Tag Archives: flow-through

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. 

S Corporations for Beginning Solopreneurs

Last month the blog discussed the beginning of the self-employment journey. Specifically, it discussed how one pays taxes when they become self-employed. This post goes further. It explores a potentially powerful tax planning for self-employed solopreneurs, the S corporation. 

None of the below is tax advice for any particular taxpayer. Note that if you are considering an S corporation, you are generally well advised to work with a tax professional before and during the process of implementing an S corporation. 

The S Corporation Concept

Generally speaking, a corporation is subject to federal income tax at a 21 percent rate. For example, if Acme Incorporated has $100,000 of taxable income for the year, it owes the IRS $21,000 of federal income tax. Further, the shareholders are subject to taxes on the receipt of dividends from the corporation. If Acme Incorporated pays its after tax profit of $79,000 to its shareholders, generally its shareholders must include the receipt of the dividend in taxable income (though the dividend may qualify for the favorable qualified dividend income rates). 

Based on both the corporation and the shareholders having to pay tax on the same income, it is said that many corporations (so-called “C corporations”) are subject to double tax. 

For smaller businesses, this can be very problematic. The tax rules recognize this, and thus, for certain small business entities, allow an “S corporation” election (meaning that the corporation is taxed under the rules of Subchapter S of the Internal Revenue Code).

S corporations are generally subject to only one level of tax, as all of the tax items of the S corporation (taxable income, gain, loss, credits, etc.) are reported and taxed on the shareholder(s) individual tax returns. The S corporation itself usually does not pay federal income tax. 

Most states replicate this treatment to a large extent. For example, in my home state of California, S corporation income is reported on the shareholders’ tax returns, but the S corporation itself is subject to a 1.5% income tax (with a minimum annual tax due of $800 regardless of income). 

The Self-Employment Tax Savings and Reasonable Compensation

There is another wrinkle to S corporations which can make them advantageous to solopreneurs. The S corporation must pay owner-employees reasonable compensation as W-2 salary. However, the rules generally allow the owner-employee to take some of the earnings of the S corporation as a dividend. This has the rather interesting effect of, in many cases, reducing the overall payroll tax liability of the solopreneur. 

Here’s a quick example of how that could work:

Aurora works as a private detective. After business expenses, she has a net income of $110,000. The payroll taxes she pays will depend on whether the business is organized as a sole proprietorship or an S corporation. 

If she is operating as a sole proprietorship, she will pay $15,543 in self-employment taxes, as computed on Schedule SE (roughly, 14.13% of her profits are due in self-employment taxes). 

Things are different if the business is organized as an S corporation. Assume, just for the sake of this example, that the S corporation pays Aurora $55,000 in W-2 compensation and this is reasonable. The FICA tax she and the S corporation together pay is 15.3% of that amount, $8,415. 

In this example, Aurora saves over $7,000 in payroll taxes by electing to operate out of an S corporation.

Of course, compensation must be reasonable. S corporation owner-employees who pay themselves very small W-2 salaries can have dividend payments recharacterized as W-2 salary, prompting disputes with the IRS and state taxing agencies and the collection of back payroll taxes.

Solopreneur Requirements for an S Corporation

Below I discuss, very broadly, the general requirements to establish and maintain an S corporation for a solopreneur who does not employ other people. Those items with a single asterisk can (but does not have to) apply to a Schedule C sole proprietorship (for example, for solopreneurs a limited liability company can be either a Schedule C sole proprietorship or an S corporation). The item with a double asterisk also applies to a sole proprietorship, but perhaps to a somewhat lesser extent. 

Entity Formation*

To have an S corporation, one must operate out of a legal entity. Generally, the legal entity can be a corporation or a limited liability company (an “LLC”). Corporations and LLCs are creatures of state law. Each state has its own formation and regulation procedures, requirements, and fees. Often it is wise to consult with legal counsel when forming a legal entity.

Under the federal income tax rules, an S corporation generally must have 100 or fewer shareholders and only a single class of stock outstanding. 

Tax Election

Electing S corporation status requires the filing of a Form 2553 with the IRS with the signatures of all the shareholders. In community property states, usually one’s spouse is considered a shareholder. Taxpayers omitting a spouse’s signature where the S corporation stock is community property can fix the omission under the procedure available under Revenue Procedure 2004-35. 

Entity Maintenance*

Legal entities have requirements for maintenance. These vary by state, and can include annual fees, annual shareholders’ meetings, and meetings of a Board of Directors. Consultations with legal counsel can be helpful in this regard. 

