Tag Archives: Section 199A Dividends

Section 199A Dividends

What are Section 199A Dividends?

Did you receive a Form 1099-DIV which lists an amount in Box 5 “Section 199A dividends”? If so, you might be asking, what the heck are Section 199A dividends? 

You probably never came across the term “Section 199A dividends” in high school algebra. That’s okay. Below I discuss what a Section 199A dividend is and how to report it on your tax return. 

Watch me discuss how Section 199A Dividends are reported on tax returns.

Who Pays Section 199A Dividends?

Real estate investment trusts (“REITs”) pay Section 199A dividends. REITs are a special type of business entity. A REIT owns almost entirely real estate. Many office buildings, hotels, hospitals, malls, and apartment buildings are owned by REITs. Investors can own the stock of a single REIT, or they can own mutual funds or ETFs that are partly or entirely composed of REIT stock. For example, there are some REITs in the Vanguard Total Stock Market Index Fund (VTSAX). 

REITs are advantageous from a tax perspective. In exchange for paying 90 plus percent of its income out to investors as dividends, the REIT itself does not pay federal corporate income taxes. This results in REITs often paying higher dividends than companies in other industries. The dividends paid by the REIT are Section 199A dividends.

I discuss the Section 199A dividends paid by VTSAX in this video.

What is the Tax Benefit of a Section 199A Dividend?

A Section 199A dividend qualifies for the Section 199A qualified business income deduction. This is also referred to as the QBI deduction. The qualified business income deduction is a 20 percent federal income tax deduction. 

Here is an example of how the tax deduction works for Section 199A dividends.

Catherine owns shares of ABC REIT Mutual Fund. The mutual fund pays her $1,000.00 of dividends, all of which are Section 199A dividends reported to her in both Box 1a and Box 5 of Form 1099-DIV. She gets a $200 qualified business income deduction on her federal tax return (20 percent of $1,000.00) because of the $1,000.00 of Section 199A dividend.

There are several things to keep in mind when considering Section 199A dividends:

  1. Section 199A dividends are a slice of the pie of dividends. The full pie of dividends, “total ordinary dividends,” is reported in Box 1a of Form 1099-DIV. Since Box 1a reports all of the dividends, Box 5 must be equal to or less than Box 1a.
  1. There is no income limit (taxable income, MAGI, or otherwise) on the ability to claim the Section 199A qualified business income deduction for Section 199A dividends. The QBI deduction for self-employment income is generally subject to taxable income limitations on the ability to claim the deduction. Not so with the Section 199A dividends. Taxpayers can claim the QBI deduction for Section 199A dividends regardless of their level of income.
  1. Taxpayers get the Section 199A QBI deduction regardless of whether they claim the standard deduction or itemized deductions. 
  1. There is no requirement to be engaged in a qualified trade or business to claim the QBI deduction for Section 199A dividends. 
  1. The QBI deduction does not reduce adjusted gross income. Thus, it does not help a taxpayer qualify for many tax benefits, such as the ability to make an annual contribution to a Roth IRA. 
  1. Section 199A dividends are not qualified dividends (which are reported in Box 1b of Form 1099-DIV). They are taxed as ordinary income subject to the taxpayer’s ordinary income tax rates. They do not qualify for the preferred federal income tax rates for qualified dividends. 

Where Do I Report a Section 199A Dividend on My Tax Return?

Section 199A dividends create tax return reporting in three prominent places on a federal income tax return.

First, Form 1099-DIV Box 1a total ordinary dividends are reported on Form 1040 Line 3b. As Section 199A dividends are a component of Box 1a total ordinary dividends, they are thus reported on the Form 1040 on Line 3b. Section 199A dividends are not reported on Line 3a of Form 1040 because Section 199A dividends are not qualified dividends. 

Second, Section 199A dividends are reported on either Line 6 of Form 8995 or Line 28 of Form 8995-A. In most cases, taxpayers will file the simpler Form 8995 to report qualified business income and Section 199A dividends. By reporting Section 199A dividends on one of those lines most tax return preparation software should flow the dividends through the rest of the form as appropriate (but it never hurts to double check).

Third, the QBI deduction, computed on either Form 8995 or Form 8995-A, is claimed on Line 13 of Form 1040. 

Tax return software varies. Hopefully, by entering the Form 1099-DIV in full in the software’s Form 1099-DIV input form, all of the above will be generated. Ultimately, it is up to the taxpayer to review the return to ensure that the information has been properly input and properly reported on the tax return.

Conclusion 

Section 199A dividends create a taxpayer favorable federal income tax deduction. They are reported in Box 5 of Form 1099-DIV and should be reported on a taxpayer’s federal income tax return. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on X at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Qualified Business Income Deduction Update

For those interested in tax planning for the FI community, some interesting news came from the Senate this week. Senator Ron Wyden, a Democrat and the Chairman of the Senate Finance Committee, released a proposal to modify the Section 199A qualified business income (“QBI”) deduction.

My view is that this is very good news, for reasons I will discuss below.

