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How Clients Can Max Out on the Section 199A Deduction

Jul 15th 2019
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The new Section 199A deduction has led to considerable confusion and uncertainty among taxpayers and practitioners alike. At least new final regulations issued earlier this year provide some clarity.

For those unaware, the Tax Cuts and Jobs Act (TCJA) provides many small business owners with a tax bonanza, thanks to a big new write-off under Section 199A for qualified business income (QBI) of pass-through entities and sole proprietors.

Moreover, under the TCJA a qualified taxpayer can deduct up to 20 percent of the QBI earned during the year, subject to certain limits. For this purpose, a qualified taxpayer includes owners of S corporations, partners in a partnership, members of LLCs and sole proprietors.

One important distinction, however, is whether or not the taxpayer participates in a “specified service trade or business” (SSTB). This category includes a vast array of personal service providers ranging from physicians to painters (but engineers and architects are specifically exempted). Then three main rules are applied:

1. If you’re a single filer with income below $160,700 or $321,400 for a joint filer in 2019, you can claim the full 20 percent deduction—no restrictions.

2. If you’re a single filer with income above $210,700 or $421,400 for a joint filer in 2019, your deduction is completely eliminated if you’re in a SSTB. For non-SSTB taxpayers, the deduction is reduced, possibly down to zero.

3. If your income in 2019 falls between the thresholds stated above, your QBI deduction is reduced, regard regardless of whether you’re in a SSTB or not.

For SSTB taxpayers, the deduction is phased out on a pro-rate basis until it disappears at the upper income threshold. For non-SSTB taxpayers, the deduction is then limited to the lesser of 20 percent of QBI or the greater of:

  1. 50 percent of the wages paid to employees on W-2s or
  2. 25 percent of wages plus 2.5 percent of the basis of the qualified property owned by the business

Usually, your clients will leave it up to you to work through the numbers and help them stay under the thresholds, if possible. But the TCJA failed to provide a bright-line test as to whether real estate activities constitute a trade or business, despite the large number of such enterprises operating around the country.

To address this situation, the final regulations created a new safe harbor rule. Here’s how it works:

A rental activity (including multiple activities combined into a single enterprise) is treated as trade or business if the following requirements are met…

  • The taxpayer maintains separate books and records for each rental activity (or combined enterprise)
  • The taxpayer performs 250 hours or more of rental services for the activity (or combined enterprise)
  • The taxpayer maintains contemporaneous records, including time reports and similar documents, concerning: 
  1. hours of services performed
  2. a description of all services performed
  3. dates on which services are performed
  4. the identities of the parties performing the services

However, certain rental activities are specifically excluded from the safe harbor rule. This includes:

  • Real estate you use as a residence for any portion of the year
  • Property rented on a “triple net lease” basis

In related guidance, the IRS defines a triple net lease as a lease agreement requiring the tenant or lessee to pay taxes, fees and insurance and be responsible for maintenance activities for a property and rent and utilities.

By becoming an expert in this area, you can provide valuable advice to clients and help them maximize any available Section 199A deduction.

Next week, Ken discusses the impact on the "kiddie tax"