This new deduction within the Tax Cuts and Jobs Act produces big tax savings. Several clients have asked us again for more information about this new deduction, so here are the main points:
Deduction Detail #1: It Shelters Pass-Through Income
The Sec. 199A deduction applies to qualified business income. Most commonly, this includes income from Schedule C sole proprietorships, Schedule E real estate investors, Schedule F farmers and ranchers, as well as the business and rental income reported on a K-1 from a partnership, S corporation, trust or estate. The government may issue guidance around which activities qualify and which ones don’t.
However, there’s a wrinkle: the deduction also applies to real estate investment trust dividends, qualified agricultural and horticultural cooperative dividends, and publicly traded partnerships.
Deduction Detail #2: The Deduction Tentatively Equals 20 Percent
The actual Sec. 199A deduction tentatively equals 20 percent of the qualified business income. As a result, a taxpayer with $1 million of qualified business income, for example, may get a $200,000 deduction.
Deduction Detail #3: Taxable Income Limits
The deduction formula includes several limiters. The most important one says the Sec. 199A deduction can’t exceed 20 percent of the taxpayer’s taxable income taxed at ordinary income rates. For example, if some taxpayer’s taxable income equals $100,000, but that amount includes $20,000 of capital gains and $80,000 of other “ordinary” income, the Sec. 199A deduction can’t exceed 20 percent of the $80,000.
Deduction Detail #4: Sec. 199A Shelters Domestic Business Income
Sec. 199A only shelters domestic income. Someone who operates their venture outside the United States doesn’t get to use the deduction to shelter their income from taxes.
Deduction Detail #5: Service Businesses May Get Excluded
If a taxpayer earns business income from a professional service business such as an athlete, performer, attorney, health care provider, consultant, or investment professional, they may find their deduction limited or eliminated.
The rules can quickly get complicated; if a single taxpayer enjoys more than $207,500 in taxable income or a married taxpayer enjoys more than a $415,000 in taxable income, they do not get to use the deduction.
Deduction Detail #6: High-Income Taxpayers Need W-2 Wages and Depreciable Assets
If a taxpayer crosses those thresholds mentioned in the previous detail’s discussion – $207,500 for a single person or $415,000 for a married person – the business generating the qualified business income needs either W-2 wages or depreciable property in order for the taxpayer to get the deduction.
Again, this part of the deduction formula gets complicated, but above these thresholds, the Sec. 199A deduction can’t exceed the greater of either 50 percent of the business’ W-2 wages, or 25 percent of the business’ W-2 wages plus 2.5 percent of the original purchase price of its depreciable property.
Deduction Detail #7: There Are Phase-Out Zones for Upper-Income Taxpayers
For single taxpayers with income ranging from $157,500 to $207,500, and for married taxpayers with income ranging from $315,000 to $415,000 taxable income levels, the deduction gets phased out if the taxpayer’s business is a specified service business or lacks adequate wages and depreciable property. Beneath the phase out range, a taxpayer gets the deduction even without wages or depreciable property or from a specified service business.