QBI Deduction

The Section 199A QBI deduction provides small business owners a deduction of up to 20 percent of their “qualified business income.” Usually, this is income from self-employment (reported on Schedule C) or income from a partnership or S corporation (reported on Form K-1). The deduction is subject to a host of limitations which tend to kick in hard for upper income taxpayers. 

I’ve written plenty on the Section 199A QBI deduction. My introductory post is here, and a more advanced post is here. 

The QBI deduction is good for the financial independence community. It lowers the federal income tax burden on those with small businesses and side hustles. 

Expiration

But there is one lurking issue with the QBI deduction: will it last? There are two reasons to worry that it will not. First, it was enacted by Republicans in late 2017 in a polarized political environment. While that means Washington Republicans generally support the deduction, it also means Washington Democrats may have no particular political reason to support it. Second, the deduction has an expiration date: December 31, 2025: The deduction is not available in tax years beginning after that date. 

While there are few things more permanent than a temporary tax deduction, obviously it is worrisome that if nothing else happens, we only have four and a half more years of the tax deduction. 

Wyden Proposal

Senator Wyden introduced a proposal to modify the Section 199A QBI deduction. The legislative language is available here and a summary of the legislation from Senator Wyden’s staff is available here.

I am still reviewing the language, so at this point (July 21, 2021) I only have a basic understanding of it. Please take the below as a preliminary analysis subject to change. 

The bill keeps the QBI deduction, but appears to eliminate it entirely (as related to qualified business income itself) if taxable income reported on the tax return is $500,000 or more. Between $400K and $500K of taxable income, the QBI deduction is phased out. It appears single taxpayers do very well with this provision, as the limits apply per tax return, and are not doubled for married filing joint taxpayers. 

The Wyden proposal eliminates the ability for married filing separately taxpayers and estates and trusts to claim the QBI deduction. 

The bill also eliminates the concept of a “specified service trade or business.” This simplifies the QBI deduction and will help many self-employed professionals qualify for the deduction where under current law they would not. 

See the example of Jackie I posted here. Without a deduction for Solo 401(k) contributions Jackie did not qualify for any QBI deduction at all because he was a single lawyer with a taxable income over $215K. If the Wyden proposal is enacted as written, Jackie could have up to $400K in taxable income and claim a full QBI deduction. Single moderate to high income professionals appear, at first glance, to be the big winners if the Wyden proposal is enacted. Some married professionals will also benefit from this provision. 

Section 199A Dividends

The proposed bill appears to keep the 20 percent deduction for “Section 199A dividends” which are dividends paid by real estate investment trusts (“REITs”) and mutual funds and ETFs which own REITs. It appears, however, that a taxpayer’s ability to deduct Section 199A dividends would phase out between $400K and $500K of taxable income. Under current law there is no taxable income limit on the ability to deduct 20 percent of Section 199A dividends. 

Expiration 

The Wyden proposal does not eliminate the expiration date, December 31, 2025. To my mind, that is not too surprising. Eliminating the expiration date would increase the “cost” of the Wyden proposal and thus, under Congressional budgeting procedures, likely require cutting spending or raising other taxes. 

The Good News

To my mind, the Wyden proposal is good news for those fond of the QBI deduction. Instead of eliminating the QBI deduction, we now have a powerful Washington Democrat embracing large parts of the deduction, and expanding its availability for some taxpayers. If this were to pass (and that is very speculative), then both Republicans and Democrats would have passed a version of the QBI deduction. At that point, it is unlikely that either party would want to be responsible for the deduction dying in full in 2026. 

This legislative proposal is simply a first step: stay tuned for further developments. But for the FI community, I see a powerful Washington Democrat embracing a large portion of the QBI deduction to be a positive development. 

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Understanding Your Form 1099-DIV

If you’re reading this in the Winter of 2024, you may have already received a bill from your financial institution. It’s called a Form 1099-DIV. Oddly, the financial institution isn’t demanding a penny of payment. Rather, your 1099-DIV prompts the IRS and your state tax agency (in most states) to expect the payment of income tax with respect to your financial assets.

A Form 1099-DIV is a great window into your taxable investments. By learning how to read the major boxes of your 1099-DIV, you can gain valuable insights about your investments and their tax efficiency.

VTSAX Form 1099-DIV 2024 Update

The Basics

Form 1099-DIV exists so that taxpayers and the IRS know the income generated by financial assets in dividend paying accounts. These include stocks, mutual funds, and exchange traded funds (“ETFs”). The financial institution prepares the Form 1099-DIV and submits a copy to the IRS and a copy to the taxpayer. 

Let’s be clear about what we are talking about. We are not talking about assets in retirement accounts (401(k)s, IRAs, Roth accounts, HSAs, etc.). You do not receive a Form 1099-DIV from a retirement regardless of how much money the account earned during the year. This is one of the advantages of saving through a retirement account. Dividends and other income generated by assets in a retirement account are not taxable to the account holder when generated (so long as the funds stay in the retirement account).

Dividends

Corporations pay dividends to their shareholders as a return to the shareholders of their portion of some or all of the earnings of the corporation. The corporation’s Board of Directors vote from time to time to pay dividends to the shareholders. Boards determine dividends based on a variety of factors, including the company’s profitability, industry, stage in the corporate life cycle, and business cash needs.

