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!
Not only is Steve an amazing accountant, he’s also an accomplished author who wrote QuickBooks for Dummies and Quicken for Dummies (both of which sold over a million copies).
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 $56,000 ($11,200).
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.
Actionable Insights
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.
This is a great opportunity for business owners who qualify to save on our taxes. Thanks for sharing! I’ll be sure to reread this as I boost my business income.
Also, I think there may be a typo in the sentence “for the years 2018 through 2015.”
Jason, regarding the possible typo, I was just trying to say the Section 199A deduction appears on the 2018 return, the 2019 return, the 2020 return… and so on through the 2025 return.
Whoops, I corrected that typo but I must have undid the correction when updating something else. Fixed now though so thanks for letting me know!
I’m just trying to get some clarity on the real estate investor side of this new tax law. Let’s say you own 50+ units (apartments, townhouses, etc.), which are owned across five separate LLC’s, and you are essentially retired and pulling a relatively (occasional work within the business-accounting, etc.) passive income stream off each LLC. Let’s also assume the combined income from Schedule E’s is still under the $315,000 (married filing jointly) threshold. Would this type income be considered “allowable” (Qualified Business Income) for the 20% deduction? Would the deduction be adjusted prior to calculating MAGI (or AGI) on a 1040 or below the MAGI line (relavent for Obama subsidy calculations). Thanks in advance for any input. Great article.
ThomH, the real estate part of this is slightly murky. Lots of people, me included, thought real estate investors would FOR SURE automatically get to use the Section 199A deduction–so in the same way a sole proprietorship does. But the proposed regulations say your real estate activity needs “to rise to the level of a trade or business” as contemplated by another chunk of tax law, Section 162. Basically, that means an investor can’t be sporadic, the activity can’t merely be a hobby, rather her or his activity needs to show “regularity and continuity.”
BTW, the very first example in the new regulations indirectly talks about an investor with “several” pieces of raw unimproved land which he rents to suburban airports. And that qualifies for the Section 199A treatment. So with 50+ units, an investor is way, way, way, way past the threshold of “several.”
I also think that someone with a single rental property might qualify if the landlord met the “regularity and continuity” threshold. For example, regularly using an extra bedroom as an AirBnB rental. But the point is, someone with one property doesn’t automatically qualify.
Regarding MAGI, the Section 199A deduction isn’t a deduction for AGI so it’s not a deduction for modified AGI. It’s like a standard deduction or total itemized deduction amount that moves AGI toward taxable income. It shouldn’t have any impact on Obamacare subsidy calculations.
Thank you for the very thorough response. This helps significantly. My CPA has been unsure to date, but everything I’ve read, including your explanation, indicates I should be able to utilize the deduction. Many thanks.
Hi,
I have a question about the rental income. Is the rental income here referred to taxable income reported on Schedule E, Line 24? Or the income before deduction (expenses) and depreciation?
Thanks,
ML
I would like the answer to this question from M, Nov 29, as well. Is the 20% based on gross rental income or net rental income AFTER depreciation? Thank you. ~ Diane H
I am also very curious about this.
P.S. I missed out the first time around. How do I actually order a T-shirt? I don’t see a “buy” shirt link anywhere on the site. Am I missing it somewhere?
Sorry, I tried to make the PayPal buttons look less shitty and my CSS moved the buttons offscreen on some mobile devices.
I removed the offending code so hopefully you can see the buttons now on any device!
Thank you! Ordered!
While I”m disappointed that you decided against the MF underwear that I designed, maybe society is better for it.
Just gotta say that I love my MF t-shirt. So soft… So beautiful… So green…
And I have a lot of t-shirts from folks in the FI community and this is the only one someone has come up to me and said: “Mad FIentist! I love that blog!”
I was wearing my MMM shirt the other day and someone at a store cocked their head at me with a quizzical look and blurted out “Mr. Monkey Mustache!?”
No… but not a bad idea! lol
Haha, MF underwear is definitely still in play! I’m just waiting on your final design proofs (you will be modeling them, after all, so I want you to be completely happy with them).
This batch of shirts will allow me to complete the 1500 family collection so can’t wait to get a group photo when we’re in Colorado!
This is good stuff. Lots of asterisks to wade through, but it’s looking pretty good for our family. Another reason I love being a contractor. (And I LOVE my Mad Fientist shirt!).
