What do owners of S Corps, Partnerships, LLCs or Sole Proprietorships need to know about the new 20% deduction provided by Section 199A?
General Background to Section 199A
Now that the Tax Cuts and Jobs Act (Section 199A) has passed, many entrepreneurs and owners of companies that are currently structured as pass-through entities (S corporations, partnerships, LLCs or sole proprietorships) are asking whether they are eligible to take the new Section 199A deduction for what is called “Qualified Business Income” (QBI).
For those businesses that are eligible, this provides a new income tax deduction equal to 20% of the QBI for each qualified trade or business (subject to certain limitations). Thus, the effect of this deduction is that, subject to a lot of rules, and assuming that the individual has a married filing jointly filing status and is in the highest (new) income tax bracket ($500,000 or more of income), this business income will be taxed at an effective tax rate of 30.7% instead of at a marginal rate of 35%. Similar tax savings are achieved at lower tax brackets as well.
Determining Eligibility and Computing the Section 199A Deduction
I can’t emphasize this strongly enough, but each taxpayer’s situation is going to be different. Do not assume that because a colleague in the same line of business has told you that their accountant has told them that they will be able to receive the deduction, that you will also be able to receive an actual tax benefit from it. There are simply too many “moving parts” in computing the deduction.
In an effort to bring some clarity, the attached Section 199A Decision Matrix provides more details and will bring some clarity towards determining eligibility and the amount of the deduction. In addition to the questions on the first page, the user needs to read the definitions on the second page of the decision matrix.
At its essence, the deduction and the amount of the deduction depends on the answers to several key questions:
- Do you have Qualified Business Income?
- For rough analytical purposes, QBI is going to mean the ordinary net income that arises from the U.S. business operations of a pass-through business.
- How much is your total taxable income?
- If your taxable income is less than $157,500 (single) or $315,000 (MFJ) and you have QBI, then certain limitations will not be applicable.
- Does your income arise from certain types of service-related businesses?
- If your business is on a list of “specified” service businesses (including doctors, lawyers, and accountants, as well as other businesses where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees), then your ability to take the deduction is limited.
- How much in wages does your business pay to its employees and how much Qualified Property does it have?
- In many circumstances, these amounts are relevant to and impose a limit on the amount of the deduction.
For help understanding Section 199A and what it means to you, please contact us.