All shareholders of a corporation receive dividends. Some of those shareholders are themselves mutual funds or ETFs. Mutual funds and ETFs distribute out dividends and certain other income they receive (such as interest) to their shareholders as dividends.

Box 1a and Box 1b

Box 1a lists the so-called “total ordinary dividends” received from the account. That is all of the dividends paid by the stocks, mutual funds, and ETFs in the account. 

Box 1a should be understood as the entire pie. It represents all of the dividends received in the taxable account. The amounts in Box 1a are reported on line 3b of the Form 1040 (and on Schedule B if required).

Box 1b qualified dividends should be understood as a slice of the pie. It represents the portion of the total ordinary dividends that qualify for the long-term capital gains rates. Dividends create “ordinary income” for U.S. federal income tax purposes. However, certain “qualified dividends” (referred to as “QDI”) are taxed at preferential long term capital gains rates. As I have previously written, “[g]enerally, two requirements apply for the dividend to qualify for favorable QDI tax treatment. Very generally stated, they are:

  • The shareholder must own the stock for 60 of the 121 days around the “ex-dividend” date (the first date on which the stock sells without the right to receive the upcoming dividend); and,
  • The paying corporation must be incorporated either in the United States or in a foreign country with which the United States has a comprehensive income tax treaty.

Shareholders can obtain QDI treatment for stock owned through mutual funds and ETFs.

It may be that your qualified dividend slice is the entire pie. In most cases, there are usually some dividends that do not qualify for QDI treatment. 

Amounts reported in Box 1b are reported on line 3a of the Form 1040.

Box 2a Capital Gain Distributions

Box 2a is the danger zone of the Form 1099-DIV. In a way, it is unavoidable to recognize dividends (even if such dividends are QDI) if one wants to invest in a broad based portfolio of equities in a taxable account. Eventually corporations pay out dividends. While younger companies tend not to pay dividends, as companies mature they tend to start paying dividends.

What are much more avoidable (at least to a degree) are capital gain distributions. Capital gain distributions come from mutual funds and ETFs (they do not come from individual stocks).

Capital gain distributions occur when fund managers sell individual holdings at a gain. The fund is required to (usually toward year end) pay out those gains to the shareholders. The paid out gains are reported in Box 2a.

Three things tend to increase capital gain distributions: 1) active management; 2) a bull market; and 3) fund redemptions.

Active Management

Usually, this is the most significant factor in capital gain distributions. In order to actively manage a mutual fund or ETF, fund managers generally need to buy and sell different holdings. The selling of holdings is what creates capital gain distributions.

Frequent trading can make certain actively managed mutual funds and ETFs very tax inefficient, because they trigger capital gain distributions that are currently taxed to the owner at capital gains rates. 

From this, we can deduce the secret tax advantage of index funds. Index mutual funds and ETFs seek to simply replicate a widely known index. Other than occasional mergers and acquisitions of companies in the index, index fund managers rarely need to sell a holding to meet an investment objective. Thus, in many cases holding index funds in taxable accounts is tax efficient and will be better from a tax perspective than holding an actively managed fund.

Bull Market

Mutual funds and ETFs pass out capital gain distributions, not capital loss distributions. But in order for the shareholders to have a capital gain distribution, the mutual fund or ETF must (a) sell a holding and (b) must realize a gain on that sale.

In bear markets, it is often the case that the second requirement is not satisfied. The fund often realizes a loss on the sale of holding, meaning that the portfolio turnover does not generate a capital gain distribution reported in Box 2a. However, bear markets don’t always mean there will be no capital gain distributions, as active management and fund redemptions can still trigger capital gain distributions.

Fund Redemptions

There is an important distinction between mutual funds and ETFs in this regard. ETFs trade like public company stock — other than IPOs and secondary offerings, generally you buy and sell the stock of a public company and an ETF with an unrelated party that is not the issuer itself. 

Mutual funds, on the other hand, are bought and sold from the issuer. If I own 100 shares of the XYZ mutual fund issued by Acme Financial, when I redeem my 100 shares, Acme Financial buys out my 100 shares.

In order to buy out mutual fund shares, the mutual fund must have cash on hand. If it runs out of cash from incoming investments into the fund, it will have to sell some of its underlying holdings to generate the cash to fund shareholder redemptions. This creates capital gain distributions for the remaining shareholders. 

Interestingly, Vanguard has created a method to reduce the tax impact of mutual fund redemptions. Further, in recent times, fund redemptions have not caused significant capital gain distributions in many cases because in this current bull market mutual fund inflows often exceed outflows. 

Box 3 Nondividend Distributions

There are occasions where corporations make distributions to shareholders during a time where the corporation does not have retained earnings (i.e., it either has not made net income or it has previously distributed out is net income). Such distributions are not taxable as dividends. Rather, such dividends first reduce the shareholder’s basis in their stock holding. Once the basis has been exhausted, the distribution causes a capital gain.