Separate Books, Records, and Bank Accounts**

A legal entity should have its own bank account to collect revenue and pay expenses. Most solopreneurs operating out of either a sole proprietorship or an S corporation are well advised to hire a (very likely virtual) bookkeeper to track revenues and expenses. 

Separate Federal Income Tax Return

S corporations must file an annual income tax return with the federal government, the Form 1120-S. Included in this Form is a Form K-1. Form K-1 reports to both the shareholders and the IRS the ordinary income and other tax results of the S corporation for the year that must be reported on the income tax returns of the shareholders.

Generally speaking, the Form 1120-S is due March 15th, but can be extended to September 15th. 

Separate State Income Tax Return

In most states, S corporations have to file income tax returns. There can be entity level taxes on S corporations (such as California’s 1.5% income tax, $800 minimum tax) and in most states the shareholders will need to report the S corporation’s income on their own state income tax return. 

Running W-2 Payroll/Reasonable Compensation

S corporations must pay their employees, including solopreneur owners, reasonable compensation. This requires running W-2 payroll, including federal and state payroll tax withholding and remittance. There are payroll processors that specialize in providing payroll services for small S corporations. 

As discussed above, W-2 compensation must be reasonable. 

Forms W-2, W-3, 940, and 941

There are both quarterly and annual payroll tax returns that must be filed to report salaries paid and payroll taxes withheld and remitted. The Form 941 is filed for each quarter and is generally due one month after the end of the quarter. 

Forms W-2, W-3, and 940 are filed on an annual basis and generally due January 31st.

Tracking Distributions and S Corporation Stock Basis

Shareholders must track their “basis” in their S corporation stock. Generally speaking, dividends from an S corporation are not taxable to the shareholder. However, they reduce the shareholder’s basis in their S corporation stock. If the shareholder receives a distribution at a time he or she does not have basis in their S corporation stock, it triggers a taxable gain to the shareholder.

Basis should generally be tracked as part of the tax return preparation process. However, basis should also be tracked during the year prior to the shareholder taking significant dividends from the S corporation. 

Increased Professional Fees

Operating out of an S corporation generally increases the professional fees a solopreneur pays. This absolutely can be worth it, but in many cases there needs to be professional assistance regarding reasonable compensation, tax filings, legal maintenance, and payroll processing. 

Tax Planning

In a world without two of my favorite tax topics, the qualified business income deduction and the Solo 401(k), the analysis was usually somewhat straightforward. Estimate business income and run it through the filters of income and self-employment tax if reported on a Schedule C versus income and payroll tax if reported through an S corporation. This yielded an estimate of the overall tax savings obtained using an S corporation structure. 

To make the “S corporation or Schedule C” decision, the taxpayer would then, for the most part, compare the estimated annual tax savings versus the additional administrative burden and costs associated with the S corporation. 

Today, we live in a world with the qualified business income deduction and the Solo 401(k). These planning opportunities make the “S corporation or Schedule C” question more nuanced. At a minimum, solopreneurs should work with their tax advisors to model out what the income tax, self-employment tax, qualified business income deduction, and retirement plan results look like at their anticipated business income level and desired retirement plan contribution level to determine whether the S corporation or the Schedule C route is better. 

Operating through an LLC

One option available to solopreneurs is operating out of an LLC as the sole owner. LLCs provide a legal entity out of which to conduct business. Properly operated, an LLC can provide a solopreneur with liability protection and reputational advantages. One great feature of LLCs is their tax flexibility. They default to disregarded status, meaning that for a solopreneur, the default option is that the taxable income of the LLC is simply reported on their Schedule C. However, using the Form 2553, a solopreneur can elect to have the LLC treated as an S corporation.

Those looking to work through an LLC should consider hiring legal counsel regarding the establishment and maintenance of their legal entity. 

Conclusion

Operating out of an S corporation is a significant additional operational commitment. There are instances where it can make a great deal of sense for a solopreneur. Those considering using an S corporation should understand the administrative commitment involved and should work with advisors as appropriate to ensure they make an informed decision. 

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.

Section 199A and Retirement Plans

Previously I have blogged about small business retirement plans. This post (revised in January 2020) folds the new Section 199A qualified business income (“QBI”) deduction into the discussion.

For an introduction to Section 199A, please read this. For more on Section 199A, please read this additional post.

The Basics

Section 199A, enacted in December 2017 as part of tax reform, gives owners of businesses (including partners, owners of S corporations, and sole proprietors) that generate QBI a deduction in the amount of 20 percent of the QBI.

