Author Topic: How to lose Section 199A Deduction on your Small Business  (Read 2659 times)

SeattleCPA

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How to lose Section 199A Deduction on your Small Business
« on: January 24, 2019, 04:49:10 PM »
I don't know if anyone here is in this situation but because it is so CATASTROPHIC I want to point out an easy way to lose your Section 199A deduction.

As affected parties probably know, you get a Section 199A deduction equal to 20% of your business income. Some rules exist. If you enjoy a high income, you can't get a deduction equal to greater of either 50% of your wages or 25% of your wages plus 2.5% of your depreciable property. Another rule? If your taxable income gets high enough, you don't get the Section 199A deduction for specified service businesses (white collar professionals, white coat professionals, athletes, performing artists, etc).

But here's the thing that became clear last weekend when final regulations appeared: If you have a non-specified-service business (a blog or ecommerce site) but you do a bit of specified service stuff inside that business (some consulting), that specified service may taint your entire business and cause you to lose the Section 199A deduction on everything.

Example: You have an online store generating $400K of revenue... but your spouse does $50K of consulting and you guys run that through the same business. In this case, your entire $450K business is treated as a consulting business... and if your income is high enough, you lose the Section 199A deduction.

The bad news: You can't do anything about this for 2018. (Sorry.) You probably can do something to salvage the deduction for 2019. (The solution? Break the two businesses apart.)

Something to be alert to if you're self-employed...

MDM

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #1 on: January 24, 2019, 04:59:37 PM »
On a related note, @SeattleCPA what do you predict for the QBI calculation having to subtract the sum of (1/2 SE tax + SE health insurance + SE retirement savings) from Schedule C income?  Maybe different for 2018 vs. 2019 and beyond?

SeattleCPA

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #2 on: January 24, 2019, 05:23:59 PM »
Oh gosh, good question. And over in the twitter storm of CPAs discussing this, people are just pulling out their hair...

But here's pretty much what people think after reading the final regulations that appeared last weekend.

Stuff like the self-employment taxes that represent the employer share, self-employed health insurance, and definitely employer-type pension fund contributions potentially do reduce QBI.

BTW, lots of practitioners (including yours truly here) got this wrong and thought these things would NOT reduce QBI because they aren't appearing on entity tax returns as deductions. But final regs explicitly say if items are attributable to business, they reduce qualified business income. And regs use these as examples...

Some other comments...
1. Disagreement exists about how broadly retirement contributions dial down QBI. E.g., do IRA contributions push it down? (Most think "no" I think...) do elective deferrals? (Most think "yes" I think...)
2. If something like SE health insurance isn't "in" the QBI, you don't deduct for it. E.g., if the self-employed health insurance is coming to business owner in the form of wages which aren't QBI or guaranteed payments which aren't QBI, you don't take out SE health insurance because you're essentially double-deducting in that case.

One other disturbing reality: The high end industrial grade tax software isn't doing many of these calculations automatically. The CPAs are having do do them by hand. That is a bad situation.

GetSmart

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #3 on: January 24, 2019, 05:27:07 PM »

From the IRS:

Q5. What is a qualified trade or business?

A5. A qualified trade or business is any trade or business, with two exceptions:

1. Specified service trade or business (SSTB), which includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. This exception only applies if a taxpayer’s taxable income exceeds $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers
 
2. Performing services as an employee

If you are a sole proprietor wouldn't the underlined part above preclude you from getting this deduction regardless of the service you provide ?

MDM

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #4 on: January 24, 2019, 05:52:26 PM »
any trade or business where the principal asset is the reputation or skill of one or more of its employees.
If you are a sole proprietor wouldn't the underlined part above preclude you from getting this deduction regardless of the service you provide ?
That does seem a problematic catch-all.  Fortunately, the IRS chose to define the catch-all VERY narrowly.  See that article for more.

MDM

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #5 on: January 24, 2019, 05:55:13 PM »
Oh gosh, good question. And over in the twitter storm of CPAs discussing this, people are just pulling out their hair....

One other disturbing reality: The high end industrial grade tax software isn't doing many of these calculations automatically. The CPAs are having do do them by hand. That is a bad situation.
Oh, well, there are thousands of minutes before the IRS begins accepting efiled returns - plenty of time to resolve this and make any necessary software changes. ;)

Seriously, thanks for the reply.

jpdx

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #6 on: January 24, 2019, 10:51:35 PM »
The Tax Cuts and Jobs Act sure has simplified the tax code!

sol

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #7 on: January 24, 2019, 11:03:40 PM »
The Tax Cuts and Jobs Act sure has simplified the tax code!

