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The Tax Cuts and Jobs Act introduced the 199A deduction in 2018. Taxpayers earning domestic income from a trade or business operating as sole proprietorships, partnerships, S corporations, or LLCs may be eligible for this deduction. This 20% deduction against qualified business income will be effective until the end of 2025 unless extended by Congress. While it is attractive, 199A has complex requirements. Here’s an overview of this new tax provision and how it may benefit you.
What is the 199A Deduction?
QBI refers to the U.S. income of the business excluding investment income from:
- Dividends and any dividend income equivalent
- Interest income not allocable to the business
- Capital gains and losses
For a sole proprietor, the qualified business income (QBI) refers to the profit or loss from the business as reported on Schedule C of Form 1040.
What does "Pass-Through Entities" refer to?
Pass-Through Entities refer to S corporations, LLCs, sole proprietorships, and partnerships where the tax is imposed on the personal tax return of the owner and not on the business. In other words, the income "passes through" the business and falls on the individual.
How do I know if my business is a pass-through entity?
If you are not paying income tax for your business by filing a separate Corporate Tax Return (Form 1120) but you are declaring income from all sources including that business in your personal tax return (on Schedule C of Form 1040), your business is a pass-through entity.
Where does the name "199A" come from?
This deduction comes from Section 199A of the Tax Cuts and Jobs act, hence the name. It is also referred to as the 20% Qualified Business Income (QBI) of Pass-Through Entities since it applies to businesses where income is taxed on the personal tax return of the owner or the partner.
Who needs to know about this deduction? Who can take this deduction?
The 199A deduction is applicable to those who are earning income from a pass-through business but has exceptions. The amount of the deduction will also depend on certain thresholds. If you are at or below a taxable income of $315,000 (for joint filers) and $157,500 (for single filers), any type of pass-through business can take the full deduction. Above this income threshold, the deduction is based on whether you are a specified service trade or businesses (SSTB) or not.
The law designates certain trades or businesses as SSTBs including the following:
- Actuarial sciences
- Financial services
- Investment management
- Any other business or trade whose primary asset is reliant on the skill or reputation of the company’s employees
When the taxable income is between $315,000 to $415,000 (for joint filers) and $157,500 to $207,500 (for single filers), SSTBs and non-SSTBs can still get the deduction with limitations.
Above the $415,000 / $207,500 thresholds, SSTBs are not allowed to apply the 199A deduction. Meanwhile, non-SSTBS will compute the deduction subject to the limit imposed by wages paid by the business and/or the property owned.
Anyone performing services as an employee is disqualified from taking this deduction.
Why should you care?
The 199A deduction provides significant tax savings. With the 20% deduction, a taxpayer on the top bracket paying 37% will only pay taxes based on 80% of their QBI. This decreases the effective tax rate to 29.6%.
How does it work?
Anyone who owns or is a partner in a pass-through business, you may qualify for the 199A deduction. Here is a flow chart to help you determine how 199A works.
How can you maximize your 199A deduction?
1. Keep your income under the threshold. Below the $315,000 threshold for joint filers and $157,500 threshold for other taxpayers, the deduction is less restrictive. The nature of your business will not matter either. If your income goes over the limit, consider accelerating deductions, deferring income, or making additional contributions to your retirement plans including IRAs, 401(k)s, and defined-benefit plans.
2. Make changes to owner wages. You can’t get a 199A deduction on your income from compensation. To maximize QBI and get a larger 199A deduction, you can decrease the compensation you receive as long as the amount is still reasonable compensation.
Take note that this compensation will be considered under the W-2 limitation.
3. Shift money from guaranteed payments to income. Avoid guaranteed payments to partners since this will not increase the wage limitation computation or the QBI. A better way to enjoy benefits under the 199A deduction is to opt for priority allocation of profits.
Doing this can be tedious as the partners have to renegotiate an allocation with substantial economic effect. They need to amend the partnership agreement.
4. Invest in REITs. Income from qualified REITs and Publicly Traded Partnerships (PTPs) are not subject to the SSTB limitation or a W-2 limitation. These income sources are eligible for a 20 percent deduction. The only component to consider is the overall limit based on the taxable income over net capital gains.
How can you “structure” to avoid personal service business designation?
Due to the explicit disqualification of businesses engaged in providing personal services, many taxpayers are looking for ways to be eligible for the deduction.
There is a de minimis exception for SSTB. This exception sets a minimum threshold for businesses to escape the SSTB designation in any of the following circumstances:
- Gross receipts from SSTB is 10% or less if total gross receipts is $25 million or less, or
- Gross receipts from SSTB is 5% or less if total gross receipts is more than $25 million
Taxpayers looking to infuse qualified business into a disqualified business have to meet the requirements above to get the 20% deduction under 199A.
Another approach is to create a separate entity which provides business and administrative support to a disqualified business.
Forming a new LLC to provide alternative services to the business is safer. For instance, if an LLC leases a building to the business, that LLC can qualify for 199A deduction provided that rental payments are at a justifiable rate.
Main Takeaways About the 199A Deduction
- For SSTBs the best way to enjoy the 199A deduction is to keep taxable income below the threshold.
- Under the new tax law, no entity is penalized but many businesses may be disqualified from taking the 199A deduction.
- Businesses other than SSTBs should consider strategies to increase W-2 wages if their income is above the threshold.
- Plan strategies on how to increase or decrease QBI depending on your income level.
Plan with Caution: Beware of Anti-Abuse Rules
The 199A deduction is a new tax item which is open to interpretation. In fact, the IRS just issued a new regulation to guide taxpayers.
Always keep anti-abuse rules in mind when drafting a tax minimization plan. The IRS and the Treasury have specific rules for employees shifting to independent contractors and for SSTB businesses creating another entity to get the 199A deduction.
At this point, it’s better to consult an expert to have a solid grasp of your options and if the strategies you plan to implement is actionable.
While understanding this deduction provides significant tax savings, remember that 199A is just a single consideration of your tax-planning roadmap. You need to think how the recent changes in the tax law affect you on a macro level. Doing this will help you implement a better strategy to minimize taxes.