Thank you for this. Also was just reading your post on “how to access retirement funds early” and saw that in your calcs the Roth 401K is worth less than the traditional 401k at the start of this hypothetical person’s retirement. Wouldn’t the two accounts be equal if they were contributing the same amount every year, regardless of Roth vs Traditional?
Thank you for helping me to understand. I really appreciate it.
Having not reread the 401k article, I would suspect the Roth is lower because you have to put in post tax money. Most people don’t just have 18k lying around. What they have is that last 18k in their salary they can choose to differ or not, if different 18k goes to the 401k, but if taken as income to put into a Roth, taxes are payed. This potentially reduces the amount by 25-35% because all other deduction and progressive tax brackets have been applied to the rest of the salary already. So the Roth contributions of 12-15k are typical for planing.
Daniel’s correct. When you contribute to a Roth instead of Traditional, you pay more tax up front so you have less to invest (assuming spending is constant).
Thanks for the helpful information. My wife and I own a vacation house with another couple. Our business is organized as an LLC. We rent the house out on Airbnb and VRBO. Would our K-1 earnings qualify for this loophole, even though we are not part of an S-Corp or a sole proprietorship?
Eric, Airbnb and VRBO vacation rentals through a partnership should work for Section 199A… that surely rises to level of “trade or business.”
Do REIT Preferred stocks qualify for the 199A special tax treatment?
Lamaont, qualified REIT dividends work and that link in post that points to “how Section 199A changes investing” provides more detail and explains what qualified REIT dividends are. But one caution. It’s unclear at this point whether a REIT mutual fund or REIT etf gives you qualified REIT dividends. Technically, they won’t. But maybe IRS will fudge the statute or maybe Congress will tweak the law.
Where can I learn more about Gambit #4?
Jeremy, this stuff is so new that most of the info is still getting processed by the tax accountants and attorneys.
But to give you a bit more detail about using the Section 199A deduction to help with Roth conversions, here’s an example: Suppose someone makes $124K in a sole proprietorship and for 2018 will take the $24K standard deduction. (This means they have a $100K taxable income.)
This person gets a $20,000 Section 199A deduction as per the blog post above. Depending on the person’s filing statute, that $20,000 deduction effectively shelters $20,000 of income from basically a 22% or 24% income tax.
This person could use the $20,000 deduction to reduce their income taxes, therefore, by $4400 or $4800. Lots of folks will probably do that.
But if a person *was* interested in Roth conversions, they could use the $20,000 deduction to shelter $20,000 of Roth conversion. This means they, in effect, use the $4400 or $4800 of taxes the Section 199A deduction saves to pay for the $4400 or $4800 of taxes on the Roth conversion.
Here’s why (to me at least) this may make sense to consider: Rates are pretty low for next few years… maybe paying a 22% or 24% rate *is* the low point.
Wow, what a great post. Thank you so much. I wish I had you as my tax guy! A question for you. It looks like my wife and I will be over the 315K limit for 2018, but only by about 30-40K. Here’s the question: Is that 315K limit pre-deductions or post? A bit of background — I’m a tenured professor who also has a consulting and speaking business on the side (an LLC that’s just me – no employees – which will earn about 170K this year). However, I have plenty of small business deductions that I’m hoping will bring that number down, and thus hopefully get us back under the 315K limit. But am I correct to think about it this way? That the deductions will apply to bring our income down? Probably a silly question but my brain spins when I try to understand taxes. I’d really hate to just barely miss out on the full deduction, so any advice you might have would be most appreciated. I’m even thinking about cancelling some events if I can defer them until next year, but perhaps that’s not necessary? Thanks again!
Jess, the thresholds ($157,500 for single taxpayers and $315,000 for married taxpayers) are taxable income before the Section 199A deduction.
E.g., if a family has one adult earning $150K, another adult using $100K, and then a sideline business that makes $150K, the family’s total income equals $400K
But what you need to look at is the family’s taxable income before the Section 199A deduction.
If family loads up the tax return with, say, $90K of deductions, their taxable income is $310K before the Section 199A deduction. And so these folks are under the threshold and the phase-out doesn’t apply.
Note: The family’s Section 199A deduction equals 20% of lesser of the $150K of qualified business income or the family’s $310K of taxable income.