In January 2019, the IRS and Treasury issued regulations providing detailed rules under Section 199A. Those rules define QBI. As part of the definition of QBI, taxpayers must subtract contributions to self-employment retirement plans from QBI.

80% Deductions

When a self-employed individual contributes to a traditional retirement plan, they generally reduce the amount of their QBI deduction (because the retirement plan contribution lowers QBI).

Here’s a quick example (using 2018 tax numbers) of how that works.

Example: Mike makes $50,000 from his sole proprietorship (as reported on Schedule C). He pays $7,065 in self-employment tax (Social Security and Medicare). He deducts half of his self-employment tax ($3,533) from his taxable income and his QBI. Mike is married to Jane. Jane has $34,000 of W-2 wages. Mike and Jane file jointly and take the $24,000 standard deduction.

Mike thus receives a QBI deduction of $9,293 (20% of $46,467). This makes Mike and Jane’s taxable income $47,174 ($50,000 less $3,533 plus $34,000 less $24,000 less $9,293).

Let’s assume that Mike wants to make a $10,000 employee contribution to his Solo 401(k) to lower his taxable income by $10,000. Sure enough, the math does not work that way due to the QBI deduction. Mike’s QBI is now $36,467 (the original QBI of $46,467 less the $10,000 traditional Solo 401(k) contribution). Thus, his QBI deduction is now reduced to $7,293 (20% of $36,467). This makes Mike and Jane’s taxable income $39,174 ($50,000 less $3,533 plus $34,000 less $24,000 less $10,000 less $7,293).

Notice that $39,174 is $8,000 less than $47,174, not $10,000 less than $47,174. The interaction of Section 199A and the small business retirement plan creates the oddity that a $10,000 deduction (the traditional Solo 401(k) contribution) reduces taxable income by only $8,000.

QBI has thus created a new class of deductions – what I call “80% deductions.” These deductions reduce QBI and thus (in total effect) are deductible at only 80 percent of their gross amount.

As applied to small business retirement plans, 80% deductions are particularly troublesome. Recall Mike put $10,000 into his Solo 401(k), netting him an $8,000 federal tax deduction. When Mike goes to take the $10,000 (and its growth) out of the Solo 401(k), all of it will be taxable.

Matching 80% deductions with 100% inclusions is usually not smart tax planning.

I’ve written more about this phenomenon (what I call the Solo 401(k) Trap) here.

Planning Options

In cases where taxpayers are below the taxable income limitations of Section 199A ($163,300 and $326,600 (MFJ) for 2020), taxpayers will have to weigh the benefit of the 80 percent deduction for a traditional contribution to a small business retirement plan versus other options. Some of those other options include (if eligible):

  1. Make employee contributions to a Roth IRA, Roth Solo 401(k), and/or after-tax contributions to a Solo 401(k)
  2. Make contributions to a health savings account (a “HSA”)
  3. Make contributions to a traditional IRA
  4. Invest the earnings in taxable accounts and/or pay off existing debt.

Roth Contributions

Roth versus traditional receives much Internet discussion, particularly in the FI community. All agree that a taxpayer’s current marginal tax rate is vitally important. 80% deductions lower marginal tax rates. Take Mike, who with his retirement plan contributions lowered his 2018 taxable income to $39,174. As a married filing joint taxpayer, his marginal federal income tax rate is 12 percent. However, the marginal rate on the $10,000 retirement plan traditional contribution is only 9.6 percent (80 percent of 12 percent). In order for the traditional contribution to be advisable, Mike better be pretty sure he can pull the money out of the Solo 401(k) at a marginal federal tax rate below 9.6 percent. Being that the lowest marginal tax rate is 10 percent today, that does not seem very likely.

In Mike’s case, he would have been much better advised to leave his taxable income at $47,174 and made the Solo 401(k) contribution a Roth Solo 401(k) contribution.

HSAs/IRAs/Small Business Retirement Plans

Many small business owners are looking for current tax deductions, and many are in marginal tax brackets much above the 12 percent bracket. The interaction between Section 199A and small business retirement plans creates a new pecking order for self-employed individuals looking to reduce taxable income through plan contributions. That order is as follows:

  1. HSA Contributions (if eligible)
  2. Deductible Traditional IRA Contributions (if eligible)
  3. Traditional Small Business Retirement Plan Contributions

HSA Contributions

I’ve written about my fondness for HSAs here. What’s important for this purpose is that contributions to HSAs do not reduce QBI. Thus, contributions to HSAs are “100 percent deductions” and not 80% deductions. In addition to all their other advantageous tax attributes, HSA contributions should be prioritized over small business retirement plan traditional contributions from a Section 199A perspective.

