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.

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What’s a pass-through business?

A pass-through business is any business that is a:

  • Sole proprietorship (a one-owner business in which the owner personally owns all the business assets)
  • Partnership
  • S corporation
  • Limited liability company (LLC)
  • Limited liability partnership (LLP).

What deduction can a pass-through business get?

If you qualify, you can deduct from your income taxes up to 20 percent of your business income. This effectively reduces your income taxes by 20 percent.

What is the Section 199A deduction?

This is the official name of the 20 percent pass-through deduction. It is officially called the Tax Cuts and Jobs Act, Provision 11011 Section 199A.

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Who can get the Section 199A deduction?

Any small business owner can take the pass-through deduction if they qualify. The vast majority of smaller businesses are pass-through entities. Yet, you don’t qualify for it if you’ve formed a regular C corporation.

What types of businesses can get the pass-through deduction?

The Section 199A deduction is available to taxpayers with a qualified trade or business. The IRS says a “qualified trade or business” is any business other than:

  • Serving as an employee
  • A specified service business or trade.

What’s a specified service business or trade?

The IRS defines a “specified service business or trade” as something which involves services in the fields of:

  • Health
  • Law
  • Accounting
  • Actuarial
  • Actuarial science
  • Performing arts
  • Consulting
  • Athletics
  • Financial services
  • Investing
  • Investment management
  • Any field where the principal asset is the skill or reputation of one of its employees.
SERVICEINCLUDESDOES NOT INCLUDE
Healthdoctors, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and similar healthcare professionals who provide services directly to patientspeople 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
Lawlawyers, paralegals, legal arbitrators, and mediatorspeople who provide non-legal services such as printing, delivery, or stenography
Accountingaccountants, enrolled agents, return preparers, financial auditors, bookkeepers, and similar professionalspayment processing and billing analysis
Acturial Scienceactuaries and similar professionalsanalysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events
Performing Artsactors, singers, musicians, entertainers, directors, and other professionals who participate in creation of performing artpeople who broadcast or disseminate video or audio to the public, or maintain or operate equipment or facilities used for performing arts
Consultingpeople who provide professional advice and counsel to clients to assist in achieving goals and solving problems, including government lobbyistssalespeople and those who provide training or educational courses
Athleticsathletes, 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 racingbroadcasters and people who maintain or operate equipment used in athletic events
Financial Servicespeople who provide financial services to clients, including managing wealth, developing retirement or transition plans, merger and acquisition advice, and valuation work.bankers
Brokerage Servicesbrokers who arrange transactions for buyers and sellers of securitiesreal estate agents and brokers, insurance agents and brokers
Investment Managementpeople who receive fees for providing investing, asset management, or investment management servicesreal estate property managers
Tradingtraders insecurities, commodities or partnership interestsfarmers or manufacturers who engage in hedging transactions as part of their trade or business

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What’s a specified service business or trade?

Employees do not 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 is probably not a good idea for most people. This means you’ll lose 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.

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 have $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.

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How to calculate your deduction

To calculate your deduction, determine your taxable income. This 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. 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 taxable income exceeds $315,000 (married and filing a joint tax return with your spouse), 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) 50 percent of the W-2 employee wages paid by your business, or
  • (2) 25 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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Can service-providing businesses get this deduction?

No, the new tax law doesn’t apply to a small business that provides a service and who earn over a certain threshold.

If your taxable income is over $315,000 (married) or $157,500 (single) the deduction is phased-out if your business involves providing services in the fields of:

  • Health (doctors, dentists, nurses, and other health professionals)
  • Law
  • Accounting (includes the preparation of and financial statements and preparing tax returns)
  • Actuarial science
  • Performing arts
  • Consulting (providing advice and counsel to clients)
  • Athletics
  • Financial services
  • Brokerage services
  • Trading or dealing in securities, partnership interests, or commodities
  • Investing and investment management, or
  • Any business where the principal asset is the reputation or skill of one or more of its owners.

If you’re such a service provider, you get no pass-through deduction at all if your taxable income exceeds $415,000 (married) or $207,500 (single).

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Stephen Fishman

Stephen Fishman

Stephen Fishman is a self-employed tax expert and regular contributor to MileIQ. He has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for entrepreneurs, independent contractors, freelancers and other self-employed people. He is the author of over 20 books and hundreds of articles, and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Visit Fishman Law and Tax Files for more information on his work.
Stephen Fishman