As we enter the second tax season since the Tax Cuts and Jobs Act of 2017 (TCJA) went into effect, a tax deduction, 199a, that was created for owners of pass-through businesses remains one of the most popular features of the law, despite being extremely complex.

Pass-through businesses include S Corporations, limited liability companies, partnerships, and sole proprietorships. The profits or losses from these businesses “pass through” to their owners and are reported on the owners’ personal income tax returns. They are also sometimes called “flow-through” businesses.

The vast majority of businesses in the U.S. are pass-through entities as opposed to corporations, and Congress included the 199a deduction in the TCJA to level the playing field between the two types of businesses. Since the new tax law reduced the maximum tax rate for corporations to 21 percent (from the former high of 35 percent), owners of pass-through businesses wanted some comparable tax relief. Hence, the 199a deduction.

The 199a deduction allows owners of pass-through entities a 20 percent deduction off qualified business income (QBI). The TCJA defines QBI as ordinary income that does not include capital gains, dividends and interest, annuity payments, foreign currency gains, reasonable compensation, or guaranteed payments to a partner for services rendered.

Though it sounds simple, the 199a deduction is extremely complex due to the methodologies available to calculate it. The deduction can be calculated as the lesser of:

  • 20 percent of the QBI from the taxpayer’s trade or business, OR the greater of:
    • 50 percent of the total W-2 wages the business paid to all employees, or
    • 25 percent of the W-2 wages, plus 2.5 percent of the original acquisition cost of the business’ real and tangible property

For business owners and tax advisors, the 2019 tax season was a trial by fire, as each methodology had to be tested to determine which one yielded the greatest benefit for each taxpayer. Add to that the fact that many business owners have multiple Schedule K-1s (the form that reports a business owner’s or partner’s income), and the complexity only grows. Now that one tax season is complete, most business owners and tax advisors are more familiar with which methodology produces the greatest tax benefit.

Expected entity changes didn’t materialize

Tax advisors anticipated many pass-through business owners and partners would want to convert to corporations because of the deeper cut in tax rates for corporations, but that wave of entity structure changes never materialized.

Test tax returns were run for several taxpayers to determine if a change in entity structure would benefit them and showed even at the highest personal tax rates, owners of S Corporations realized a blended rate of about  29.6 percent once the 199a deduction was factored in. The difference between that and the C Corporation rate of 21 percent did not justify the change for them. Business owners are happy with the 199a deduction as it is an effective offset to the tax rate cuts for corporations.

Impact on individual business owners

Like many provisions of the tax code, the 199a deduction can have unforeseen impacts on tax planning for individual business owners. For instance, when it comes to retirement savings, if your income on the Schedule C is $100,000, and the 199a tax deduction backs it down to $80,000, your retirement plan deferral is made on a lesser amount of income. If you’re maxing out your deferral, this costs you in terms of retirement savings. Discussions with your tax advisor and financial planner can help you figure out how to mitigate these issues and get the maximum tax benefits possible for your situation.

There are many additional intricacies of 199a that are beyond the scope of this article.  If you have questions about the impact of the 199a tax deduction on your taxes, please contact our tax advisors.

 

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