Year-End Tax Planning: Section 199A Deduction

Section 199A of the Tax Cuts and Jobs Act (TCJA) lets you deduct up to 20% of your qualified business income (QBI) on your income taxes. Your deduction hinges on factors like your business structure and income level. To maximize this benefit, grasp how Section 199A tax deductions function and take year-end tax planning steps now.

Don’t risk a reduced or eliminated deduction by not planning properly. Explore three potential year-end tax moves to enhance your Section 199A deduction and lower overall income tax.

If your 2022 taxable income exceeds $170,050 (or $340,100 for joint returns), factors like business type, wages paid, and property ownership may impact your deduction.

If your deduction is below 20% of your QBI, consider using strategies to increase your Section 199A deduction. Ready to save?

Learn more about these tactics in our blog. Don’t miss out—read further for a tax-smart 2023-24!

Understanding the 20% Deduction for Qualified Business Income

Section 199A allows eligible taxpayers to deduct up to 20% of their qualified business income (QBI) from their taxable income. This deduction is available for tax years beginning after December 31, 2017, and before January 1, 2026.

Limitations on the Deduction

The deduction is limited to the greater of:

25% of W-2 wages paid by the business + 2.5% of the unadjusted basis of qualified property
50% of W-2 wages paid by the business

The deduction is also limited to the excess of taxable income over net capital gain plus total eligible cooperative dividends. This limitation is in place to prevent the deduction from being applied to income that is already taxed at lower rates.

What Qualifies as QBI?

QBI is the net amount of income, gain, deduction, and loss from a qualified trade or business. Qualified trades or businesses are generally those that perform services in the United States and are not classified as “specified service trade or businesses” (SSTBs). SSTBs include businesses in the fields of law, accounting, finance, and others where the reputation or skill of one or more employees is the primary asset of the business.

How to Claim the Deduction?

Taxpayers who are eligible for the Section 199A deduction should calculate it separately for each qualified trade or business they own. The deductible amount is then subject to the overall limitation based on taxable income, net capital gain, and eligible cooperative dividends.

How to Maximize Your Section 199A Deduction

Prioritize income over guaranteed payments: Instead of making guaranteed payments to partners, focus on growing your business’s income. This will increase your qualified business income (QBI) and potentially boost your 199A deduction.
Adjust owner’s compensation: Consider reducing your salary if it’s higher than what’s considered reasonable compensation. This will increase your QBI and allow you to claim a larger 199A deduction.
Invest in REITs: Income from qualifying REITs and publicly traded partnerships (PTPs) is not subject to the W-2 or SSTB limitations. This means you can claim a 20% deduction on this income, without any restrictions.
Keep your salary below the cutoff: If your taxable income is below $315,000 (joint filers) or $157,500 (other taxpayers), you won’t be subject to the W-2 or SSTB limitations. This means you can claim the full 20% deduction on your QBI.
Time your income and deductions: If your income is above the cutoff, consider accelerating deductions, postponing income, or increasing retirement plan contributions to lower your taxable income. This will allow you to claim a larger 199A deduction.

Who Can Claim the Section 199A Deduction?

The Section 199A deduction is available to “pass-through” businesses, including:

Sole proprietors
Landlords
S corporations
Partnerships
Trusts with ownership in pass-through entities

Future regulations will provide guidance on how to calculate the deduction for tiered entities.

Calculating the Section 199A Deduction

The Section 199A deduction is limited by several factors, including:

W-2 wages
Unadjusted basis immediately after acquisition (UBIA) of property used in the trade or business

These limitations are complex and involve several calculations.

How to Maximize Your 199A Deduction?

1. Earn Income Instead of Guaranteed Payments

Instead of making guaranteed payments to partners, prioritize allocating earnings directly to yourself. This will increase your Qualified Business Income (QBI) and allow you to take a larger 199A deduction.

2. Adjust Your Owner’s Compensation

Your salary is not eligible for the 199A deduction. If you want to optimize your QBI and maximize your deduction, you can consider reducing your salary as long as it remains reasonable compensation.

3. Invest in REITs

Income from qualifying Real Estate Investment Trusts (REITs) and Publicly Traded Partnerships (PTPs) is not subject to the W-2 limitation or the SSTB limitation. You can take a 20% deduction on this income without any additional restrictions.

4. Keep Your Salary Below the Threshold

The 199A deduction is less limited for taxpayers who earn below $315,000 (joint filers) or $157,500 (other filers). If your income exceeds these thresholds, you can reduce your taxable income by accelerating deductions, postponing income, or increasing contributions to your retirement plans.

5. Who Can Claim the Deduction

The 199A deduction is available to any taxpayer who is not a corporation. This includes:

Sole proprietors
Landlords
Owners of S corporations or partnerships
S corporations, partnerships, or trusts that have an interest in pass-through entities

7. Calculating the Deduction

The amount of your 199A deduction is limited by several factors, including your W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of property used in your trade or business. You will need to carefully calculate these factors to determine your maximum deduction.

8. Fiscal-Year Businesses

Calendar-year owners of fiscal-year businesses are entitled to claim the full 199A deduction on their 2018 tax returns, even if some of the income earned by the fiscal-year business was earned prior to 2018.

9. Additional Considerations

There are several other tax planning strategies that you can use to maximize your 199A deduction. A tax advisor can help you identify the best strategies for your specific situation.

What is a Qualified Trade or Business?

To qualify for the Section 199A deduction, your business must be a “qualified trade or business.” This means that your business must be actively engaged in the sale of goods or services. The following types of businesses are not eligible for the deduction:

Specific service trade or businesses (SSTBs)
Businesses that provide services as an employee

In simpler terms, the Section 199A deduction is not available to employees who want to deduct a portion of their salary from their paycheck.

Reduced Threshold for Accuracy-Related Penalty

If you underestimate your taxes by a significant amount, you may be subject to a 20% accuracy-related penalty under Section 6662. For taxpayers other than C corporations, a significant underestimate is typically considered to be one that exceeds either 10% of the tax owed or $5,000.

However, if you claim the Section 199A deduction, you will be subject to a lower threshold before this penalty is applied. The lower threshold is equal to the greater of 5% of the tax owed or $5,000. This lower threshold is particularly concerning due to the complexities of the Section 199A deduction and the challenges taxpayers face when interpreting the law.

Importantly, the changes to Section 6662 do not require that the significant underestimate be directly related to the Section 199A deduction. In other words, even if your tax underpayment has nothing to do with the Section 199A deduction, you will still be subject to the lower threshold if you claim the deduction.

Key Takeaways ~

The Section 199A deduction can provide significant tax savings for eligible businesses. If you own a business, it is important to consult with a tax advisor to determine if you qualify for this valuable deduction.

The Section 199A deduction can be a valuable tax break for pass-through businesses.
There are several strategies you can use to maximize your deduction.
The deduction is available to a wide range of businesses.