The Tax Cuts and Jobs Act (TCJA) was passed on December 22, 2017 and resulted in complex changes affecting individuals and businesses. To maintain the incentive for individuals to own and operate pass-through entities, the TCJA introduced Section 199A Qualified Business Income (QBI) Deduction. Owners of pass-through business entities are defined as sole proprietorships, partnerships, S Corporations and limited liability companies (LLCs) treated as sole proprietorships or partnerships for tax purposes.
Section 199A Deduction Overview
Under Section 199A, the Qualified Business Income (QBI) Deduction is defined as the net amount of qualified items of income, gain, deduction and loss relating to any U.S. qualified trade or business of the taxpayer. QBI doesn’t include certain investment items, reasonable compensation paid to an owner of an S Corporation for services rendered to the business, or any guaranteed payments to a partner or LLC member for services rendered to the partnership or LLC.
Through 2025, the Section 199A deduction allows pass-through businesses to deduct up to 20% of QBI. Eligible taxpayers can also deduct up to 20% of their qualified real estate investment trust (REIT) dividends and publicly traded partnership income. The deduction may be limited if the taxpayers income exceeds the following thresholds:
- Single Individuals, Trusts and Estates: $160,700 – $210,700
- Married filing jointly: $321,400 – $421,400
The QBI deduction isn’t allowed in calculating the owner’s Adjusted Gross Income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction though you don’t have to itemize to claim it.
When the income-based limit applies to owners of pass-through entities, the QBI deduction generally can’t exceed the greater of the owner’s share of:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property is the depreciable tangible property (including real estate) owned by a qualified business as of year-end and used by the business at any point during the tax year to produce qualified business income.
Taxpayers conducting certain specified services trades or businesses may not qualify for the deduction. Examples include businesses that involve investment-type services and most professional practices such as health, legal and accounting other than engineering and architecture.
The W-2 wage limitation and the service business limitation don’t apply if your taxable income is under the applicable threshold. In that case, you should qualify for the full 20% QBI deduction.
Income taxation and owner liability are the main factors that differentiate one business structure from another. Many business owners choose entities that combine pass-through taxation with limited liability, namely limited liability companies (LLCs) and S Corporations, LLCs can’t pay wages to their owners. S Corporations can pay wages to their owners. If they pay bonuses that amount to earnings for the year, they eliminate any QBI deduction. If the pay is considered “reasonable compensation” they could still claim the deduction.
Maximize Your Section 199 Deduction
At the end of the year your firm may be able to time certain items to your tax advantage. For instance, if your enterprise is in danger of being limited by the 50 percent rule for W-2 wages, it might be beneficial to pay bonuses before year end. It may also be beneficial to replace subcontractors with employees. Similarly, if a deduction would be lowered due to taxable income limitation, you might recognize more income before the close of the tax year, if possible.
Computing and Claiming the Section 199A Deduction
There have been multiple updates from the IRS to help clarify the complexities of the Section 199 or QBI deduction. The calculation is complex and subject to limitations, but every business owner should consult their tax advisor to determine the appropriate deduction.
Items not included in the calculation are earnings from investments, gains from sales of property, reasonable compensation paid, guaranteed payments from a partnership and W-2 wages paid to an owner of an S Corporation.
The IRS provided guidance to describe how to calculate W-2 wages for purposes of the deduction with three detailed explanations of the methods of calculating applicable W-2 wages in Revenue Procedure 2019-11. The easiest method is to use the total amounts reported in box 1 of all W-2s..
In Spring 2019, the IRS issued instructions for tax-exempt trusts claiming a Section 199A deduction with unrelated business income. Noncorporate taxpayers may claim an income tax deduction for their QBI through 2025. The deduction is generally 20% of a taxpayer’s QBI from a partnership, S corporation or sole proprietorship. Taxpayers with taxable income that exceeds a threshold amount are subject to limitations based on W-2 wages paid by the business and the unadjusted basis in the business’s qualified property.
The IRS also released two draft forms to compute the QBI deduction under Section 199A. The draft forms are Form 8995 (“Qualified Business Income Deduction Simplified Computation”) and Form 8995-A (“Qualified Business Income Deduction”). Review draft Form 8995 and draft Form 8995-A for specific details.
Section 199A Updates from the IRS
- Instructions for Schedule C, Form 1040, reflect many of the key tax changes that apply to sole proprietors. These changes, enacted by the Tax Cuts and Jobs Act, include accounting method liberalizations, limitations on deductions for business interest and business losses, a new deduction for qualified business income, and restrictions on deductions for business meals and entertainment expenses. Read the “Profit or Loss From Business” instructions for further information.
- Guidance for real estate businesses. Individuals and entities who own rental real estate directly or through a disregarded entity can treat a rental real estate enterprise as a trade or business for purposes of the QBI deduction if certain requirements are met. Not eligible for the deduction are real estate used as a residence for any part of the year and real estate rented under a “triple net lease.” To learn more, read IRS Notice 2019-07.
The tax professionals at LBMC can help minimize the tax burden and provide crucial information on an ongoing basis to assist in day-to-day operations.
Contact Stephen Turner to learn whether this potentially powerful deduction could reduce your business’s tax liability when you file your tax return.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.