BTW, if the family’s deductions (to continue the example) only get them “down” to taxable income of $365K, things get tricky. $365K is half way through two phase-outs…
Mad Fientist linked above to a blog post I did about how the phase-out calculations work… you want to look at that if you think the phase-out calculations apply. But to give you a rough idea, if you were earning $150K in a consulting business and you were half way through a phase-out range, you could lose half your Section 199A one time due to being a consultant… and then you could lose half of the remaining half due to not having adequate W-2 wages or depreciable property.
Thank you for your quick response. I think my best bet is to try to move a few events to 2019 and to load up on as many deductions as possible in an effort to stay under 315K. Do you agree? Again, thanks!
One way to get the number down is to have a Solo 401K or SEP IRA deduction in the consulting business for the year. This more than likely, coupled with your other deductions would get you below the threshold. This is what I have been advising clients in your situation.
I should have thanked you for this reply back in August, but I’m only seeing it now. I think that’s exactly what will happen for us – after my business expenses (mainly travel) and my SEP IRA contribution, we should be below the 315K. Thanks!
With that consulting income, if it is steady from year to year, you could consider a defined benefit pension.
With business deductions and a pension, you’d probably be able to drop your taxable income into the right range. You could use a good accountant whose goal is to reduce your taxes, not the usual accountant whose goal is to fill in the blanks.
Stephen,
I sell tradelines on my credit cards, for which I am paid via 1099, Line 7 (non-employee compensation). Would this income be eligible for this deduction?
I should add that I file this income as sole proprietorship.
I have already been contributing 20% of this income as an employer contribution to a SEP IRA, so it would be great to shield another 20% of it.
Kyle, I obviously don’t know the level of activity you engage in with the trendlines stuff. But if you’re reporting correctly on a Schedule C, any profit should count as qualified business income.
Would the contribution to the SEP IRA (or SE Health insurance, or SE tax deduction) reduce the amount of 199a deduction?
I’m new to the whole FI community. My husband and I own a sales and marketing consultant LLC. I take a very small paycheck as an employees and everything else is either left in our business account or used as my husbands income. We gross around 200k for our business. Does this type of work as an LLC qualify for the deduction?
Mes, that should provide a Section 199A deduction equal to the lesser of either 20% of your family’s taxable income or 20% of the business profit that appears on the tax form.
E.g., the business makes $50K after expenses (including your salary). But your family taxable income is say $100K due to salaries.
In this case, deduction equals 20% of the $50K or $10K.
Just for clarity, with all the limits, what’s the max possible individual/married deduction available from this particular law?
(E.g. something like “20% of 415k = $83k”)
Dan? The 20% deduction is not limited.
For example, someone has a business that makes $10,000,000 and their tax return shows a taxable income of, say, $15,000,000 due to other “investments.”
Further, assume the business has a bunch of employees and so pays millions in W-2 wages.
In this case, the Section 199A deduction equals $2,000,000–20% of the $10,000,000–and the taxpayer saves about $750,000 of federal income tax.
This is fantastic. I have a w2 job where I make 100k and I have my side business which generates 40k. If I’m understanding this right, since I’ll take that 40k as taxable income I can put 10k (25% elected S Corp for my LLC) into my solo 401k and take the 199A deduction for 8k. Then I would owe tax at my marginal rate of 39% (federal + SECA still) * 22,000 = 8,580 in tax. Which is an effective tax rate of 21%. And there’s that sweet spot soon from ~128k-~157k where there is no FICA/SECA and your marginal is only 24%, and where (assuming 401k space) you could have an effective tax rate of 13%!!!! Assuming I understand this correctly.
Zak, for an S corporation, the 20% applies to the value that appears in box 1 of the K-1 you receive from S corporation. I think that’s less than the value you “scratch-pad calculate” in your comment above.
Oh no! You’re right I thought this was going to be fantastic. It actually doesn’t really do anything for me then I guess
A very interesting post as usual. When I first heard about this tax break in December, I assumed it wouldn’t apply to me as I fell firmly under the ‘exempted professions’ list; I’m a single-proprietor software consultant. Now, I’m reading that maybe it will apply to me so long as I’m within income limitations. For 2018 my total income will be ~400K so I might be too close to the phaseout for it to be worth much (plus 25K w-2 income from wife, who I file jointly with). In 2019 however my LLC income will probably be closer to $130-140K.