On the "bright" side, the IRS is unfunded and audits are being conducted at record low rates.  This is a great time to be white collar criminal of the tax cheat variety.  You can probably get away with just about anything this year, as long as you're a small fish.  Less than one in two hundred returns from households with between $25k and $200k of income were audited last year, and that number has been dropping steadily for years.  Next year seems likely to be even lower.

White Collar Crime: The President says it's okay!
« Last Edit: January 24, 2019, 11:05:19 PM by sol »

terran

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #8 on: January 25, 2019, 06:16:26 AM »

1. Disagreement exists about how broadly retirement contributions dial down QBI. E.g., do IRA contributions push it down? (Most think "no" I think...) do elective deferrals? (Most think "yes" I think...)

Well, that sucks. So it sounds like my solo 401(k) contributions (both employee and employer) probably reduce my QBI as a sole proprietor?

From page 44 of the recently released Revenue Procedure:

Quote from: IRS
Thus, for purposes of section 199A, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.

If this is the case, as it seems to be, I take it I would might be better off contributing to a Roth solo 401(k) in the future as that wouldn't reduce my QBI. Is that right?


SeattleCPA

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #9 on: January 25, 2019, 08:04:39 AM »
any trade or business where the principal asset is the reputation or skill of one or more of its employees.
If you are a sole proprietor wouldn't the underlined part above preclude you from getting this deduction regardless of the service you provide ?
That does seem a problematic catch-all.  Fortunately, the IRS chose to define the catch-all VERY narrowly.  See that article for more.

+1

P.S. For the principal asset thing to apply, we basically need to be able to identify you with just your first name: LeBron, Steph, Aaron, Serena, etc.

SeattleCPA

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #10 on: January 25, 2019, 08:12:10 AM »

1. Disagreement exists about how broadly retirement contributions dial down QBI. E.g., do IRA contributions push it down? (Most think "no" I think...) do elective deferrals? (Most think "yes" I think...)

Well, that sucks. So it sounds like my solo 401(k) contributions (both employee and employer) probably reduce my QBI as a sole proprietor?

From page 44 of the recently released Revenue Procedure:

Quote from: IRS
Thus, for purposes of section 199A, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.

If this is the case, as it seems to be, I take it I would might be better off contributing to a Roth solo 401(k) in the future as that wouldn't reduce my QBI. Is that right?

So a couple of comments. First, that document referenced is actually not a revenue procedure but the final regulations for Section 199A. (I mention this because on other bulletin boards and forums people are talking about still needing final details. We for all practical purposes have the final details.)

Second, the thing about rethinking pension fund choices given Section 199A is right on according to a number of CPAs who've thought about this.

In simplest example, you don't with Section 199A get a full deduction for a big pension fund contribution if your pension fund deduction simultaneously loses you a Section 199A deduction equal to 80% of the pension contribution.

Then pair that with the realities that (a) you may have to pay income taxes on the money when you later draw out the funds and (b) by putting the money into a retirement account you may be converting preferentially taxed long-term capital gains and qualified dividends into ordinary income taxed at a higher rate and then (c) at some point you may be forced to "tax gain harvest" because you'll need to take RMDs.

It's tricky. :-(

SeattleCPA

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #11 on: January 25, 2019, 08:27:51 AM »
I forgot that I did a pretty good summary of how Section 199A maybe impacts retirement planning choices here:

Section 199A Changes Retirement Planning

It goes over details of lots of the connections between Section 199A and retirement plans...

SilverAg47

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #12 on: January 26, 2019, 09:59:40 AM »
I forgot that I did a pretty good summary of how Section 199A maybe impacts retirement planning choices here:

Section 199A Changes Retirement Planning

It goes over details of lots of the connections between Section 199A and retirement plans...

Very informative post.  I really like your analysis of the situation. 

I am not able to comment directly on your site, so I'll add my question here:

Quote: "Your taxable income in this case equals $76,000 before the Section 199A deduction. The Section 199A deduction in this case, however, adds another deduction to your return. That deduction equals 20% of the $76,000 of taxable income, or $15,200, which drops your taxable income another $15,200 down to $60,800."

