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What is the Section 199A Deduction?

November 14, 2024

What is the Section 199A Deduction? – Explanation & Tips

One of the most important aspects of running a business is settling taxes. Several federal and state tax laws apply to small and enterprise companies in the United States.

Taxes are complex, and you shouldn’t handle them yourself. However, you still need to understand how they work—so you are on the same page with your financial advisor. In this article, we’ll do a deep dive into the Section 199A deduction and what it means for you as a small business owner.

Here’s What We’ll Cover:

What is the Section 199A Deduction?

Who Can Claim the Section 199A Deduction?

What Businesses Do Not Qualify for QBI Deduction?

What is the Eligible Income for QBI Deduction?

How to Calculate the Section 199A Deduction

Taxable Income Thresholds

Limitations on the Qualified Business Income Deductions

How to Claim Section 199A Deductions

How Do QBI Deductions Apply to Business Losses?

How Do Limited Losses Affect Qualified Business Income Deductions?

7 Easy Ways to Maximize Your Qualified Business Income Deductions

The Gray Areas in Section 199A

More Small Business Tax Resources

What is the Section 199A Deduction?

Section 199A is the part of the Tax Cuts and Jobs Act that caters to tax deductions for pass-through businesses, including sole proprietorships, S corporations, and limited liability businesses.

Based on this regulation, eligible taxpayers may qualify for a fixed percentage of deduction on their taxable income when calculating their federal tax liability.

QBI and REIT/PTP Categories

There’s a ton of information to unpack in this law, but the first things you need to know are its QBI and REIT/PTP categories.

The QBI component means businesses can claim a deduction of up to 20% of their Qualified Business Income. Simultaneously, the REIT/PTP component equals 20% deductions on your combined qualified REIT dividends, including cooperative dividends.

The IRS introduced the Section 199A deduction in 2017, and it runs through to 2025. You don’t have to do anything special to qualify for it. The federal tax law already states “who” can get the deduction and the limitations for other businesses.

Who Can Claim the Section 199A Deduction?

Deductions on qualified business income are only available for pass-through entities. Pass-through entities are companies subjected to individual tax rates as opposed to federal business income taxes. Here, the taxpayer reports the business income on their personal tax returns.

A common denominator for these entities is how much taxable income they earn. Typically, these are businesses with a taxable income of less than $157,000 for individuals and $315,000 for joint returns (couples).

Specifically, you qualify for the Section 199A deduction if you are;

A sole proprietor
An individual owner of a rental property
A partnership and S corporations
Trust and estate with income from pass-through entities
The owner of a specific real estate investment trust
The owner of an agricultural and horticultural cooperative
A rental real estate enterprise

What Businesses Do Not Qualify for QBI Deduction?

Qualifying for deductions on your taxable income has nothing to do with your level of involvement in a business. That is, whether the taxpayer is actively involved in the company’s daily operations or owns some shares in the entity.

Employees

If you own any trade or business that performs services as an employee, you cannot convert personal service income into qualified business income and claim deductions. This means employees cannot qualify for any deduction based on their wages or salary. In addition, you cannot claim tax deductions if your business is a C corporation or if you are simply an employee who does not own an interest in a pass-through entity.

Specific Service Trades

Section 199A prevents people who own certain “specified service trades or businesses” from getting QBIC or REIT deductions. Here’s a closer look at what is initially obtainable;

Sec. 199A (d) (2) defines a specified service trade or business by reference to Sec. 1202 (e) (3) (A), which includes among the companies ineligible for the benefits of that section:” any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.

This provision casts a wide net on professional service-based businesses. Fortunately, the IRS has made several amendments, such as excluding engineering and architecture companies from prohibited SSTBs and referencing companies that make money from the skill of their owners.

Amendments to Qualifications

For example, if you own a fashion store and bag an endorsement deal with a clothing line, it passes as an SSTB and is subject to any applicable limitations. However, you can still receive the Section 199A deduction on your qualified business income.

Based on these amendments, specified service trades or businesses are those that are:

Involved in the performance of services in the fields of accounting, health, law, actuarial science, athletics, brokerage services, consulting, financial services, or
Businesses in the performing arts; or
Businesses involved in the performance of services in investing and investment management, trading, or dealing in securities, partnership interests, or commodities; or whose principal asset is the reputation or skill of one or more of a firm’s owners or employees

What is the Eligible Income for QBI Deduction?

An eligible taxpayer can claim deductions based on their Qualified Business Income level.

Qualified business income is essentially the net income you earn from business transactions, including profit from a sole proprietorship, rental income, income from qualified publicly traded partnerships, and any profit allocations listed on your K-1.