So my questions are:
1. Does section 199A apply to me (potentially)?
2. If yes, do I need to form an S-Corp to take advantage of it?
p.s. Don’t worry – I’ll consult with a tax professional before doing anything rash. I’m just trying to do my research first so I’m not going in blind.
Thanks!
Replying to Dave’s questions about whether Section 199A works for software consultant and does someone need an S corporation…
I would guess Section 199A might work for Dave’s software consultant business. The regulations describe “consulting” as situation where someone provides advice and counsel. If what a software consultant really does is programming or design, that’s probably not really per the Section 199A deductions a “consulting” activity.
Regarding the need for an S corporation, the only reason someone would need an S corporation is if they need W-2 wages to get the deduction.
This is great and very timely information. I have an opportunity to finally become self employed soon and this is just pushing me closer to the edge. Excellent information.
How does this work for side hustle people. would the 20% income tax savings be just for your side business and not on your full time employment?
I believe so, yes. So you’d save 20% of your side hustle, unless somehow your side hustle made more than your main hustle.
But then would your side hustle be your main hustle and your main hustle actually be you side hustle?
After reading section 199A, I am wondering if I qualify. My business is structured as a single member S-Corp. I earn roughly $70,000 as an interpreter in Spanish. My job is solely me and my skill, nothing more and nothing less. Would this mean that I am disqualified? From my read of this section it seems as if I wouldn’t qualify. Also, at my income level, I try to stick with the 50/50 distribution/salary ratio to avoid any “reasonable compensation” issues with the IRS. Could it be advisable to move the needle slightly to maximize the distribution portion on my income on my K-1 to maximize the section 199A deduction? Thanks for any help/advice!
Caden, I’m in a similar situation where most of my business income is for consultation services based on expertise. I own and operate an artist career consulting business in which I advise them through an on-line course, or in person. My understanding is that I do not qualify, though I have yet to consult with a professional.
So Caden’s business is not at risk of getting disqualified due to being a specified service trade or business. Caden gets the 20% deduction on the leftover S corporation profit that shows up on the K-1.
Steve’s business is a specified service trade or business (a consultant)… accordingly, if his taxable income rises high enough the phase-out calculations kick in. Accordingly, he may lose the deduction.
BTW, Chris possibly can use the Section 199A deduction on the side hustle profits. But if Chris’ taxable income is high, the phase out stuff may kick in.
Note: The Mad FIentist linked to a longer discussion at my blog (see in post) about how the phase-out calculations work. Click that if you want to go into the weeds on this.
Think about splitting your biz in two:
1. the consulting one on one which wouldn’t get the deduction, and
2. selling the course. That would prob get the deduction.
Hope the numbers work for you. ;-)
I purchased one of your Mad Fientist T-shirts a few months back, and it is literally my favorite shirt that I own now. Fits perfect and very comfortable. And of course the logo is awesome too……. Thanks man!
Glad to hear it! It’s my favorite shirt too (and it should be, since I spent years testing t-shirt brands in an effort to find the perfect one for fit, softness, quality, etc.)
I’m a little confused. Point #1 says S-corp shareholders should bump their salaries down and point #3 says maybe to bump them up. Can you give some kind of scenario to show where each applies? I’m very interested as I have an S-corp and get a salary and distributions, and to this point my accountant had advised me to keep these approximately 50/50, but we still have a few months to go, so if I need to change that strategy, now would be a good time…
Sorry Rachel. This is confusing. Ugh.
OK, first, the general rule: Your S corporation must pay you reasonable wages. Let’s just get that out there first.
Second, to save payroll taxes and to maximize your qualified business income, in general and subject to the first “general rule” just provided, you want to pay Rachel the employee the lowest possible amount that is still reasonable.
Third, if the tax return that Rachel files shows a taxable income that’s over the threshold amounts, it may be that she optimizes by bumping her salary to bump her Section 199A deduction. This means she may pay more in payroll taxes… and it means she’ll reduce the qualified business income that plugs into the Section 199A formula… but if her Section 199A deduction gets limited by W-2 wages, paying more wages to get a bigger Section 199A deduction may make sense.
I think I understand now. I shouldn’t be over the limit unless something unexpected happens this year, so more distributions for me! Thank you!
I own shares of this company with symbol CG. it’s a Publicly Traded Partnership on its investor FAQs page. It produces K-1s at end of the year. Is it qualified for this new tax law?