Box 5 Section 199A Dividends

Section 199A dividends are dividends from domestic real estate investment trusts (“REITs”) and mutual funds that own domestic REITs. These dividends are reported on Form 8995 or Form 8995-A and qualify for the Section 199A QBI deduction. The good news is that the taxpayer (generally) gets a federal income tax deduction equal to 20 percent of the amount in Box 5. This deduction does not reduce adjusted gross income but does reduce taxable income.

Section 199A dividends are another slice of the pie of Box 1a ordinary dividends.

Watch me explain Section 199A dividends

Box 7 Foreign Tax Paid

An amount in Box 7 is generally good news from a federal income tax perspective. Many countries impose a tax on the shareholder when the corporation pays a dividend is a non-resident shareholder. The corporation withholds a percentage of the dividend and then remits the net amount of the dividend to the shareholder. 

The amount in Box 7 usually creates a foreign tax credit that reduces federal income tax dollar for dollar. If you have $300 or less in foreign tax credits ($600 or less if married filing joint) you can simply claim the foreign tax credit on your Form 1040 without any additional work. If your foreign tax credits exceed these amounts, you will also need to file a Form 1116 to claim the foreign tax credit.

The ability to claim foreign tax credits is a reason to hold international equities in taxable accounts.

Watch me discuss how VTIAX might generate a foreign tax credit on a US income tax return.

Boxes 11 and 12 Exempt-Interest Dividends and Private Activity Bond Interest

Box 11 represents all of the tax-exempt dividends received in the taxable account. Typically this is generated by state and municipal bond interest received by the mutual fund or ETF and passed out to the shareholders. This income is tax-exempt for federal income tax purposes.

This income may not be tax-exempt for state tax purposes. For example, in my home state of California, this income is taxable unless it is established that 50 percent or more of the funds assets are invested in California state and municipal bonds. In that case, the exempt-interest dividend attributable to California state and municipal bonds is tax-exempt for California purposes. The financial institution must separately provide the percentage of income attributable to California bonds to the shareholder in order to compute the amount of exempt-interest dividend exempt from California income tax. 

Box 12 is a subset of Box 11 (Box 11 is the whole pie, Box 12 is a slice). Box 12 dividends are those attributable to private activity bonds. The significance is for alternative minimum tax (“AMT”) purposes. While this income is tax-exempt for regular federal income tax purposes, it is not tax-exempt for AMT purposes (and thus is subject to the AMT). After the December 2017 tax reform bill this issue still exists, though it affects far fewer taxpayers.

Conclusion

The Form 1099-DIV conveys important information, all of which must be properly assessed in order to correctly prepare your tax return. It can also provide valuable insights into the tax-efficiency of your investments. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Section 199A Examples and Lessons

Introduction

As this is being re-published (January 2021), we are in the third filing season of the new Section 199A qualified business income deduction. It is an area of the tax law that practitioners are still digesting.

I have previously written on the basics of the Section 199A deduction. This post builds on that introductory post. It provides analysis on rules from the IRS and Treasury and gives examples of how the deduction works in specific situations.

Takeaways

  • Deductions such as the deduction for one-half of self-employment taxes paid and the deduction for self-employed retirement plan contributions reduce the qualified business income (“QBI”) qualifying for the Section 199A deduction.
  • In many cases, Section 199A reduces the tax savings on traditional retirement plan contributions. Taxpayers may want to consider Roth employee contributions instead of traditional employee contributions to retirement plans because of this change.
  • Some taxpayers may want to prioritize contributions to traditional IRAs and HSAs instead of contributions to self-employed and small business retirement plans to maximize their Section 199A deduction.
  • Potentially powerful tax planning opportunities exist whereby taxpayers can reduce their taxable incomes such that they can go from no Section 199A deduction to a significant deduction. See Managing Taxable Income below for one example.
  • Many small businesses (including many sole proprietorships and S corporations) should not make charitable contributions, since these reduce qualified business income deduction. Rather, the owners of these small businesses should make charitable contributions in their own names.
  • The IRS and Treasury have provided a safe harbor under which rental real estate activities can qualify for the Section 199A deduction.
  • Dividends received from mutual funds and ETFs investing in domestic REITs can qualify for the Section 199A deduction.

Below are examples and commentary addressing Section 199A.

Side Hustler

Mike works a full-time job. His W-2 for 2018 reports $90,000 of wages. Mike also receives $1,000 of qualified dividend income (“QDI”) in his taxable account. Mike has a side hustle where he nets $10,000 in Schedule C profit. Mike pays $1,413 in self-employment tax on that profit. Mike claims the standard deduction.

Recall that the Section 199A deduction is the lesser of:

  1. 20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your QDI; or,
  2. 20 percent of your qualified business income (“QBI”).

The deduction for one-half of self-employment taxes is factored into the determination of QBI. Thus, in Mike’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($90,000 plus $10,000 plus $1,000 less $707 less $1,000 less $12,000 = $87,293) = $17,459; or,
  • 20% of QBI: 20% times ($10,000 less $707 = $9,293) = $1,859

In this case, Mike’s Section 199A deduction is $1,859.

Mike’s taxable income is determined by deducting, for adjusted gross income, one-half of the self-employment taxes ($707) he pays with respect to his side hustle income. However, that deduction for half of his self-employment tax must also be subtracted in determining his QBI.

