Updated January 24, 2019 in accordance with the final guidelines published by the IRS
The new tax law is in place for the 2018 tax year. A big change is the creation of a brand-new tax deduction for a pass-through business. Here are the basics you need to understand the Section 199A deduction.
What is the Section 199A deduction?
This is the official name of the 20 percent pass-through deduction. It is officially called Section 199A of the Tax Cuts and Jobs Act to put it another way.
What deduction can you get?
If you qualify, you can deduct from your income taxes up to 20 percent of your business income. That is to say, this deduction effectively reduces your income taxes by 20 percent.
Who can get the Section 199A deduction?
Any small business owner who operates a pass-through business can qualify for the pass-through deduction. Consequently, the vast majority of smaller businesses are pass-through entities.
What’s a pass-through business?
A pass-through business is any company that is a:
- Sole proprietorship (a one-owner business in which the owner personally owns all the business assets)
- S corporation
- Limited liability company (LLC)
- Limited liability partnership (LLP).
What types of businesses can get the pass-through deduction?
The Section 199A deduction is only available to taxpayers with a qualified trade or business. Eligibility applies to any bona fide business owned and operated through a pass-through entity. But it does not include:
- Working as an employee
- Specified service businesses that earn over a threshold amount
- Businesses owned and operated through a regular C corporation.
Employees don’t qualify for the pass-through deduction
If you’re an employee, you can be eligible for the deduction only if you quit your job and become a self-employed independent contractor.
This move is probably not a good idea for most people. Changing your employment status means losing the employee benefits like health insurance and paid vacation. You’d have to earn enough extra as an independent contractor to make up for the loss of such benefits.
Also, you may not qualify for the pass-through deduction if you quit your job and perform the same work for your old employer. Reason: The IRS will presume you’re not an independent contractor for the next three years.
What’s a specified service business or trade?
The IRS defines a “specified service trade or business” as something which involves businesses in the fields of:
- Actuarial science
- Performing arts
- Financial services
- Investment management.
|SERVICE||INCLUDES||DOES NOT INCLUDE|
|Health||doctors, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and similar healthcare professionals who provide services directly to patients||people who provide services not directly related to medicine, even though they may improve health, such as the operators of health clubs or spas, or people engaged in research, testing, and sale of pharmaceuticals or medical devices|
|Law||lawyers, paralegals, legal arbitrators, and mediators||people who provide non-legal services such as printing, delivery, or stenography|
|Accounting||accountants, enrolled agents, return preparers, financial auditors, bookkeepers, and similar professionals||payment processing and billing analysis|
|Acturial Science||actuaries and similar professionals||analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events|
|Performing Arts||actors, singers, musicians, entertainers, directors, and other professionals who participate in creation of performing art||people who broadcast or disseminate video or audio to the public, or maintain or operate equipment or facilities used for performing arts|
|Consulting||people who provide professional advice and counsel to clients to assist in achieving goals and solving problems, including government lobbyists||salespeople and those who provide training or educational courses|
|Athletics||athletes, coaches, team managers in sports such as baseball, basketball. football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing||broadcasters and people who maintain or operate equipment used in athletic events|
|Financial Services||people who provide financial services to clients, including managing wealth, developing retirement or transition plans, merger and acquisition advice, and valuation work.||bankers|
|Brokerage Services||brokers who arrange transactions for buyers and sellers of securities||real estate agents and brokers, insurance agents and brokers|
|Investment Management||people who receive fees for providing investing, asset management, or investment management services||real estate property managers|
|Trading||traders insecurities, commodities or partnership interests||farmers or manufacturers who engage in hedging transactions as part of their trade or business|
Can service-providing businesses get this deduction?
Specified service business owners get the full pass-through deduction if their taxable income is below $157,500 (filing as a single) or $315,000 (married, filing jointly).
If your taxable income is over $157,500/$315,000, the deduction is phased-out.
You get no pass-through deduction at all if your taxable income exceeds $415,000 (married) or $207,500 (single).
Can you separate non-service functions and take a deduction for them?
Can a specified service business separate non-service functions and take a pass-through deduction for the income they earn? For example, could the owners of a law firm personally purchase a building, rent it to their law firm, and take a pass-through deduction on their rental income?
No. The IRS says that if a person or business rents property or provides services to a commonly controlled service business, the income received is service business income not eligible for the pass-through deduction
Can a landlord qualify for the pass-through deduction?
Yes, landlords who earn a profit from renting property can qualify to deduct up to 20 percent of their net rental income. Indeed, the same rules apply to landlords as for other businesses.
But, a rental activity must qualify as a business to take this deduction. Smaller landlords with only a few rentals might not qualify as a business.
To help small landlords, the IRS created a special rule. If a landlord, and his or her employees, agents, and independent contractors, put in at least 250 hours per year providing rental services, the activity will be deemed a business for purposes of the pass-through deduction.
Do you qualify for the pass-through deduction?
The pass-through deduction allows qualifying business owners to deduct from their income taxes up to 20 percent of their business profit. For example, if you had $100,000 in business profit in 2018, you may be able to deduct up to $20,000.
You can get his deduction if you’re self-employed (a sole proprietor). It is also available for any business you own other than a regular “C” corporation. Employees can’t get this deduction.
How to calculate your Section 199A deduction
The pass-through deduction allows qualifying business owners to deduct from their income taxes up to 20 percent of their business profit.
To calculate your deduction, determine your taxable income. This amount is your total income from all sources minus all your deductions.
If your taxable income is below $157,500, your Section 199A deduction is equal to 20 percent of your qualified business income (QBI). That limit is $315,000 if you’re married and filing jointly. Thereupon, the result is the maximum possible pass-through deduction.
Example: Tom is single and operates his business as a sole proprietorship. His company earns $100,000 in qualified business income and the total taxable income for the year amounts to $120,000.
Tom’s pass-through deduction is 20 percent x $100,000 QBI = $20,000. Thus, he can deduct $20,000 from his income taxes.
If your taxable income is within the $315,000/$157,500 thresholds, that’s all there is to the pass-through deduction.
What if I make more than the thresholds?
Calculating the pass-through deduction is much more complicated if your combined taxable income exceeds $315,000. As in the case of married couples filing a joint tax return. Or you’re single, and your taxable income is over $157,500.
First, a limitation based on how much you pay your employees or how much property used in the business is phased in. Once your taxable income reaches $415,000 (married) or $207,500 (single) your pass-through deduction can’t exceed the greater of:
- (1) Fifty percent of the W-2 employee wages paid by your business, or
- (2) Twenty-five percent of W-2 wages, PLUS 2.5 percent of the original purchase price of the long-term property used in the production of income, for example, the real assets or equipment used in the business.
Thus, if you have neither employees nor business property, you get no deduction. The rule is intended to encourage pass-through owners to hire employees and/or buy resources for their business.
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MileIQ’s blog does not constitute professional tax advice. You should contact your own tax professional to discuss your situation.