Doesn't the SE tax deduction also lower the QBI?  So in your example, wouldn't the Section 199A deduction be only $14,126 and not $15,200?  Hopefully my math is correct.

terran

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #13 on: January 26, 2019, 11:38:57 AM »
Doesn't the SE tax deduction also lower the QBI?  So in your example, wouldn't the Section 199A deduction be only $14,126 and not $15,200?  Hopefully my math is correct.

Yes, that seems to be what these new regulations say. The post you're referencing was written well before these new regulations when most people thought the SE tax deduction wouldn't reduce QBI -- turns out that wasn't right.

SilverAg47

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #14 on: January 26, 2019, 12:37:03 PM »
Doesn't the SE tax deduction also lower the QBI?  So in your example, wouldn't the Section 199A deduction be only $14,126 and not $15,200?  Hopefully my math is correct.

Yes, that seems to be what these new regulations say. The post you're referencing was written well before these new regulations when most people thought the SE tax deduction wouldn't reduce QBI -- turns out that wasn't right.

This is why I asked...

"Note: This blog post’s information has been updated for the final Section 199A regulations which appeared on January 18, 2019."


SeattleCPA

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #15 on: January 26, 2019, 03:10:32 PM »
Doesn't the SE tax deduction also lower the QBI?  So in your example, wouldn't the Section 199A deduction be only $14,126 and not $15,200?  Hopefully my math is correct.

Yes, that seems to be what these new regulations say. The post you're referencing was written well before these new regulations when most people thought the SE tax deduction wouldn't reduce QBI -- turns out that wasn't right.

You guys are right that SE taxes reduce the QBI. So does SE health insurance potentially. And so do pension plan contributions.

I maybe should have lathered on this additional complexity. But when I was writing that, it seemed like it made sense to  simplify.

BTW, note that in order to make the the SE tax adjustment, you look at 92.35% of the net earnings from self employment and then usually apply a 7.65% rate... but sometimes a 1.45% rate... .

« Last Edit: January 26, 2019, 04:12:50 PM by SeattleCPA »

dhc

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #16 on: February 11, 2019, 07:35:46 PM »
Doesn't the SE tax deduction also lower the QBI?  So in your example, wouldn't the Section 199A deduction be only $14,126 and not $15,200?  Hopefully my math is correct.

Yes, that seems to be what these new regulations say. The post you're referencing was written well before these new regulations when most people thought the SE tax deduction wouldn't reduce QBI -- turns out that wasn't right.

You guys are right that SE taxes reduce the QBI. So does SE health insurance potentially. And so do pension plan contributions.

I maybe should have lathered on this additional complexity. But when I was writing that, it seemed like it made sense to  simplify.

BTW, note that in order to make the the SE tax adjustment, you look at 92.35% of the net earnings from self employment and then usually apply a 7.65% rate... but sometimes a 1.45% rate... .


Is there a worksheet available yet for calculating this? Seems like software (at least freetaxusa) is currently taking the "too complex" approach and just having you enter the adjustment yourself. I'm happy to do the calculation, but so far I'm not understanding what I'm calculating. For a schedule C business, is it just line 13 of schedule SE, and does that get subtracted from the QBI itself, or from the 20% deduction?

Edit - found the simplified worksheet, but it doesn't mention SE tax at all. Does that mean if you qualify to use the simplified worksheet (below the taxable income cutoff) you don't need to worry about adjusting it for SE tax?


Edit again - nope, that's just the worksheet being user-unfriendly. Pretty certain after reading the instructions more carefully, as well as pub 535 guidance, that the number at the top of the worksheet is just assumed to already have 1/2 SE tax already taken out of it.
« Last Edit: February 11, 2019, 08:08:20 PM by dhc »

MDM

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #17 on: February 11, 2019, 07:45:12 PM »
Is there a worksheet available yet for calculating this? Seems like software (at least freetaxusa) is currently taking the "too complex" approach and just having you enter the adjustment yourself. I'm happy to do the calculation, but so far I'm not understanding what I'm calculating. For a schedule C business, is it just line 13 of schedule SE, and does that get subtracted from the QBI itself, or from the 20% deduction?
Of the commercial programs, at least TurboTax and TaxSlayer do it already.  Last I checked HR&Block said they would update on 2/14 (or 2/21?).

