What To Know About S Corp. Section 199A Deductions

What To Know About S Corp. Section 199A Deductions

We will present several examples comparing scenarios of non-S Corps, such as sole proprietorships, single-member (one-person) limited liability companies (disregarded entity), and other pass-through (partnerships) environments with the same tax situations as an S Corps. We will explain the benefits of the Section 199A deduction and its impact on the "Should I elect S Corp?" question.

In addition to the usual suspicions, such as earning no more than $30,000 in net income after spending or operating in Tennessee, New Hampshire, or New York, each scenario also offers an added advantage in electing S Corp status on section 199A deduction. 

  • Calculation of section 199A: There are four variables to which values are assigned, a definition to consider, a tax category to memorize, and two phase-out numbers to understand. Let's get started, shall we?

  • End of 24%: The 24% tax break ends at $157,500 for single taxpayers and $315,000 for married taxpayers. The next category of taxes goes to 32%. The move from 24% to 32% is intentional and, in our opinion, draws a line between the middle class and the upper-middle class. Depending on the situation, the Section 199A benefit may be eroded (eliminated) beyond the 24% tax bracket. Tax subsidies are indexed each year.

  • Phase Out Range: The income waiting period is $50,000 for singles and $100,000 for couples.

  • Qualifying Business Income (QBI): Take your net business income after expenses and enter 20% of that number.

  • SSTB (Specified Service Trade or Business): Does your business outlive the reputation or skills of its owners? Are you an accountant, actuary, lawyer, consultant, financial advisor, doctor, paid athlete, or performance artist? 

  • Taxable Income: You need to figure out what the whole family is reporting as taxable income, not just business income. See line 15 of Form 1040 2020 for an overview of your current situation. Jot down & write 20% of this number.

  • W-2 and Depreciable Assets: You need to workout the total amount of W-2 salaries paid by the company, including employee salaries. Write 50% of that number. You need to work out the unadjusted basis immediately after the acquisition (the amount immediately after the purchase before depreciation) of depreciable assets held by the business. Write down 2.5% of this number.

Section 199A Deduction Limits

The usual question a tax expert gets as regards this subject matter is, "How do I calculate my section 199A deduction?" In addition to using expensive tax software, you should seek professional advice.

If your tax basis is in the marginal tax bracket of 24% or less, stop. You are done and can select the lowest 20% of your qualifying business income or 20% of your taxable income.

Now, assuming that your household's taxable income is within the marginal tax bracket of 32% or more, you need to include some additional limitations in section 199A based on the following:

Unspecified Service Business: You should now consider deducting section 199A based on W-2 wages or depreciable assets and using the most restrictive of all section 199A calculations. If you are in the income step range (or the deduction limit phase-in range but want to see the nomenclature), there is a linear sliding limit scale based on W-2 salaries and depreciable assets. 

In other words, the more you are in the phase-out range, the stronger the limiting effect of W-2/depreciable assets. It is not necessary to prejudge the calculation at this time.

  • Specified Service Trade or Business

Suppose you are a Specified Service Trade or Business (SSTB). In that case, you must now reduce the Section 199A deduction to a linear scale that reaches $0 as you move through the elimination interval ($50,000 for single taxpayers and $100,000 for married taxpayers). W-2 wages or depreciable assets come into play, but differently (towards the end, we offer an example of phasing out). Your Section 199A simply ends after $207,500 (for single) and $415,000 (for married). 

Remember that being designated as SSTB only affects you if your taxable household income exceeds the 24% tax bracket.

Examples of Section 199A

Here are some examples to illustrate various deductions from qualifying business income under Section 199A.

Note: $157,500 and $315,000 represent the end of the 24% marginal tax bracket. These are the figures for 2018 (base year) and are indexed each year.

John earns $100,000 in net business income from his sole proprietorship and deducts $5,000 for health insurance for the self-employed, $7,065 for self-employment taxes, and $10,000 for a SEP IRA. These are not business deductions; they are adjustments to Form 1040 to calculate adjusted gross income. John's deduction is less than 20% of $77,935 (net business income after deductions above) or 20% of his taxable income, which may be less.

Jane owns three rentals with net income of $20,000 and $5,000, and one loses $8,000 annually. This is the equivalent of $17,000. Jane will deduct 20% of $17,000.

Jane has passive losses carried forward and are "released" because she now has net rental income; these passive losses are assumed first. Using the same example above, with reported passive losses of $10,000, Jane's deduction would be $17,000 minus $10,000 or 20% of $7,000.

Jude earns $100,000 from his pass-through business but reports $80,000 of taxable income on his tax return due to other deductions, such as his itemized deductions. The section 199A deduction would be $16,000 because the owner limits it to 20% of $100,000 or $80,000.

Cena runs an online retail S-Corps business that pays $100,000 in W-2 wages and earns $400,000 in qualifying net business income. Because Cena is considered "high income" for exceeding the income limits, his deduction is limited to 50% of W-2 or $50,000, which means less than 20% of $400,000.

On the other hand, Cena acts as the sole proprietor and earns $500,000 but does not pay the W-2 salary, his deduction is 50% of the owner's W-2 salary (or $0 in this example ) or 20% of the $500,000. If he paid out $200,000 in wages and have $300,000 in net business income, the section 199A deduction will take 50% of $200,000 or 20% of $300,000. In other words, he would deduct $60,000 ($60,000 is less than $100,000). You want to start an LLC, tax it as an S corporation, and pay W-2 wages to maximize the Section 199A deduction.

On the other hand, Cena operates as a specific service business as defined above, he would eliminate the Section 199A deduction by exceeding the income limit of $207,500 and $415,000. This is the specified service.

If Cena was married and ran a specific service business, and taxable income considering all sources of income (spouse, investment, etc.) exceeded $315,000 but was less than $415,000, there would be a deduction eligibility scale. Tax reform does not mean tax simplification.

Joe is a slumlord and earns $500,000 in rental income. Not W-2, because he manages the properties as an individual (and converting passive income to income versus W-2 would be stupid). Suppose Joe bought the properties for $1,000,000 (no adjustment). The calculation would be as follows: 20% x $500,000 equals $1,000,000 (direct calculation). 50% of $0 is equivalent to $0 (calculation of limit W-2). 2.5% of $1,000,000 is equal to $25,000 (calculation of depreciable asset limit).

Section 199A is limited to the lessor of $100,000 over the greater of $0 (W-2) and $25,000 (depreciable assets).



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