Note further that the Section 199A deduction does not reduce self-employment taxes. The Section 199A deduction is only an income tax deduction. It does not reduce the amount subject to self-employment taxes (in Mike’s case, $10,000).

Sole Proprietor with a Solo 401(k)

Lisa owns a sole-proprietorship that generates $100,000 of business income in 2020 as reported on Schedule C. Lisa pays $14,130 in self-employment taxes. Lisa contributed $19,500 to her traditional Solo 401(k), and makes an employer contribution to her traditional Solo 401(k) of $18,587. Lisa is married to Joe who makes $75,000 in W-2 wages. Lisa and Joe claim the standard deduction.

The deduction for retirement plan contributions is factored into the determination of QBI. Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($100,000 plus $75,000 less $7,065 less $19,500 less $18,587 less $24,800 = $105,048) = $21,010; or,
  • 20% of QBI: 20% times ($100,000 less $7,065 less $19,500 less $18,587 = $54,848) = $10,970

In this case, Lisa’s Section 199A deduction is $10,970.

QBI has the effect of making certain income “80% income.” What I mean by that term is that only 80% of the income is subject to income tax. This has a flip side – some deductions become only “80% deductions,” meaning that only 80% of the deduction generates a tax break.

Notice that the Solo 401(k) contributions reduce the QBI deduction. Thus, Solo 401(k) contributions are now “80% deductions” due to the QBI regime. For example, if your marginal tax rate is 22 percent, the marginal tax rate savings on your traditional 401(k) employee contribution is only 17.6 percent. But years later, when you withdraw the money from the Solo 401(k) the money will be “100% income.” You will not get a QBI deduction for those withdrawals.

I blogged more about the 80% deduction phenomenon here.

This will cause many sole proprietors to consider Roth Solo 401(k) employee contributions instead of traditional Solo 401(k) employee contributions, since the the tax savings on traditional self-employed employee contributions is reduced as a result of the QBI deduction.

Note further that for the Solo 401(k) employer contribution there is no choice to be made because there is no option to make a Roth employer contribution. All employer contributions must be traditional contributions.

Another observation: If Lisa and Joe had a low enough adjusted gross income (under $105,000) and Lisa made a deductible $6,000 contribution to a traditional IRA, that contribution would not have counted against her QBI. A contribution to a health savings account would also not have lowered her QBI.

For taxpayers whose Section 199A deduction is limited by 20% of QBI, contributions to traditional IRAs and HSAs should be favored over self-employment retirement plan contributions, since the IRA and HSA deductions are 100% deductions while the self-employment retirement plan contributions are 80% deductions. Hat tip to Jeff Levine who made the retirement plan contribution prioritization point on Twitter.

For taxpayers whose Section 199A deduction is limited by 20% of taxable income, contributions to traditional IRAs, HSAs, and self-employment retirement plans are all 80% deductions, and thus Section 199A normally does not factor into determining how to prioritize these contributions. However, all of these are tools taxpayers may be able to use to lower taxable income to qualify for a Section 199A deduction, as discussed in the Managing Taxable Income section below.

S Corporation

Assume the facts are the same as the previous example, except for the following differences. Lisa operates her business as a wholly-owned S corporation instead of as sole proprietorship. Before any sort of compensation, the S corporation makes $100,000. Assume that in this case, the S corporation pays Lisa $50,000 of W-2 wages, which is further assumed to be reasonable. Lisa makes employee contributions of $19,500 to her traditional Solo 401(k) from those wages. The S corporation makes the maximum employer contribution of $12,500 (computed as $30,500 of Box 1 W-2 wages plus $19,500 of elective deferrals times 25 percent). Thus, Lisa will have flow-through income from the S corporation (reported to her on a Schedule K-1) of $33,675 ($50,000 less $12,500 less $3,825 — the employer portion of the payroll tax).

Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($50,000 plus $33,675 plus $75,000 less $19,500 less $24,800 = $114,375) = $22,875; or,
  • 20% of QBI: 20% times ($33,675 — the QBI) = $6,735

In this case, Lisa’s Section 199A deduction is $6,735 because in the S corporation structure, the business income is split between a salary the S corporation pays her (which is not QBI) and the flow through profit of the S corporation, which is QBI (assuming it is domestic trade or business income).

The S corporation has various pros and cons from a tax perspective. Lower employment (payroll) taxes are a significant benefit, while lower maximum employer retirement plan contributions and lower Section 199A deductions are drawbacks.

Managing Taxable Income

Jackie is a lawyer operating as a sole proprietor. Law is one of several specified service trade or businesses (“SSTBs”) where the benefits of Section 199A are completely phased out if your taxable income exceeds $213,300 ($426,600 for married filing joint taxpayers using 2020 numbers). In 2020 Jackie has $240,000 of Schedule C income from the business. His self-employment taxes are $17,075 in Social Security taxes and $6,428 in Medicare taxes, for a total of $23,503 reported on Schedule SE. Jackie takes the standard deduction.