Deductible Traditional IRA Contributions

Deductible contributions to traditional IRAs (for those who qualify) also should be prioritized over traditional contributions to small business plans from a Section 199A perspective.

In the previous version of this post, I expressed the concern that deductible traditional IRA contributions might reduce QBI. Fortunately, there is nothing the IRS and Treasury has provided (including the instructions to the new Form 8995) indicating that the government believes deductible traditional IRA contributions reduce QBI. Based on my understanding of the tax law, which has been reinforced by IRS and Treasury silence on the matter, I am comfortable that deductible traditional IRA contributions should not reduce QBI.

Taxable Accounts

There is no requirement to contribute to small business retirement plans. You can simply take profits and invest them in taxable accounts. Considering that traditional small business retirement plans contributions are now 80% deductions that must later create 100% income, you may opt to simply not make plan contributions and keep profits in taxable accounts. That may be very sensible if either or both the following are true: 1) you are currently in a very low marginal federal tax bracket and 2) you anticipate being in a much higher marginal federal tax bracket in the future.

S Corporation Owners

For S corporation owners, only the operating income after the owner’s W-2 salary is eligible for the Section 199A deduction. Small business retirement plan contributions are 80% deductions for the S corporation owner just as they are for the sole proprietor and for partners of partnerships with flow-through QBI.

Consideration should be given to employee versus employer contributions. To my mind, the new Section 199A deduction does not necessarily impact whether to make an employee contribution to a Solo 401(k) as a W-2 employee of your business. Yes, your salary is an 80% deduction. But what you from there with your salary (take it home, put it into a traditional Solo 401(k), or put it into a Roth Solo 401(k)) does not increase or decrease your qualified business income (though it could impact the taxable income limitations).

But an employer contribution to a Solo 401(k) (which must be a traditional contribution) does reduce your QBI. Employer contributions to Solo 401(k) plans often fall into the Solo 401(k) Trap.

In many cases, if you qualify for the QBI deduction you should give strong consideration to foregoing the employer contribution. Planning in this regard can benefit from professional consultations.

Your Employees

If you have employees, offering a SIMPLE IRA plan does not change the Section 199A result with respect to their salary. Normal operating expenses (including salaries) of QBI-generating businesses do create 80% deductions, but there is only so much that can be done about that. Unlike your own retirement plan contributions, which are (almost) entirely discretionary, operating expenses are necessary for the conduct of the business. Giving your employees the option of deferring some of their salaries through a SIMPLE IRA does not change the math on the Section 199A deduction, since employees’ salaries reduce QBI regardless of whether the employees contribute some of their salary to a SIMPLE IRA.

The relatively small mandatory employer contribution to employees’ SIMPLE IRAs are 80% deductions, making them a bit more expensive for the business owner (assuming the owner qualifies to claim the QBI deduction).

The Section 199A QBI deduction makes SEP IRA contributions more expensive for most self-employed business owners. In order to make contributions to his/her own SEP IRA, the owner must also make contributions (in an equal percentage of compensation) to the employees, and now those deductions are only 80% deductions (assuming the owner qualifies to claim the QBI deduction).

Upper Income Taxpayers

For some taxpayers, Section 199A will make their small business retirement plan contributions more, not less, valuable. In a previous post, I gave the example of Jackie, a sole proprietor lawyer whose 2020 taxable income (pre-retirement plan contributions) of $215,848 left him unable to claim any Section 199A QBI deduction. Maximum employer and employee traditional contributions of $57,000 to a Solo 401(k) lowered his taxable income such that he was able to qualify for a $31,770 QBI deduction (a 100% deduction) in addition to the $57,000 traditional retirement plan contribution deduction (an 80% deduction).

This interaction turned the $57,000 deduction into an effective $77,370 deduction (80 percent of $57,000 plus $31,770). In this case, Jackie’s retirement plan contributions are 136% deductions!

For upper income taxpayers near the QBI taxable income limitations, small business retirement plans may be a very powerful tool, and unlike those with more modest incomes, these upper income business owners may have an opportunity to maximize their Section 199A deduction by contributing to retirement plans.

Conclusion

The combination of Section 199A and small business retirement plans creates tax planning opportunities and challenges. Many small business owners will benefit from professional advice to determine the best path forward considering the new law, opportunities, and challenges.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! 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.

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.