Yes. It’s a qualified publicly traded partnership. You’ll get 20% of whatever you get from REITs and the income you get from this partnership and any others like it.
Would the Madfientist or Mr. Nelson be able to comment if this tax break has an impact on a small business? ie a blog or similar with minimal expenses. I may be missing something but I assume the Madfientist’s LLC is relatively small. Just curious if there are tricks to maximize the benefits of a small business and this tax change.
Let’s say you own an s-corp that does software development. You pay yourself 146,000 W2 salary and defer 18.5k in your 401k for the employee portion (W2 deduction). You then also get 750k for the distribution/K-1 of the S-Corp. Is it correct that only 50% of the W2 taxable income (146,000 – 18,500) * .50 = 63,750 could be used as a deduction?
Justin, the Section 199A deduction in your example is lesser of 20% of the $750K… or 50% of the $146K…
You get, therefore, $73K.
This begs the obvious question, should you bump (or can you bump) your wages… High school algebra says you can calculate the optimal W-2 wages percentage as equal to 28.5714% of the sum of $750K + $146K).
Hey Stephen! Appreciate your response. My s-corp also pays my wife a salary (W2) of 146k. How do you think this would change the approach?
Thanks!
Justin, if your S corp makes $750K and pays two employees $146K each (so $292K in total), the Section 199A deduction equals the lesser of 20% of $750K (or $150K)… or 50% of $292K (or $146K)…
Obviously $146K is less than $150K so deduction is $146K.
BTW, the above situation looks so optimized (perhaps inadvertently) that one would want to make sure everything withstands close scrutiny. E.g., one would want to make sure the W-2 wages amounts were right per the proposed revenue procedure that came out with regulations, that corp accounted for wages and other items of income and deduction in manner that complies with statute, etc.
If you have a small (profitable) business, you’re probably going to get Section 199A deduction equal to 20% of the profit.
For example, if your small business makes ten thousand in profits, you’ll get a two thousand dollar Section 199A deduction.
And if your small business makes ten million in profits–subject to W-2 wages and depreciable property limiters–you’ll get a two million dollar Section 199A deduction.
Is there any reason to be concerned that TurboTax won’t calculate this correctly?
These thoughts from someone who runs a boutique tax practice serving entrepreneurs and business owners…
For simple situations like a taxpayer with one business treated as a sole proprietorship and handled with a Schedule C, I would think TurboTax will do fine. (IRS estimates this work will add about 6/10ths of an hour on average to a little over 1,000,000 tax returns.)
But beyond that, the accounting will get really tricky. (IRS estimates for slightly more than 8 million S corporation and partnership returns, the extra work of Section 199A runs nearly 2.75 hours per return on average but can go to 20 hours.)
Therefore, I believe this is way beyond do-it-yourself in many situations… and I am a big booster of DIY tax return preparation. (To say this here out-loud, most people should use TurboTax!)
One metric to hint at this: The law that says you can sell your house without paying capital gains, Section 121, runs about 5 pages and the regulations that back that up (with detailed instructions and examples) runs about 20 pages.
The Section 199A law runs 10 pages (which doesn’t sound too bad)… but the first, incomplete wave of regulations (including a proposed revenue procedure they left out) runs over 200 pages. That tells us something.
One other related comment: I think many small CPA firms and tax accountants will struggle to be prepared to handle this law in time. They very possibly won’t be up to speed in time. And they very possibly won’t have the available capacity to actually do the new work required once they do learn the law. (Not to air my profession’s dirty laundry, but this *has* happened in recent past…most recently in a big way with the “tangible property regulations” for the 2014 tax returns.)
Also consider this: By the time you start using TurboTax to handle a complicated situation, it’ll be too late to re-structure your previous year’s financial statements, tweak W-2 wages, move depreciable assets around, etc.
“The Section 199A deduction can’t exceed 20% of your taxable income.”
Here’s where I’m confused. I’m wondering if it still makes sense to do pre-tax retirement contributions in my situation.
I’m a sole proprietor (service business), making $60-$70k, no employees, no other income. For the sake of the example, let’s say I make $60k.
60k – 12k standard deduction = 48k of taxable income, so I’d get a ~$9,600 deduction under Section 199a – correct?
BUT, if I contribute to my SEP IRA, which I was planning on doing:
60k – 12k standard deduction – 10k SEP = 38k of taxable income, so I’d get a ~$7.6k deduction – right?
