I have a confession…
For the first time in my life, I paid someone else to do my taxes.
I know this may be surprising, since I write a lot about tax avoidance around here.
While I do enjoy figuring out ways to hack the tax code to help you retire even earlier, I have a valid reason for outsourcing this time – I set up an S-Corp for my business and I didn’t want to learn how to do S-Corp tax returns.
Thankfully, I found a brilliant guy named Stephen Nelson to do it for me!
When I found out Steve was also an expert on the most exciting new tax break to be released in decades (i.e. Section 199A of the Tax Cuts and Jobs Act of 2017), I knew I had to get him to write a guest post.
The new Section 199A deduction will save me and my wife over $10,000 in taxes in 2018 so hopefully it will save you a bunch too!
Take it away, Steve…
The Section 199A tax deduction surely counts as the best small business and individual investor tax break of the 21st century.
Using Section 199A, business owners and real estate investors may get to simply “not” pay income taxes on the last 20% of the income they earn!
And the best part? You don’t need to burn any cash or make big financial commitments or suffer through mind-numbing complexity.
To get the big savings, you just need to do your tax return right.
Let’s get into the details…
What is the Section 199A Deduction?
The Section 199A deduction gives owners of pass-thru business entities (e.g. sole proprietors, partners in partnerships, some real estate investors, and S corporation shareholders) an extra deduction equal to 20% of their “qualified business income”.
And just what is “qualified business income?” Qualified business income equals your bottom-line business profit adjusted for any of the other deductions directly connected to the business, including self-employment taxes, self-employed health insurance, and employer retirement plan contributions.
Example 1: Assume your tax return shows a $108,000 bottom-line Schedule C profit, an $8,000 self-employment tax deduction and a $20,000 SEP-IRA deduction. In this case, your qualified business income equals $80,000, calculated as $108,000 minus the $8,000 and minus the $20,000. You potentially get a deduction equal to 20% of the $80,000—or $16,000.
The only rub for the typical taxpayer? The Section 199A deduction can’t exceed 20% of your taxable income.
Example 2: You earn $80,000 in sole proprietorship qualified business income but you also use the $24,000 married-filing-jointly standard deduction. In this case, your taxable income equals $56,000. You don’t get a Section 199A deduction equal to 20% of the $80,000 of qualified business income ($16,000) but instead get a Section 199A deduction equal to 20% of $54,000 ($10,800).
The taxable income limitation doesn’t always matter though, as you’ll see in the following example:
Example 3: You are married and earn $80,000 in qualified business income from a sole proprietorship. Your spouse earns $60,000 in a regular, W-2 job. You two use the $24,000 standard deduction. In this case, your qualified business income equals $80,000 so the deduction equals 20% of the $80,000 ($16,000). Your family’s taxable income, $116,000, doesn’t come into the Section 199A deduction calculation since it’s higher than the qualified business income.
The Finer Details of IRC Sec. 199A
Qualified business income includes sole proprietorship profits, real estate investor rental income (if your real estate investing rises to the level of a trade or business), and the shareholder and partner “profit allocations” reported on the K-1s that S corporations and partnerships send their owners.
Qualified business income does not include capital gains, interest income, or dividend income.
Another important thing to note: Qualified business income doesn’t include income earned outside the United States. The qualified business income deduction only applies to domestic income (not foreign income).
And then a couple of surprises to the unwary: Qualified business income doesn’t include S corporation shareholder-employee wages, guaranteed payments made to partners of a partnership, or other amounts a partnership pays to a partner for services.
Example 4: If an S corporation shareholder’s share of the profits in some venture equals $100,000, but $60,000 of this profit is paid out as shareholder-employee wages and then the other $40,000 gets reported on the S corporation K-1, only that $40,000 of profit counts as qualified business income and plugs into the qualified business income deduction formula.
Example 5: If a partner’s share of the profits in some venture equals $100,000, but $80,000 of this profit is paid out as a guaranteed payment and then the other $20,000 gets paid out as a distribution and reported on the partnership K-1, only that $20,000 of profit counts as qualified business income and plugs into the Section 199A formula.
A High-Income May Limit IRS Sec. 199A Deduction
Most folks don’t need to worry about this, but single taxpayers with taxable incomes more than $157,500 and married taxpayers with taxable incomes more than $315,000 get their qualified business income deduction limited based on the W-2 wages the business pays and based on the depreciable property held in the business. But how this works is complicated…
Below the $157,500 or $315,000 taxable income levels, neither wages nor depreciable property matters.
For single taxpayers with taxable income more than $207,500 or married taxpayers with taxable income more than $415,000, the qualified business income deduction can’t exceed the greater of two amounts:
50% of the W-2 wages paid by the business, or
25% of the W-2 wages paid by the business plus 2.5% of the original cost depreciable assets used in the business.
For single people with taxable incomes between $157,500 and $217,500 and for married folks with taxable incomes between $315,000 and $415,000, the limitation phases out on sliding scale (for the gory details about how this works, you can refer here: Sec. 199A Phase-out Rules).
High-income Professionals Potentially Lose Twice
All the standard professionals (doctors and lawyers and such), investment professionals, athletes, performers, and any one-person celebrity businesses (someone earning appearance fees or product endorsement income) face another equally painful phaseout.
