Section 199A- a key tax break for pass-through business owners

The new section 199A created by the Tax Cuts and Jobs Act allows many pass-through business owners to deduct up to 20% of their qualified business income (QBI).  Section 199A went into effect after December 2017, meaning you can claim it for the first time on your 2018 income tax return (form 1040) regardless of whether you take itemized or standard deductions.  Given this section is both complex and new, maximizing the tax deduction will require careful planning.  

Let‘s get into the detail.

1. Definition:

 Qualified Business Income (QBI)

QBI includes the net domestic business taxable income, gain, deduction, and loss from any qualified trade or business.  It excludes investment-type income such as dividends, interest income, capital gains, guaranteed payments to partner.

Specified Service Trades or Businesses (SSB) :
SSB includes “ a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees” - (source: irs.gov)

2. Section 199A in general:

If you have Qualified Business Income (QBI) from a domestic business other than a C Corporation, you are entitled to deduct the lesser:
a)  Twenty percent (20%) of your QBI, plus 20 percent of your qualified REIT dividends and qualified PTP income, or
b)  20 percent of the taxpayer’s taxable income reduced by net capital gains.

Example 1:

If you are a sole proprietor whose business (not a SSB) earns a net profit  (QBI) of $100,000.  After deducting $40,000 for standard deduction and pre-tax retirement plan, your taxable income is $60,000 ($100,000-$40,000).   You may deduct $12000 ($60,000x20%) under 199A section.
If your wife works and earns $100,000  from W-2 wages.  You both file a joint return.  Your taxable income, in this case, would be $160,000.  As a result, you can deduct $20,000 ($100,000 x 20%) which is a maximum QBI deduction.

Example 2:

Return to the facts as example 1 above but assume that your wife earns $40,000 from wages and $60,000 from capital gain.  Your taxable income is still $160,000 but you can only deduct $18,000 under 199A (($160,000-$50,000) x20%)  

 3-Wages and Capital Limitation:

The wages and capital limitation does not apply if your taxable income is lesser than $315,000 (MFJ) or $157,500 (other).  If your taxable income exceeds the above threshold, the limitation amount is the greater:
a)  50% of W-2 wages allocated to your qualified business income (QBI), or
b)  25% of W-2 wages plus 2.5% of the qualified property.

The deduction is phased-out over your taxable income range from $315,000 to $415,000 (MFJ) or  $157,500 to $207,500 (other).  The wages and capital limitation do not apply to the Specified Service Business (SSB).  It means that if your business is a SSB and your taxable income exceeds the top end of the range, you are not eligible for the deduction.   

Example 3:

If you are a sole proprietor of a business (not a SSB) that earns a net profit  (QBI) of $300,000. Your business pays W2 wage of $150,000 but has none unadjusted basis of the depreciable property.  Your taxable income is $355,000.  As a result:
-  Applicable percent:   60% ( 1-(355000-315000)/100,000)
-  Your qualified business income:  $180,000 ( $300,000 x 60%)
-  50% of W-2 wages:  $48,000 ( 150,000x60%x50%)
-  Maximum of 199A deduction:  $ 30,000  
 

Example 4:

Return to the same facts of example 3 but assume that the W2 wages is $90,000.
-  50% of W-2 wages:  $27,000 ($90,000 x 60% x 50%)
-  Phase-in reduction:  $1,200 ( $ 30,000-$27000)x40%
-  199A deduction:  $28,800 ( $30,000-$1200)  
 

 4-Specified service trade or business (SSB) Limitation  

The SSB limitation does not apply if your taxable income is below the  $315,000(MFJ) and $157,000(others) threshold.  Once your taxable income exceeds the thresholds, the 199A deduction will phase out regardless W-2 amount and property.  

Example 5:
Return to the same facts of example 3 except that your business is a SSB.
-  Phase out percent:  40% ($355000-$315000)/100,000)
-  Tentative 199A deduction:  $60,000 ($300,000 x 20%)
-  Maximum of 199A deduction:  $ 24.000 (60,000 x40%)

Example 6:

Given the same facts as example # 3 but assume that your business is a SSB and your taxable income is $425,000. Because your taxable income exceeds the threshold $415,000 (MFJ), you are not eligible for the 199A deduction.


Tax planning considerations:  

Given all we know about limitations and phase-out of the section 199A deduction, here are few tips that may be helpful to maximize your deduction.  

-  Increase your qualified business income (QBI)

A basic approach is to review your income structure and develop a good strategy to increase your qualified business income.  For example, guarantee payments received from a partnership, or wages paid to yourselves are not eligible for QBI deduction.  You may want to review the possibility to convert this income to a pass-through income.

Sometimes, you may want to consider shifting the assets ( real estate, equipment ) or human resource to a pass-through entity and lease them back to your main business.   For instance, if you own a law firm (a SSB) that has an income of $700,000.  You would not be able to take any QBI deduction because your income is over the income limit threshold.  However, if you create a leasing entity that leases building, equipment back to your own law firm and shift $200,000 of your law firm income to this entity, you may be able to take $40,000 deduction. ($200,000 x 20%) - a tax saving of $14000 ( at tax rate 35%).

-  Keep an eye on your taxable income

In the first part of example 1, you leave money on the table because your taxable income is lower than QBI.  If you contributed $16,000 to a post-tax retirement plan ( i.e. Roth) instead of pre-tax retirement plans,  you would increase your taxable income to $76,000 and as a result, you increase your deduction by $3200 ( $16000 x 20%).  On the other hand, you may want to consider reducing your taxable income if it is over the income limit threshold.  Options may include buying assets, increasing your contribution to pre-tax retirement plans,  outsourcing your work to reduce your W2 wage  

-  Optimize W2 wages and "qualified property”

If your business is subjected to wages and capital limitation, increasing your W2 wage or the amount of qualified property can increase your QBI deduction. There are several options that you may benefit from.  For example, you can increase W2 wage by increasing your own W2 wages or hiring employees instead of using independent contractors.  Likewise,  you may consider delaying the sale of “qualified property” until the next tax year or purchase the property before the end of the current tax year to increase the amount of qualified property

How can I help?

Ultimately, the section 199A opens a door for numbers of planning opportunities to reduce your tax burden.  If you’ve never consulted with a CPA tax professional for individual and or business tax strategy, now is the time to do it. Call me at 832-276-8805.  Together we can develop a great plan to reduce your tax burden and put it into action.

Copyright © 2018 Thanhdung Arnold, CPA