In this situation, does it still make sense to make pre-tax SEP contributions, or should I look into getting a Roth Solo 401k? (already maxing a personal Roth IRA).
Sorry if it’s a dumb question – this stuff makes my head spin!
Austin, okay, first your question is absolutely NOT a dumb question.
And, second, seems to me like your comments about a Roth account kind of amount to another way to approach “gambit #4” above: Not wasting the Section 199A deduction and using it to allow for Roth contributions.
In effect, you’re proposing to stop using tax-deferred retirement accounts because Section 199A deduction will be higher… and probably because Section 199A will “save the taxes” that you would have saved with a tax-deductible retirement contribution.
Let’s see if MADFIentist comments on this, but at first glance, I see your twist as really rather clever.
But what about the other way around? I’m marginally in danger over being over the 315K limit. Will my wife’s and my SEP and Roth contributions bring down our approx 340K of income this year? I’m still trying to determine whether these retirement contributions and the business deductions I mentioned in my earlier post will “help” get us back to or below the 315K limit. Thanks again!
Just to be more specific, I should be able to contribute nearly 19K to my SEP and my wife will contribute to her Roth. Will these contributions help bring us down to the 315K limit?
Jess, the Roth won’t bring down your taxable income. The SEP will.
Hmm, okay – something to think about! Unfortunately I JUST opened the SEP IRA last week haha.
Is it possible to have a SEP IRA, Roth solo 401k, and Roth IRA at the same time?
I assume the SEP and Solo 401k are closely aligned, and likely share limits – but can I have both and contribute to both in the same year (so long as I stay under limits)?
Austin, I bet the 401(k) plan supplants the SEP. Also, they work against the same limits and percentages so are essentially redundant.
Also, as pointed out in a comment made earlier, the SEP drives down taxable income and Roth elective deferrals don’t. Therefore, if someone is at risk of losing Section 199A due to a high income, person wants to look at not doing Roth contributions.
You can’t simultaneously do a SEP IRA and a solo 401k for the same business. You have to pick one or the other for that tax year.
Not totally true. You can contribute your employee contribution to your solo 401k and then use your SEP IRA as your employer contribution.
If you depend on subsidies for your health insurance that you get on the ACA exchange then you would still want to lower your AGI down to maximize these.
Austin, that sounds like it could be a great plan. In this case, you’d be trading tax-deferred retirement money for tax-free retirement money (and thanks to Sec. 199A, you may not even have to pay more taxes up front for the privilege).
In cases like these, I like to put together a simple spreadsheet to run the numbers so you should do the same. Have two columns (one for the SEP scenario and one for the Roth scenario), play around with the contributions, and see what’s best (remembering that the money saved in the SEP scenario could be taxed eventually).
Putting together your own little tax-calculator spreadsheet isn’t that difficult to do but it really helps you understand the rules and how all the variables interact.
@ The Mad Fientist
I’ve already contributed to the SEP this year. Can I open and contribute to a Roth Solo 401k this year, as well?
Or say next tax year – if I leave the SEP alone and don’t contribute to it, can I open and contribute to a Roth Solo 401k?
Thanks!
So where do you think this 20% deduction is going to end up on the 1040? Or do you think it would be on the Sch C itself and affect Line 12? I’m wondering how it will affect certain MAGI calculations. Maybe it will be placed on Line 27 with the SE Deduction?
Steve, deduction appears on 1040 (usually), specifically doesn’t impact AGI and so won’t impact MAGI, and as a good guess will get the spot that used to go to the now expired Section 199 deduction.
The draft Form 1040 shows the QBI deduction on 1040 line 9, after 1040 line 8 (standard or itemized deduction) and before line 10 (taxable income).
Thanks for a great post! This is a huge potential tax benefit.
I receive some “guaranteed payments” to partners in an LLC where I’m not technically a partner but the business return lists me as such with a zero percent partnership interest. I’m wondering if I should ask the accountant to recharacterize me as an independent contractor (although I might not fit that definition either as the business pays for things like malpractice insurance and provides me with an office) or otherwise change the payments so that they are not “guaranteed payments.” Seems like that might require special wording in the underlying contract I have with the business. If not independent contractor, perhaps they could be distributions even though I have a 0% interest? Is there special wording in the underlying contract that will pass muster with the IRS? Thoughts?