Jackie’s taxable income is thus $215,848 ($240,000 less $11,752 less $12,400). Because Jackie’s QBI is from an SSTB and his taxable income is above $213,300, he cannot claim any Section 199A deduction.

Now let’s add some tax planning to the scenario. Imagine that early in 2020 Jackie realizes he won’t qualify for the Section 199A deduction based on his numbers. He decides to open a Solo 401(k), which he can make an $19,500 employee traditional contribution to, and he can make an employer contribution of $37,500 for total contributions of $57,000 (the maximum allowed). This radically changes his Section 199A math, since (as will be demonstrated) his taxable income is now below $163,300. Once your income is below $163,300, you qualify for the Section 199A deduction only subject to the computational limits. Thus, in Jackie’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($240,000 less $11,752 less $12,400 less $57,000 = $158,848) = $31,770; or,
  • 20% of QBI: 20% times ($240,000 less $11,752 less $57,000 = $171,248) = $34,250

Thus, Jackie’s Section 199A deduction is now $31,770! By managing his taxable income (by maximizing retirement savings), Jackie turned a $57,000 deduction into a more than $88,000 of deductions. Sure, the $57,000 deduction for retirement plan contributions is an “80% deduction,” but it creates the additional $31,770 of a Section 199A deduction (which is itself a “100 percent” deduction).

Jackie also lowered his marginal federal income tax rate from 35 percent to 24 percent and reduced his taxable income from $215,848 to $127,078!

Note that contributions to a health savings account would be another tool to deploy to lower your taxable income if you are concerned about Section 199A’s taxable income limitations.

Taxpayers bumping up against Section 199A taxable income limitations will likely need to prioritize traditional employee contributions to Solo 401(k) plans over Roth employee contributions. In addition, self-employed taxpayers bumping up against the taxable income limits in 2021 may want to establish 2021 Solo 401(k)s (if they are eligible to do so) to lower taxable income in order to qualify for the Section 199A deduction.

It will be wise for taxpayers to consult with tax advisors to run the numbers on Section 199A and other tax planning considering the complexity of the rules and the potential benefits of successful planning.

Charitable Contributions

The IRS gave us a bit of a head-scratcher in the instructions to the new Form 8995. The Form 8995 is used (starting with 2019 tax returns) to compute the QBI deduction. In the instructions, it states that charitable contributions reduce QBI.

Here is an example of how that rule would play out:

Cosmo is the sole shareholder of Acme Industries, an S corporation. In 2019, Acme reports QBI operating income of $100,000 to Cosmo on his Form K-1. It also reports $1,000 of charitable contributions made by Acme during 2019. The total QBI Cosmo can claim from Acme Industries is only $99,000, as the charitable contribution reduces QBI, according to the IRS. This is true even if Cosmo claims the standard deduction and thus has no use for the charitable contribution on his 2019 tax return.

Personally, I believe the IRS is on questionable ground in claiming charitable contributions reduce qualified business income. However, with some rather simple tax planning (which I generally believe to be prudent), you can avoid this issue altogether. If you want to make a charitable contribution, simply do so in your own name. Do not have your business — whether an S corporation, a small partnership, or a sole proprietorship, make the charitable contribution.

Rental Real Estate

The IRS and Treasury issued Notice 2019-7 and Revenue Procedure 2019-38 providing a safe harbor under which rental real estate activity can qualify for the Section 199A deduction. A safe harbor is a set of requirements, which, if satisfied, automatically qualify a taxpayer for a particular benefit. Stated differently, a safe harbor is a sufficient, but not necessary condition, to receive a benefit.

While rental activities that constitute a trade or business can still qualify for the deduction if they do not meet the requirements of the safe harbor, as a practical matter it will be much easier to sustain the deduction if you can qualify for the safe harbor.

Requirements

The requirements to satisfy the safe harbor with respect to any “rental real estate enterprise”  (a “RREE”) are as follows:

  • Separate books and records documenting the income and expenses of the RREE must be maintained.
  • At least 250 hours per year of qualifying activity must be done with respect to the RREE.
  • Starting in 2020, detailed records documenting the time spent on the RREE must be maintained (see Revenue Procedure 2019-38).
  • A statement electing the application of the safe harbor must be attached to the tax return.

Multiple Rental Properties

Rental property can be combined for purposes of determining if you have an RREE. However, residential and commercial real estate cannot be aggregated and must be kept separate. Thus, at a minimum if you own both commercial and residential property, you have two RREEs, and you must apply the tests to each separately to determine if each RREE qualifies for the safe harbor.

Qualifying Activities

In a bit of good news, the 250 hours can be done by the owner, agents, employees, and/or independent contractors. However, many activities do not count toward the 250 hours, including building and long-term redevelopment, finding properties to rent, and arranging financing. Qualifying activities include collecting rent, daily operation of property, negotiating leases, screening tenants, and maintenance and repairs.

Triple Net Leases

Triple net leases do not qualify for the safe harbor. For purposes of the rule, these include “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.”