Investment-related earnings like capital gains and net gains from foreign currency and commodities transactions are not qualified income. It is also essential to know that any compensation the business owner receives for a service rendered to their company does not pass for qualified business income.

The IRS also excludes the following sources of income:

Long-term capital gains and losses
Interest earnings
Dividend income
Any amounts you pay to a partner for their services
S Corporation shareholder-employee wages
Income from notional principal contracts that do not pass as hedging transactions
Deductions or losses resulting from investment-related income

Business activities that involve guaranteed payments to partnerships do not pass as qualified business income.

According to Section 707 (c), “payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61 (a) (relating to gross income) and, subject to section 263, for purposes of section 162 (a) (relating to trade or business expenses).”

A guaranteed payment is a reasonable compensation that a partner is entitled to because of services rendered, including any capital contributions. Guaranteed payments differ from the income typically generated by the partnership.

Section 199A further states that qualified business earnings do not include personal deductions connected to;

Gains from transactions reported on Form 4797, including revenue from the sale of business property
Deductions for one-half of self-employment tax
Deduction for self-employed SEP, SIMPLE, or other retirement plans
Partnership expenses claimed by a partner on his or her tax returns, that are yet to be refunded.
A self-employed health insurance deduction

How to Calculate the Section 199A Deduction

QBI Deductions = 20% of Qualified Business Income + 20% of REIT Dividends and Qualified Publicly Traded Partnership Income

Keep in mind that the resulting deductions do not affect a single taxpayer’s adjusted gross income. This is because the IRS records your gross income before any qualified business deductions.

Here is a 3-step guide to help you calculate qualified business deductions:

Determine Your Qualified Business Income
Apply the Right Laws
Determine the Deductions

Determine Your Qualified Business Income

You need to know the amount of qualified income your business made over a specific period.

Skim through your records and extract the required information—the net amount of qualified items of income, gain, losses, and deductions from qualified domestic trade.

Subtract income from investments and any earnings that do not result from qualified trade. If you have two or more businesses, you should treat them separately and determine your qualified business earnings on those terms.

Apply the Right Laws

Now that you have your QBI numbers, the next step is matching them against the stipulations in Section 199A. Three taxable income thresholds determine whether you’re eligible for a deduction.

The IRS sets a taxable income limitation of $160,700 for single individuals and $322,400 for couples filing joint tax for the first threshold.

If your income is above the limitation threshold amount, you may still qualify for deductions if you fall within the phase-in/phase-out range. This threshold is for taxpayers with a taxable income of $160,700–$210,400 (for individuals) and $321,400–$421,400 for joint returns.

The final taxable income threshold affects specified service trades or businesses. Typically, these entities are exempt from qualified income deductions. However, waivers apply when taxable income is at or below the threshold amount. SSTB can claim lower deductions in the phase-in range, but anything above this mark removes them from qualified income deductions of any amount.

Determine the Deductions

The deductions for each taxpayer depend on their initial taxable income and business type. For example, if you own a specified service trade or business like a consulting firm, some limitations might affect your total deductible amount. The IRS calculates your deduction and applicable limits separately and adds the results to get your total deductible amount.

Taxable Income Thresholds

First Threshold Deductions

Suppose your taxable income is $321,400 or less for married people (joint returns) or $160,700 or less for single individuals (head of household). In that case, you qualify for the standard deduction even if your business is classified as an SSTB.

Here;

QBI Deductions = 20% of Qualified Business Income or 20% of Modified Taxable Income

Let’s say you have some ownership of an S corporation and a partnership. And you get $100,000 and $60,000 as qualified income from both businesses; your tentative deductions would be $20,000 and $12,000, respectively.

Third Threshold Deductions

Once your taxable income exceeds the first threshold and phase-out zones, calculating your qualified business income deduction becomes more complex. You cannot take the straight 20% deductions without applying either W-2 wages or qualified property limitations.

Depending on the limitations that apply, your deductible income can be;

Less than 20% of your qualified business income;
Greater than 50% of the taxpayer’s share of W-2 wages;
Greater than the sum of 25% of the taxpayer’s share of W-2 wages plus 2.5% of the unadjusted basis immediately after acquiring all qualified property.

High-income taxpayers need to understand these key terms and apply them to their tax returns.

Limitations on the Qualified Business Income Deductions

W-2 Wages
Unadjusted basis immediately after acquisition (UBIA) of qualified property.

What are W-2 Wages?

W-2 wages are the total wages reported by an employer in a W-2 form. The IRS requires every business owner to provide information on the taxable earnings of every employee plus any withheld taxes for a specific year.