For an estimate, the case study spreadsheet also will subtract 1/2 SE tax, SE health insurance, and SE SEP/SIMPLE contributions from Schedule C amount to get QBI.  You could download and try that.

SeattleCPA

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #18 on: February 12, 2019, 08:03:46 AM »
This is really written for CPAs but if you're someone doing the QBI adjustments, it might be helpful.

https://evergreensmallbusiness.com/section-199a-qualified-business-income-adjustments/

Summarizing the basic rules:

1. You adjust the business income from the Schedule C, K-1, etc, for additional deductions that get calculated based on the business income: the SE tax deduction, the SE health insurance deduction, pension fund contributions that use the trade or business income.
2. You need to be careful not to double-count deductions. E.g., you don't need to adjust for the three examples in preceding paragraph for an S corporation... Or at least you don't in every situation I can think of right now.
3. If you have more than one trade or business generating a Section 199A deduction, you need to proportionally allocate the QBI adjustments across the trades or businesses.

I assume the software is getting better and better. (That's true with the professional tax prep software.)

Padonak

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #19 on: February 12, 2019, 08:10:24 AM »
Ptf

terran

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #20 on: February 12, 2019, 11:03:49 AM »
It's been suggested by a bogleheads poster who is usually very well informed that perhaps elective solo 401(k) deferrals would not reduce QBI. I think that user would be the first to admit that this is simply a question he/she still has, and not a position he/she is taking, but the basic idea is that the phrasing of the regulations, which states:

Quote from: IRS
the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.

This seems much more applicable to the percentage based profit sharing contribution than to the straight dollar limit employee salary deferral contribution, which is only proportionate to income to the extent that their must be enough income to support the contribution.

I wonder what you think of this suggestion @SeattleCPA?

SeattleCPA

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #21 on: February 13, 2019, 08:03:19 AM »
It's been suggested by a bogleheads poster who is usually very well informed that perhaps elective solo 401(k) deferrals would not reduce QBI. I think that user would be the first to admit that this is simply a question he/she still has, and not a position he/she is taking, but the basic idea is that the phrasing of the regulations, which states:

Quote from: IRS
the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.

This seems much more applicable to the percentage based profit sharing contribution than to the straight dollar limit employee salary deferral contribution, which is only proportionate to income to the extent that their must be enough income to support the contribution.

I wonder what you think of this suggestion @SeattleCPA?

So I answered or addressed this exact point in the comment thread from Harry Sit (who blogs as the finance buff) at that blog post... and I think the way you read the final reg is not that you adjust for pension fund amounts if deduction amounts take into account the income from the trade or business AND the amounts are proportional.

Rather, you adjust if deduction amounts take into account the income from the trade or business.

So what the does the reference to proportionate basis mean in that case? It addresses the situation where some deduction like SE taxes, SE health insurance, retirement plan, etc., take into account several businesses. And in that case, you need to proportionally allocate.

Extreme example to illustrate: Someone earns $200K in guaranteed payments from partnership #1 (which BTW are not QBI and so don't generate a Section 199A deduction), earns $200K in sole proprietorship that runs a little retail shop (so is QBI and should generate a Section 199A deduction), and then also earns $200K from being a partner in a law firm (which could be QBI and so could generate a Section 199A deduction except for the fact that law firm is a specified service trade or business).

What the "proportionate basis" language means is you'd allocate something like a (say) $15K SE tax deduction, a $30K self-employed health insurance deduction and a $60K pension fund contribution (that combines say both elective deferral and profit sharing) on a proportionate basis.

Applying the "extreme example" numbers, and assuming W-2 wages and depreciable property don't matter, the QBI in the example would be the $200K from the sole proprietorship minus $5K of SE taxes, $10K of SE health insurance and $20K of pension. That would leave $165K of adjusted QBI and produce a $33K Section 199A deduction.

One other way to get a handle on this... Think about how the bogleheads approach applies to SE health insurance. The SE health insurance deduction is not proportional. Does that mean it doesn't adjust QBI? (Clearly it does and the final regs explicitly state so.)


terran

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Re: How to lose Section 199A Deduction on your Small Business
« Reply #22 on: February 14, 2019, 06:17:38 AM »
Interesting, I can see that making sense.

 

Wow, a phone plan for fifteen bucks!