danger Zone #10” discussion. Ugh.
Oh my gosh, Section 199A gets complicated right? This deduction doesn’t work like a mortgage interest or IRA deduction.
Accordingly, three suggestions. First be sure to allow time to deal with all the complexity. You’re probably looking at nearly an extra hour for many 1040s. And the IRS says you’ll take on average nearly an extra three hours for pass-through entities.
Note: The IRS also acknowledges that some pass-through entity tax returns will require an extra 20 hours to deal with Section 199A.
Second, make sure any staff or paraprofessionals who haven’t yet learned at least the basics of Section 199A take some CPE on the new law. Or read something like our monograph.
Finally, this third suggestion: Please bill appropriately for all the extra work and value you and your crew will create by correctly handling the Section 199A deduction. You should save clients thousands in taxes or more. That should allow both your firm and my firm to capture additional billing for this massive extra work Section 199A represents. Or it will as long as we know the law and don’t make too many mistakes.
Other Free Section 199A Resources
We’ve also published and keep up-to-date a number of other Section 199A qualified business income deduction blog posts, too: If you’re learning the law, these can be useful free resources.
Real Estate Broker Section 199A Deductions
Section 199A Trade or Business Concept Deconstructed
Section 199A Rental Property Trade or Business Definition
S Corporation Section 199A Deduction Connection.
Section 199A Changes Investment Portfolio Construction
In your paragraph “understanding the taxable income limitation” , are we missing something? We can’t figure out how you got from 100,000 sole proprietorship income to 50,000 taxable income using the requirement to deduct capital gains and dividends from taxable income in order to compute the limit on the QBI deduction. Was your example not meant to be an example of the capital gain and dividend requirement…or just an example of limiting the QBI deduction to the lesser of 20% QBI or 20% taxable income?
Sorry for lack of clarity. I was just trying to say that having $100,000 of qualified business income doesn’t mean one gets a $20,000 Section 199A deduction… because the taxable income may limit the deduction.
E.g., if someone’s tax return only shows a sole proprietorship making $100,000 a year and then $50,000 of deductions ($15K pension, $10K self-employed health insurance, $25K itemized deductions) so $50,000 of taxable income, the Section 199A deduction equals 20% of $50,000, or $10,000.
And then to your point about taxable income and capital gains, yes you’re of course right, that figures into calculations too. And just the way, I’m sure, you understand.
E.g., if someone has $100K of sole proprietorship income, $20K of capital gains, and $50K of deductions, the Section 199A deduction equals lessor of 20% of the $100K of QBI (so $20K) or 20% of the $50K of “regularly taxed” taxable income. I.e., this example person’s *real* taxable income equals $70K (that’s $100K of sole proprietorship income plus $20K of capital gains less $50K of deductions)… but that doesn’t mean the taxpayer gets a Section 199A deduction equal to 20% of $70K. They only get 20% of the the $50K.
This last subtlety shows how taxpayers can’t use Section 199A to shelter preferentially taxed income.
Is ‘taxable income” considered on a joint basis? In your example, if this was a joint return, and spouse had $50,000 of taxable income, would the 199A deduction still be 20,000?
The relevant taxable income is what shows on the tax return. So, for a married filing joint tax return, you look at the married filing joint income.
I have to strongly disagree that it is ever going to be an advantage to hold REITs in a taxable account, Section 199A or not. The reason is actually quite simple when you stop and think about it. Tax-advantaged accounts Roth or Traditional are equivalent given the same marginal rate on Roth contributions vs the withdrawal taxable rate on the Traditional path. Fairly easy concept to grasp – if you have a low tax rate in retirement the Traditional wins because you have more spendable income. Now most people understand the reason the taxable account loses to both the tax-advantaged accounts is the minute you spend $1 on extra tax from the taxable account that is a drag, SO getting a 20% pass-through means that you are still liable for that “extra” 80% as ordinary income. That is an extra 80% that would not happen if you kept the investment in the tax-deferred or the Roth!
The fact that your tax-deferred REIT income is taxed at 100% ordinary income only gets you to the point of say putting the same investment in a Roth account and paying NO extra tax. So even if your taxable account holds all qualified dividends and you are in the 12% bracket, zero tax on your taxable account dividends is still only EQUAL to the same investment in a Roth or Traditional account and not better. No way for a REIT to win because it is always going to create SOME tax drag. If your tax bracket is zero (or actually anything less than the tax you paid on the REIT investment when you put it in the taxable account) then certainly the Traditional will win.
First, FinancialDave, thanks for taking time to articulate your thoughts. Everybody wins from a healthy debate!
Second, sorry, I’m not sure I understand your comment. So I can’t really respond fully. BTW, we may agree! Nevertheless, what I will say is this: the fact that the last 20% of the income one earns from a REIT held in a taxable account (and probably from REITs held by an mutual fund too) isn’t taxed makes a difference. Even if someone pays the same marginal rates while working as while retired and drawing from retirement accounts, the fact that the marginal rate on REIT income is only 80% of the taxpayer’s marginal rate needs to be considered.
For those you care, we’ve discussed the counter-intuitive nature of Roth-style accounts before. Here’s a starter blog post: Are Roth-IRAs and Roth-401(s)s Really a Good Deal?
Brett Layton, CPA, MST says
Realize your post came before the Blue Book.
What do you think of footnote 125 and the functional examples under Treas. Reg. sec. 1.448–1T(e)(4)(iv)?
I cannot believe the consulting description in the draft Pub 535 instructions. Why focus on political consulting? Of course they use the big word INCLUDING… so they are not excluding anything….
At this stage, I am not paying a TON of attention to the Blue Book. Perhaps naively, I’m hoping final regs deliver clarity on all this stuff soon after new year. The one thing, though, that I think about with regard to “consulting” is all the people who call themselves “consultants” when really they aren’t consultants but independent contractors doing programming or hourly knowledge worker work. I worry now the final regs will call all these people consultants or say they all get scooped up as “principal asset is reputation or skill” situations.
P.S. If I did want to get nervous about the Blue Book, I would probably be grinding my teeth and wringing my hands about the phrase, “complete and separable set of books and records” which appears a couple of times.
P.P.S. I wonder if taxpayers will, due to final regs arriving in 2019, take option to use the friendlier proposed regs.