Unadjusted Basis Immediately after Acquisition (UBIA) of Qualified Property

Unadjusted Basis Immediately after Acquisition (UBIA) of Qualified Property

A qualified property refers to any depreciable business assets that have helped you generate qualified income within the tax year. For example, if you purchased a new laptop for your business, it is a form of qualified property. Land or physical structures are not subject to depreciation, so they do not fall into this category.

The IRS described qualified property as a tangible depreciable property that;

is held by, and available for use in, the qualified trade or business at the end of the tax year;
is used to produce QBI at some point during the tax year;
and has a depreciable period that does not end before the close of the tax year.

The cost of tangible property upon purchase is its Unadjusted Basis Immediately After Acquisition (UBIA). Let’s refer to the laptop mentioned earlier. If it cost you $4,000 and you made the purchase in 2021, it means you have a UBIA of $4,000 for 2021. The depreciable period for a qualified property is ten years from its purchase date.

So how do all these come to play when it’s time to calculate your QBI deduction? Let’s look at this example;

A business owner files a taxable income of $600,000 which is more than the first threshold. She also has $100,000 qualified property and has paid another $100,000 in wages. To determine her deductions, she needs to calculate both wage limitations and choose the higher amount.

Limitation 1: 50% of the company’s W-2 wages

50% of $100,000 = $50,000

Limitation 2: 25% of the taxpayer’s share of W-2 wages plus 2.5% of the unadjusted basis immediately after the acquisition of all qualified property

25% of $100,000 + (2,5% of $100,000) = $27,500

The business owner chooses the higher amount, which means her tax deduction is $50,000. You can also check out this QBI flowchart that depicts how qualified business income deductions work.

How to Claim Section 199A Deductions

Small business owners can claim their qualified business deductions by submitting Form 8995 or Form 8895-A attached to Form 1040 when filing a tax return.

Form 8995 is also known as Qualified Business Income Deduction Simplified Computation. Form 8995 is a simple document that allows qualified business owners with taxable earnings less than the first threshold to claim the 20% deductions on qualified income. The IRS guidelines spell out specific instructions for completing this form.

If your taxable income is above the first threshold, you should file for claims using File 8995-A or Qualified Business Income Deduction. Form 8995-A has four parts;

Trade, Business, or Aggregate Information, where you list your businesses
Adjusted Qualified Business Income where taxpayers state their total qualified business earnings
Phased-in Reduction
Qualified Business Income Deduction

It also has the following additional schedules;

Specified Service Trades or Businesses
Aggregation of Business Operations
Loss Netting and Carryforward
Special Rules for Patrons of Agricultural or Horticultural Cooperatives

The IRS guidelines also spell out instructions for completing Form 8995-A for your tax return.

How Do QBI Deductions Apply to Business Losses?

The earlier examples in this article assume that the small business makes profits and the business owner has a positive qualified income. However, this isn’t always the case. So what happens when your company makes losses? How do losses affect the deductible amount on your taxes?

Losses are not good news for your tax deductions. They reduce your qualified income, which affects the total deductible income you can claim on your tax bill.

Net Operating Loss Rule

If you’re filing for qualified income deductions on multiple businesses and you have a loss in one of them, you cannot apply the net operating loss rule. You cannot carry this loss forward since the IRS calculates qualified business income separately for each business.

For example, if you have a qualified income of $10,000 from your S corporation and – $3,000 from a partnership, your total qualified business income for that tax year is $7,000. Losses reduce the deductions you can claim.

Also Read: How to Calculate Net Operating Loss

Negative Income

If your total qualified income is negative, your deduction is delayed to a future taxable year. It means that you do not have any taxable income for that year. The IRS will consider the negative income as a separate qualified business earning from another entity in the next tax year and add it to your current taxable income to arrive at your total QBI.

For example, let’s say a business entity had a negative QBI of $11,000 in 2019. You carry it over to 2020. Your qualified income for 2020 is $20,000. It means your total business income for 2020 would be (-$11,000) + ($20,000) which is $9,000. You can calculate your deduction based on this amount.

How Do Limited Losses Affect Qualified Business Income Deductions?

The IRS treats limited losses on a first-in, first-out basis which means eligible taxpayers claim the oldest losses before any recent ones. Since the IRS introduced Section 199A in 2017, you cannot reflect any pre-2018 losses in your qualified business income calculations.

On the flip side, you can list any disallowed, limited or suspended losses after Jan 2018 in your qualified business income calculations. Despite this, the IRS may ask you to wait till a future taxable year before allowing you to claim any of these losses on your federal income tax.

7 Easy Ways to Maximize Your Qualified Business Income Deductions

Higher tax deductions mean you will pay lower taxes as a small business owner, and who wouldn’t want this?

