When the Tax Cuts and Jobs Act (TCJA) passed in December 2017, business owners were left to navigate a host of new rules and regulations stipulating how their operations would be treated under the new tax code. Fortunately, several promising tax incentives are scattered throughout the complex reform document. Section 199A, also known as the Qualified Business Income (QBI) Deduction, is one such incentive for pass-thru businesses.
What is Section 199A?
Section 199A allows pass-thru businesses to deduct 20% of qualified business income earned in a qualified trade or business, subject to certain limitations. The provision is a significant tax perk for the noncorporate businesses that can’t benefit from the sizable tax rate cut made available to C corporations via the passing of the TCJA.
Pass-thru businesses flow income and expenses through to the owners, rather than pay corporate income tax at the entity level. The owners then report those expenses on their own tax return and pay any resulting tax at their individual income tax rates. Pass-thru businesses can include:
- Sole proprietorships
- Partnerships
- Limited Liability Companies (LLCs)
- Trusts
- S Corporations
Qualified business income is the net amount of income, gain, deduction and loss from your trade or business. Your QBI does not include items that are not included in taxable income, such as capital gains and losses, certain dividends, and interest income. In order to calculate a taxpayer’s Section 199A deduction, you must determine if their taxable income is:
- Below the lower taxable income threshold – $157,500 or $315,000 if filing jointly;
- Above the higher taxable income threshold – $207,500 or $415,000 if filing jointly; or
- Between the lower and higher taxable income thresholds.
Section 199A Limitations
Specified Service or Trade Businesses
An important caveat to Section 199A is that Specified Service or Trade Businesses (SSTB) are not able to take advantage of the deduction in the same ways as non-SSTBs. An SSTB includes any trade or business activity involving the performance of services in the fields of:
- Health
- Law
- Accounting
- Actuarial Science
- Performing Arts
- Consulting
- Athletic
- Financial Services
- Brokerage Services
SSTBs also include any trade or business where the reputation or skill of one or more of its employees is the reason for revenue or involve investing, investing management, trading or dealing in securities, or partnerships.
The good news is that SSTBs can still benefit from Section 199A, as long as the taxpayer’s adjusted gross income falls below the lower threshold ($157,500 or $315,000 if filing jointly).
Wage and Capital Limitations
If a taxpayer has taxable income that exceeds the higher threshold and owns a non-SSTB, their Section 199A deduction is subject to a limitation based on W-2 wages and/or capital.
Maximizing the Deduction
Income Reduction
One way to boost your savings is by ensuring that you don’t exceed the income threshold that triggers the SSTB and wage/capital qualifiers. Increasing your deductions and spreading your income out over multiple taxpayers are both effective strategies to reduce your taxable income. You may also consider:
- Revisit filing separate returns for married couples
- Increase retirement plan contributions
- Manage portfolio income
- Consider donor-advised funds
Income Alteration
Another practical strategy involves transforming income from an SSTB into income from a non-SSTB to avoid the phase out that occurs when an SSTB surpasses the lower income threshold. In fact, by steering clear of strong claims in your promotional materials regarding your business’ reputation or skill, you may be able to elude the SSTB designation altogether. You may also consider:
- Spin-off business-owned real estate into a separate entity and lease-back the property
- Avoid celebrity and high-profile employees
- Create an employee leasing company – contract with the company to provide staff
Business Strategies
Because Section 199A is founded in such rigid regulations, to make the most of the deduction it is important to categorize your business income as advantageously as possible. This may involve revisiting the business’ compensation model or entity structure. You may also consider:
- Switch from salaried employee to independent contractor
- Reduce or eliminate guaranteed payments to partners
- Reduce independent contract labor in favor of hiring more W-2 employees
Section 199A is highly complex and its application varies greatly depending on each taxpayer’s situation. It is important to speak to a tax professional to ensure that the deduction is applied properly in order to maximize your tax savings. Contact Naden/Lean with any questions.