House Hacking

For those using house hacking to pursue financial independence, there are several considerations. If you house hack by renting spare bedrooms in your primary residence (tenants, Airbnb, etc.), then you do not qualify for the safe harbor with respect to the rent generated by your primary residence. However, if your house hack consists of renting out separate units in a single building, the rental income could qualify for the safe harbor if (i) those other units are separate residences and not your own residence for any part of the year and (ii) you otherwise satisfy the requirements of the safe harbor.

REIT Mutual Fund Dividends

Dividends from REITs and REIT mutual funds can qualify for the QBI deduction. Generally, box 5 of Form 1099-DIV will indicate those REIT dividends which qualify as Section 199A dividends.

Example

In 2018 Luke makes $50,000 from his W-2 job. He operates a sole proprietorship that generates a $4,000 taxable loss (which would have been QBI had it been net income). Luke also receives $3,000 of dividends from the Acme Real Estate Mutual Fund, which he holds in a taxable account. Acme’s Form 1099-DIV provided to Luke indicates in box 5 that $2,400 of the dividends are Section 199A dividends. Luke claims the standard deduction. In Luke’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($50,000 less $4,000 plus $3,000 less $12,000 = $37,000) = $7,400; or,
  • 20% of REIT Dividends: 20% times $2,400 = $480

Thus, Luke’s Section 199A deduction is $480. He gets this deduction even though the dividend was paid by a mutual fund and even though he had a QBI loss. His QBI loss will carryover to 2019, and will reduce his 2019 QBI that potentially qualifies for the Section 199A deduction.

Lastly, note that if Luke held the Acme mutual fund shares in a retirement account (traditional and/or Roth IRA/401(k), etc.) or a health savings account, the REIT dividend would not have qualified for the Section 199A deduction.

Conclusion

Even as of January 2021, taxpayers and practitioners are learning new wrinkles in the Section 199A QBI deduction. For taxpayers with side hustles and small businesses, it can represent a significant income tax break. Some taxpayers will need professional help to determine how best to maximize the deduction.

Further Reading

I have written several blog posts addressing the Section 199A QBI deduction. Here are the links below:

Introductory Post

Section 199A and Retirement Plans

Read why the Section 199A QBI deduction may mean a Solo 401(k) is better than a SEP IRA

For the self-employed, the Section 199A QBI deduction may present an opportunity to do more efficient Roth IRA conversions.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Section 199A for Beginners

Introduction

Tax is a crucial consideration for those with small businesses and side hustles. A new tax provision, Section 199A, passed as part of Tax Reform in December 2017, gives many small business owners and side hustlers a deduction determined with respect to their “qualified business income” (or “QBI”).

So what’s going on? Why would you get a tax deduction for a certain type of income? The short answer is that the Section 199A deduction was needed to help level the playing field for small businesses (especially manufacturers) vis-à-vis large corporations. Tax Reform cut taxes for corporations (generally from 35 percent to 21 percent). To keep small businesses, many of which are taxed on individual tax returns at federal rates up to 37 percent, competitive with larger corporations, Congress enacted a partial deduction for qualified business income. The deduction has the effect of lowering the federal income tax rate on that income.

The QBI deduction also applies to so-called Section 199A dividends. Please see the discussion further below regarding Section 199A dividends.

Do I Qualify for the Section 199A Deduction?

The bad news is that, even for a tax rule, Section 199A is incredibly complex. The much better news is that most of that complexity applies to about 10 percent or less of taxpayers. For 90 plus percent of taxpayers, it isn’t too complicated!

To figure out if it is going to be complicated for you, ask yourself one question (all amounts as applicable for 2021):

Is my taxable income $164,900 or less?

If you’re married filing a joint tax return (“MFJ”), change the question to

Is my taxable income $329,800 or less?

For 2020, apply the above questions with $163,300 for single taxpayers and heads of household, and $326,600 for MFJ taxpayers. For 2021, married filing separate taxpayers use $164,925 as their number.

Remember, the key number is taxable income. Taxable income is your adjusted gross income less your standard deduction ($12,550 in 2021 for singles, $18,800 for heads of householder, and $25,100 for MFJ) or your itemized deductions. So if you take the standard deduction, you’re looking at adjusted gross income of $177,450 for singles, $183,725 for heads of household, and $354,900 for MFJ filers. Those are high thresholds for most Americans and for most of those seeking financial independence).

Section 199A Basic Calculation

If you answered Yes to your bolded question, your Section 199A deduction is computed based on a relatively simple (for tax) calculation. Your Section 199A deduction is the lesser of

  1. 20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your qualified dividend income (“QDI”) or
  2. 20 percent of your QBI.

Here are two examples to illustrate the calculation (all examples avoid discussing self-employment tax for ease of illustration):

Example 1: Phil has $100,000 of W-2 wage income, $1,000 of QDI from mutual funds owned in taxable accounts, makes $10,000 from a trade or business side hustle reported on Schedule C, and claims the standard deduction on his tax return. Phil’s Section 199A deduction is the lesser of

  1. 20% of Phil’s taxable income less net capital gain ($100,000 of wages, plus $1,000 QDI plus $10,000 of QBI less $12,000 standard deduction less $1,000 “net capital gain” – in this case, his QDI – equals $98,000. $98,000 X 20% = $19,600) or
  2. 20% of Phil’s QBI ($10,000 X 20% = $2,000).