Single professionals with taxable incomes greater than $157,500 see their Section 199A deduction phase-out because they’re professionals (the phase-out is 100% once taxable income equals $207,500).
Married professionals with taxable incomes greater than $315,000 see their Section 199A deduction phase-out too for the same reason (for these people the phase-out hits 100% once taxable income equals $415,000).
These types of folks who are in the phase-out range can potentially get whacked a second time if they don’t have enough W-2 wages or depreciable property to fully support a Section 199A deduction.
Section 199A – Dividends
Just so you know, some investment income also gets sheltered by Sec. 199A and so plugs into the qualified business income deduction formula: qualified REIT dividends, qualified agricultural and horticultural dividends, and the income from qualified publicly traded partnerships.
Note: I’ve got a longer discussion about how the Section 199A impacts investing at my blog, Section 199A Changes Rules for Investors.
The new law burdens taxpayers with complexity, as the preceding paragraphs hint. But basically you have four gambits you will want to use in order to maximize the Section 199A deduction and the tax benefits you receive.
Gambit #1: Maximize Qualified Business Income
You want to maximize your qualified business income.
S corporations and partnerships, for example, want to look at dialing down shareholder-employee salaries as well as partner guaranteed payments.
Sole proprietors should reassess whether it makes sense to pay family members wages.
Business owners operating both inside and outside the US may want to look at moving business activity back into the United States.
Finally, real estate investors may want to look at deleveraging their investment portfolios to “dial up” their rental income (using cash to pay down a mortgage not only saves interest expense but may create or increase the size of a Section 199A deduction, if less mortgage interest expense means more net rental income).
But this caution: As the recent regulations indicate, your real estate investing needs to rise to the level of a trade or business. That means you’re engaged in your real estate business with “regularity and continuity.”
Note: The final regulations provide a 250-hours-of-rental-work safe harbor for investors, suggesting the IRS doesn’t think you qualify for the Section 199A deduction with just a single property.
Gambit #2: Dial Down Taxable Income
Taxpayers often have an incentive to dial down their taxable income (obviously).
But the Section 199A deduction creates new incentives for taxpayers who trip over the threshold amounts ($157,500 for single taxpayers and $315,000 for married taxpayers).
If a taxpayer will lose the Section 199A deduction or some of the deduction due to a high income, reducing taxable income delivers big benefits.
A giant pension deduction, which would always be attractive, may become irresistible if in addition to the pension deduction, the taxpayer also gets another $30,000 or $60,000 Section 199A deduction.
And keep an eye on your filing status. We’ve seen clients who in past have filed married separate returns but will probably decide to file married joint returns going forward—just to double the phase-out threshold from $157,500 to $315,000.
Gambit #3: Know Your Limitations
If your Section 199A gets limited due to wages or depreciable property, creatively explore what you can do to bump your wages or depreciable property.
Sometimes, a shareholder-employee in an S corporation may benefit from bumping up his or her wages—in spite of the additional payroll taxes—because those larger wages support a larger Section 199A deduction (you have to do the math for your exact situation in order to be sure).
And then a common trick for any real estate investors: If you are getting a Section 199A deduction because your real estate investments produce taxable income, you may want to avoid things that limit your properties’ depreciable basis.
One example of this would be avoiding a Sec. 1031 like-kind exchange but other depreciation methods and accounting choices can also depress depreciable property.
Gambit #4: Use Tax Savings Wisely, Grasshopper
A final tip—and one that especially relates to folks aggressively saving money toward financial independence…
Use the tax deduction and the savings it produces wisely.
Someone who receives a $50,000 Section 199A tax deduction might just use that deduction to dial down their income taxes by $12,000.
But you could choose to use the deduction and the savings in more creative ways.
One example? If you’ve put a $50,000 “free deduction” on your tax return, maybe you use that deduction to shelter $50,000 of Roth conversion income and maybe you do this for the next several years.
Two Final Comments
Before I wrap this up, two final quick comments.
First, the Section 199A qualified business income deduction goes away after 2025.
In other words, the deduction only appears on tax returns for the years 2018 through 2025. It’s a temporary loophole.
And then a final thing to know: Because the qualified business income deduction includes so many variables (qualified business income, taxable income, potentially W-2 wages and depreciable property), which in turn depend on a bunch of other variables, the deduction’s effect ripples through your tax return. Check your math. Then check it again!
Hey, it’s the Mad Fientist again. Thanks very much, Steve!
Exciting stuff, right?
Steve literally wrote the book on the Section 199A deduction so if you want to know everything there is to know about this new tax break, you can check it out here*.
Note: He wrote the book specifically for tax accountants and attorneys so it’s very detailed and is priced accordingly. Steve sent me a copy and I really enjoyed it though so check it out if you want to go really deep on this subject and figure out how you can save yourself the most money with this deduction.
As you’ve seen, this new tax deduction is huge news for business owners! Yet another reason why I think everyone should have their own business.
What do you think? How much is the Section 199A deduction going to save you in 2018?
Let me know in the comments below and big thanks again to Steve for his fantastic article!
* Full Disclosure: The link to Steve’s book is an affiliate link so I will be compensated if you purchase through the link.
I asked Steve if I could forfeit my cut in order to lower the price for Mad Fientist readers but since the book is targeted to industry professionals (rather than consumers), he wanted to keep the pricing consistent across all sites, which is understandable.