At some point, you’re going to need to learn the Sec. 199A deduction inside and out if you serve small businesses or real estate investors. This new deduction within the Tax Cuts and Jobs Act produces big tax savings, but to get through this tax season and your clients’ extensions, make sure you know at least the following 10 details:
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 white-collar professional service business such as an athlete, performer 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.
Note: We have a blog post that goes deep into the details of the Sec. 199A phase-out calculations in case you’re interested.
Deduction Detail #8: The Law Applies Starting With 2018
The new deduction will first appear on the 2018 tax returns we’re all preparing a year from now. However, take a look at #9 below.
We will all need to figure out how the deduction works this tax season for any taxpayers who need 1040ES payment estimates. Thankfully, Intuit ProConnect offers help for ProConnect Tax Online, Lacerte and ProSeries. The products include input fields to collect the additional data needed to estimate the impact of the Sec. 199A deduction on a taxpayer’s 2018 tax liability.
Deduction Detail #10: Tax Accountants Will Want to Learn the New Tax Law
A final tidbit: Tax accountants serving taxpayers with qualified business income will want to learn more about the Tax Cuts and Jobs Act. The deduction formula provides numerous opportunities to either shrink or expand the size of the deduction and, therefore, the taxpayer’s Sec. 199A tax savings.