Thus, Phil’s Section 199A deduction is $2,000, fully 20 percent of his side hustle income.

Example 2: Mary owns a sole proprietorship engaged in a domestic trade or business which earned $100,000 this year reported on Schedule C. Mary also earned $1,000 of QDI from mutual funds owned in taxable accounts and claims the standard deduction on her tax return. Mary’s Section 199A deduction is the lesser of

  1. 20% of her taxable income less net capital gain ($100,000 of Schedule C income plus $1,000 QDI less $12,000 standard deduction less $1,000 “net capital gain” – in this case, her QDI – equals $88,000. $88,000 X 20% = $17,600) or
  2. 20% of her QBI ($100,000 X 20% = $20,000).

Thus, Mary’s Section 199A deduction is $17,600, 17.6 percent of her sole proprietorship income.

Section 199A is great news for side hustlers and pretty good news for sole proprietors and other owners of flow-through businesses. Why the slight benefit reduction for our sole proprietor? The answer lies in the benefit of the standard deduction (or itemized deductions, if applicable). Since Mary already had the standard deduction protecting some of her QBI from full taxation, the Section 199A deduction was reduced to account for that benefit.

Note that if Mary had another source of income (other than long-term capital gains or qualified dividend income), such as a Roth conversion amount, or a spouse with income, that income would increase her taxable income limitation and she could qualify for up-to the full 20 percent QDI deduction.

What is QBI?

Now that we have the calculation illustrated, we must ask what is “qualified business income” (“QBI”)? Generally, QBI is domestic income from a trade or business (as defined under normal U.S. tax principles) received by a sole proprietor or by an individual from a “flow-through” business (a partnership, LLC, S-corporation, trust, or estate). Some important considerations:

  • QBI does not include wage income (W-2 income).
  • It is important to maintain documentation supporting that the activity is a trade or business.
  • It is important that the activity not be considered a hobby.
  • Rental income from the active conduct of a rental real estate trade or business is QBI. Income from the renting out of buildings where the owner is not engaged in a real estate trade or business is not QBI. Real estate may become a hot-spot for disputes between the IRS and taxpayers.

High Income Taxpayers

What if you answered No to your question? If you have QBI, you’re likely to need the assistance of a qualified tax professional. The rules get complicated quickly. For those with taxable income above $164,900 ($329,800 for MFJ, $164,925 for MFS), their Section 199A deduction is subject to a limitation and possibly a second additional limitation, as follows:

  1. For taxpayers over the taxable income thresholds, all QBI is subject to a limitation on the Section 199A deduction based on W-2 wages paid by the business and the unadjusted asset basis in the business. The more of these attributes, the greater the Section 199A deduction. Note that unadjusted asset basis is generally the acquisition cost of property. It includes tangible property (including buildings) but does not include land.
  2. Income from a specified service trade or business suffers an additional limitation. The Section 199A deduction for such income is phased out for taxable incomes between $164,900 and $214,900 ($329,800 and $429,800 for MFJ filers) (using 2021 numbers).

The preamble to the proposed regulations states that a “specified service trade or business” is (1) 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, or 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 or owners, and (2) any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities . . . partnership interests, or commodities.”

The general idea behind the specified service trade or business is that Congress wanted to prevent high earning doctors, lawyers, accountants, etc., from benefiting from Section 199A. Congress intended for the benefits to generally go to manufacturers.  Manufacturers will generally find themselves only subject to the first limitation, and many will have buildings and equipment with tax basis and/or will pay significant W-2 wages to employees and thus will not find the limitation to have much effect.

For those subject to these complex limitations, there can be significant benefits from doing planning and restructuring with the assistance of qualified tax advisors to maximize their Section 199A deduction. Such planning can include planning to increase current year tax deductions (through, for example, increased retirement plan contributions) to reduce taxable income below the relevant testing thresholds.

Section 199A Dividends and Income from Publicly Traded Partnerships

Qualified dividends from real estate investment trusts (“REITs”) (Section 199A dividends) and ordinary income from publicly traded partnerships qualify for the Section 199A deduction. There is no need for the taxpayer to be in a trade or business and there are no limitations based on taxable income. In terms of sheer volume, I expect more returns will claim this Section 199A QBI deduction than the QBI deduction for “normal” qualified business income discussed above.

It is important to note that dividends and other income received in tax advantaged accounts (IRAs, 401(k)s, HSAs, other retirement accounts) does not qualify for the Section 199A deduction.

Tax Reporting

Taxpayers report their QBI deduction on either a Form 8995 or a Form 8995-A (for the 2019 tax year and later). Box 5 of Form 1099-DIV (Section 199A dividends) reports the dividends that qualify for the QBI deduction.

Further Reading

I published a more detailed Section 199A post here. It provides more examples of the application of Section 199A.

I published a post discussing the Section 199A QBI deduction and how the concept interacts with small business retirement plans (click here).

I published a post on a potential planning opportunity available to some self-employed individuals to capitalize on the interplay of self-employed income, Roth conversions, and the Section 199A deduction here.


FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This posting is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.