Section 199A Deduction: How it Impacts Small Businesses

By MBO Partners | March 3, 2022

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Section 199A Deduction: How it Impacts Small Businesses

In late 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), the biggest overhaul of the U.S. tax code in more than 30 years. Today, the IRS is working on implementing the TCJA. One of the major changes in the law is, as described below, a deduction for certain “qualified business income.”

Below, we offer our analysis of the law as it currently stands, as well as highlight the proposed clarifications and what they might mean for individuals currently working as independent professionals. This law is quite complex with many interpretations still being explored. We suggest that you seek legal tax counsel if you are planning any significant changes to your business tax status.

How has the tax code changed?

The Tax Cuts and Jobs Act has changed many things about the tax code, adjusting both individual and corporate tax rates, changing the standard deduction, and much more.

While these changes are significant, one of the most important changes for independent professionals come from a new portion of the Internal Revenue Code that impacts certain sole proprietors and owners of businesses that choose to flow the profits of the business to their personal income tax returns of the owners; i.e. so-called “pass-through” businesses entities, such as S corporations and partnerships (including LLCs treated as sole proprietorships or partnerships for income tax purposes).

The pertinent text is in Section 199A, sometimes called the Qualified Business Income (QBI) deduction.

In general, the deduction is equal to the LESSER OF:

  • 20% of your business’ “qualified business income,” or
  • 20% of 1040 Taxable Income in excess of any net capital gain

Note: There are several limitations including income thresholds, wages paid, and capital invested, and certain restrictions with respect to “specified services,” as defined.

Under the law, most trades or businesses are “qualifying” businesses.  However, for certain types of businesses, referred to as “specified businesses,” the deduction is only available to a more limited extent. “Specified businesses” include (among others) any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” In particular, there had been considerable concern that the IRS might view the “skill or reputation” clause broadly.

The proposed regulations, however, take the approach that the “skill or reputation” clause is meant to refer to a “narrow set of businesses,” and generally limits it to people such as reality TV stars, media hosts, and professional gamers, as well as celebrities making money off of product or likeness endorsements.

The proposed regulations also address the scope of the term “consulting,” stating that this refers to businesses that mainly provide professional advice and counsel to clients to help clients achieve goals or solve problems.  They also clarify that a trade or business is not consulting if there is no separate payment for the consulting service and it is embedded in or packaged as part of a sale of goods.

How does this impact my business?

Effectively, this means that many independent professionals might be able to take a deduction of 20% of their Qualified Business Income.

However, the law limits the deduction in two key ways. *

First, it requires that the QBI deduction be used by qualifying business types: sole proprietorships, and owners of “flow through” entities, such as S-Corporations, partnerships, and LLCs treated as sole proprietorships or partnerships for income tax purposes.

Second, it has income cap thresholds.  This deduction is available with respect to any trade or business, even the “specified” trades or businesses discussed above, with 1040 taxable income of less than $163,300 ($326,000 if filing jointly) for taxable year 2020. Above that income cap, the deduction is phased out over the next $50k ($100k if filing jointly) in taxable income.  Above $426,000, the deduction is only available with respect to trades or businesses other than specified trades or businesses, and several other complex limitations apply including limitations based on the amount of W2 wages paid and the amount of capital deployed in the business.  We will not address these limitations in this blog.

Let’s explore what that looks like in the calculation below:

Sole Proprietor Income

Personal Income

Income from Client Billings

$150,000

Business Expenses
Conferences

                              $(8,000)

Technology

                              $(7,000)

Co-Working Space

                              $(5,000)

Professional Development

                            $(10,000)

Total Expenses

                            $(30,000)

Qualified Business Income

$120,000

$120,000

Self-Employment Tax

                            $(16,955)

 

Health Savings Account

                              $(5,000)

 

Spouse W-2

$50,000

Standard Deduction

                            $(24,000)

 

Income Before 199A

$124,045

199A Deduction Lesser of:

20% Taxable Income

$24,809

20% Qualified Bus Income

$24,000

$(24,000)

 

Net Taxable Income

$100,045

Tax Savings via Section 199A

$5,760

Using the sample calculation above, and assuming a federal tax rate of 24%, there is a $5,760 annual savings as a result of this new provision.

Will the changes help independent contractors?

For qualified independent contractors, this means there’s never been a better time to work independently.  However, the IRS emphasizes that the 199A benefit is only available for independent contractors and not employees (as W-2 wages never qualify for the benefit). The proposed regulations specifically state that the IRS will look closely (and unfavorably) upon those individuals who assert that they have changed work classification from full time employment to an independent contractor with their former employer.  In these cases, there will be a presumption that for 199A purposes the person is still an employee.  According to the proposed regulations, this presumption may be rebutted “only upon a showing by the individual that, under Federal tax rules, regulations, and principles (including common-law employee classification rules), the individual is performing services in a capacity other than as an employee.”

What should I do now?

If you are already set up as an independent business operating as a sole proprietor, you need to make sure your work arrangement will be properly viewed as that of an independent contractor and not an employee.  If you are set up as an S Corporation, there are rules that you must pay yourself a reasonable and fair W2 wage before you can pass through any QBI; this was further emphasized in the proposed regulations.

If you’re working in a restricted specified business activity, your ability to claim the 199A deduction may be limited, but we encourage you to speak with your preferred tax or legal professional for advice.

We’re happy to answer any general questions you may have, but please note that content from MBO Partners® does not constitute legal or financial advice. If you have questions about your unique situation, please contact your preferred tax or legal professional.

*There are additional limitations, but these are the two most likely to apply to independent professionals.


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