Prob8, the LLC operating agreement needs to be updated to reflect change in guaranteed payments. Too late, probably, to do anything about this for guaranteed payments already made in 2018. But you can fix things going forward.
BTW, anything that “smells” like a guaranteed payment also fails to qualify as business income that gets plugged into Section 199A calculations. (You can google on “section 707(a) payments” to learn more.)
P.S. It’s possible the CPAs doing the partnership return are already on this. They sort of should be…
Prob8, long time no see! How’ve you been doing?!
Would a sole proprietor professional gambler who is within the threshold be eligible? Thanks for this post. Had not heard of this.
So this is a funny coincidence. The seminal court case that determines just what a trade or business even is–something massively relevant to Section 199A–is Groetzinger v. the Commissioner of the Internal Revenue Service:
https://supreme.justia.com/cases/federal/us/480/23/
Groetzinger was a professional gambler…
Perfect :) You da man! And do you know if I will have to fill out anything special for this on turbo tax when I file, or is this something they will automatically be calculating like they do standard deduction and personal exemption?
Thanks again.
This is why I love using our accountant for things like this. It’s literally a full time job just to stay on top of the tax code. With our real estate, W2, and chiro business income, we’d be hard pressed to try Turbo-Taxing any of it!
Might I be correct in my current understanding of 199A regulation that if I wish to take advantage of this deduction as hands off investor considering adding Real Estate exposure to my portfolio for diversification I should consider the direct purchase of a domestic diversified Equity REIT stock instead of a REIT mutual fund or ETF? Do you know if pass-through income from direct GNMA investment will qualify even if GNMA funds and ETF do not?
Harold, qualified REIT dividends get you the 20% deduction, but Congress wrote statutes in way that means you need to own them directly. Probably best to plan for now indirect ownership doesn’t work. Note that Congress could change rules… or maybe IRS could fudge rules in some future regulation…
BTW, the three ways to get Section 199A deduction for real estate: qualified REIT dividends on REITs you directly own, rental income from a partnership or qualified publicly traded partnership you own an interest in, direct ownership in rental property as long as activity rises to level of trade or business.
Also, note not everything inside a REIT produces qualified REIT dividends. E.g., if REIT invests in stocks or bonds, income from those isn’t going to generate qualified REIT dividends.
Question from a curious non American, do you claim the cost of having your tax return prepared by a professional in the next years return? If you do, is doing it yourself just for satisfaction or something else, since it’s a tax deduction anyway?
I claimed the cost of doing my S-Corp return as a business expense but most of the cost of my personal return was a personal expense.
I’m wondering how this works for US citizens living/working full time in higher tax countries like the UK. Is there any benefit in trying to use this deduction for the US side of things when I think that ultimately we (my wife and I) will still be paying the same higher tax rate to the UK anyway?
Curious how you’ve approached this given the time you spend in Scotland
My business is based in the US so it’s considered a US business and is taxed accordingly.
Interesting. I have a normal W-2 job, but I also did some work for a different company this year as a 1099 contractor. My married-filing-joint total income is less than the phaseout, so it sounds like my contracting income (minus things like home office deduction) would be eligible for this 20% deduction, which would more than offset the self-employment tax. Is that right?
Rob, I don’t think you’re going to see any reduction in self-employment tax from the Section 199A deduction.
For example, if you have $10,000 of 1099 profit and your tax return shows something more than $10,000 in taxable income due to the W-2 job, your Section 199A deduction equals $2,000…. and your self-employment taxes get levied on 92.35% of the $10,000 in 1099 profit.
If your W-2 wages fall beneath the FICA limit, for example, the SE taxes equal 15.3% on the 92.35% of your 1099 profit…
As a 1099/Schedule C filing insurance agent, will I qualify for the 199a deduction?
Hi there – I set up an LLC to be taxed as an S-Corp to lower SE taxes (I pay approx 60% of income as wages, 40% as distribution to K-1). With these recent tax changes, it seems like it may be more of a benefit to take the 20% deduction than save on SE taxes. I’m under the income limitations. Am I correct? If so, is it possible to change the IRS election (i.e. start being taxed as LLC/sole proprietor)?
Thanks for the great article! I definitely need to reread it a few time to let it soak in. We have a small business and rental property, so I need to better understand how and if we’ll qualify. I assume 2018 tax software (TurboTax) will include it and (hopefully) guide you into the deduction.
Ordered some shirts too! WooHoo!