If you are looking to claim higher Section 199A deductions from the IRS, here are a few things you should keep in mind:

Try to keep your taxable income within the first threshold. This guarantees a 20% deduction on your qualified earnings.
If you are married, limit joint tax returns.
Consider registering a separate business that caters to any SSTB you own. You can create an LLC to handle this.
Make a pre-tax contribution for an individual or family plan of up to $7,100 to reduce your deductible health insurance plan.
Subscribe to a retirement contribution plan
Consider merging multiple businesses to increase your qualified business income, wages and UBIA.
Speed up the payments of specific expenses to reduce your qualified income earning.

Before filing for deductions, it would be best to speak with a certified public account or tax preparer to know how best to maximize your qualified business deductible income.

The Gray Areas in Section 199A

The revisions in the Tax code are pretty complex, with several gray areas. For example, the law refers to “qualified or business” as established by Section. 162. However, Section.162 does not clearly state the criteria for satisfying the trade-or-business standards, and this vagueness leaves things to chance.

There are other loopholes in crucial areas like the W-2 limitations, calculating total qualified business income, and shareholder compensation.

W-2 Wage Limitation

The W-2 wage limit is an essential factor for businesses above the income threshold and other SSTBs.

Initially, the IRS states that section 199A deductions should be determined separately. However, this can be problematic for businesses with a parent company and subsidiaries. For example, consider a scenario where one individual owns a group of companies that perform different functions but share the same employees.

The provisions in section 199A prevent the parent company from allocating the W-2 wages to any of the subsidiary companies. The implication is shareholders of the operating companies cannot claim qualified income deductions if they exceed the threshold.

Another issue with the W-2 limitation is no apparent difference between wages paid to non-owner employers and the payments made to a shareholder in an S corporation.

Let’s say two individuals own similar businesses with $700,000 qualified income. If one of them operates her business as a sole proprietorship, she cannot earn wage income as an employee of the business or file W-2 wages. Since the taxpayer’s qualified income exceeds the threshold and has no W-2 limitations, she cannot claim Section 199A deductions.

Inclusion of Owner’s Compensation

Section 199A excluded any compensation paid to S corporation shareholders or any guaranteed payments made to partners in a partnership. Ordinarily, this should not be a problem, but it works against an S corporation owner with a low-income threshold.

How?

Let’s say an S corporation has a qualified income of $100,000. Following the section 199A guidelines, the corporation still has to pay reasonable W-2 wages to its shareholders, including the owner. Since the income is below the threshold, the owner cannot benefit from the W-2 clause and gets lesser QBI deductions.

Defining Specified Service Businesses

Section 199A defines specified service businesses to professional fields like law, financial services, accounting, architecture, and others as stipulated by Section 1202(e)(3)(A). This poses a problem for classifying occupations like music producers, makeup artists, or film directors.

Defining Employees and Independent Contractors

Section 199A prevents employees from claiming tax deductions based on their wages. However, it allows independent contractors to claim deductions if their taxable income is higher than the first threshold.

The ripple effect of this advantage is that more employees may resign from their full-time engagements to qualify for tax deductions. Owners of companies can also terminate their appointments and set up S corporations that allow them to earn higher qualified income and benefit from W-2 wage limitations. This makes it difficult for the IRS to define workers for payroll and income taxes.

Key Takeaways:

Pass-through entities with qualified business income can earn deductions on tax liabilities.
Eligible taxpayers can claim 20% deductions on their qualified business income.
Professional service providers like legal and medical practitioners are subject to certain limitations under the Specified Service Trades or Business classification.
The threshold amounts for QBI tax deduction are:

Individual Taxpayers: $157,500 to $207,500 (2018); $160,700 to $210,700 (2019)
Married Taxpayers (Filing Joint Tax Returns): $315,000 to $415,000 (2018); $321,450 to $421,450 (2019)

Suppose you have over one domestic business. In that case, calculate their qualified company earnings separately and add the numbers. The Section 199A deduction will apply to the total amount.
W–2 wage limit and depreciable assets limitations apply to deductions for high-income taxpayers.
Section 199A deductions do not apply to self-employment taxable income or any income affected by the net investment income tax.

Wrapping Up

As mentioned earlier, the section 199A code is a lot to unpack. There are different dimensions involved, and the rules can get complicated fast. However, while this law takes away the job-related tax write-offs you may have enjoyed in the past, it also creates an avenue for lower taxes for small businesses.

The last thing you’d want is missing out on tax deductions because you filed the wrong information. So, while you can go through different helpful tax resources, it is best to speak with a qualified accountant or financial advisor who can explain the law’s peculiarities and how it affects your business.

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