Thank you so much for the article!
A clarifying question: My W2 this year will be ~$70,000 and my wife’s Qualified Business Income will be ~$50,000. So if I’m reading this right, we will take the standard deduction of $24,000, my wife will max out her Solo 401k at $18,500 and will contribute to her SEP IRA at ~$8,000 and we will take the $11,000 for both of our Traditional IRAs. In total we have $61,500 in deductions ($24,000 + $18,500 + $8,000 + $11,000) and since that total is smaller than my W2 of $70,000, then my wife’s Qualified Business Income is still $50,000 and we will get a deduction of $10,000?
Again thank you for the great article!
I would love to hear the answer to this question as well. Great example.
Stephen actually had a follow up blog post on his blog about this, https://evergreensmallbusiness.com/retirement-saving-qualified-business-income-deduction/#comment-6994
I think it clearly answers my original question and that my wife’s deduction will equal $10,000. But I’ll wait for Stephen to confirm!
Our corporate accountant is telling me medical practices are NOT included in the legislation (We are a LLC partnership). Seems odd to exclude certain industries. Is this correct?
Thanks for another great article. You’ve educated me in us tax and savings over the past few month which despite being a UK citizen living in the UK has been fascinating to read.
Would you ever look to cover UK tax planning maybe your US readers would be interested in the comparison?
I retired earlier this year, but my wife (age 55) continues to work as a sole proprietor, doing consulting work for several companies (working from home). We live in California (no plans on moving out of state). Wife has been contributing to her SEP IRA for over 10 years now. In 2019, she’ll make and estimated $320K. Subtracting out deductions (other than retirement plans), such as Property Tax (limited to $10K/yr), Mortgage Interest ($10K), Health insurance premiums for the two of us (~20K), and limited Business expenses, it’ll bring us down to about $275K in QBI.
My question is…should she keep the SEP IRA, or instead start either a Solo 401K , or a Roth 401K? With a Roth 401K, a Roth 401K, approx $36,500 will be pre-tax, thus lowering the QBI even more, while she can put away $24,500 in a Roth account). Would this be the best path, or would having a regular Solo 401K be better?
Thanks RB
This is the best article on Section 199A that I have been able to find; unfortunately, I think I may have found it too late. I met with my CPA last week and he informs me that my S-Corp (Physician services) will not qualify for any Section 199A deductions. Maybe it’s wishful thinking on my part, but I having a nagging feeling that my accountant is mistaken. Here are my specifics:
Total 1099 income for the S-Corp:$450k
Employee W-2s (myself and wife): $160k+$34k=$194k
Cash Balance Plan contributions by S-Corp to employees (ages mid-50s): $213k
Profit Sharing (6%) for both employees: $11,640
Social Security and Medicare taxes for employees: $14,841
Business Expenses: $10k
Other income: $60k (pension)
Interest, dividend and capital gains: minimal
Roth 401(k) employee contributions: $24,500 each = $49k
Is my accountant correct in that my income is too high for me to qualify for the 20% pass through deduction?
Thanks,
Chairman
Go Seahawks!
I am a limited partner in a partnership that owns several revenue generating properties. Would I qualify for the deduction? Please let me know what other information you would need.
Could you use the 199A to reduce the taxing of taking early withdrawals from a retirement account?
I am the author of textbooks published by a large publishing company. Do the royalties on these textbooks paid to me by this publishing company qualify for Section 199! treatment?
Hello:
I am a CPA, I have several clients in Hotel motel business operating as S Corp or Partnerships. Will the earnings reported on their K1 qualify as 199-a deductions?
Thanks
Am a limited partner in a privately owned limited partnership that owns a self-storage facility. Im in other other limited partnerships and have no activity or other interests in the partnership other than my limited partnership.
I exceed the maximum income levels.
Am I eligible?
Excellent stuff!! I’m doing the 199A worksheet now. Thank you
I’m a realtor in Maryland and made $100k (paid with 1099). After expenses I netted $70k.
Do realtors qualify for 199A? Can I take the QBI deduction?
Example 2 should end with $56,000 not $54,000.
Thank You Mad Fientist!
My accountant had not used the 199A. I reviewed my 2019 return after reading this article and she has now amended it thus saving me thousands from last year and many more going forward.
I am planning on using your roth conversion ladder as well.
All of your information is eye opening and informative.
Thank You Again!