In the months since the IRS published the Section 199A proposed regulations, people have discussed the absurd Section 199A deduction “cliff” that hits businesses providing a specified service as part of their operation.
I still struggle to see how such a cliff makes any sense and the recently updated Publication 535 suggests to me that no cliff actually exists. Then again, we don’t have the final regulations for Section 199A and those are really the only place we’ll get a definitive answer about the cliff.
In this post, I’m going to talk about why such a cliff may (or may not) be an issue. And then I want to suggest a way some affected businesses may be able to salvage their Section 199A deduction if it turns out one does exist.
The Section 199A Formula and its Many Limitations
Superficially, Section 199A gives owners of unincorporated businesses as well as S corporations a deduction equal to 20 percent of the business’s income. Example: A sole proprietor who earns $100,000 may receive a $20,000 Section 199A deduction. An S corporation that generates $10,000,000 of profit may also create $2,000,000 of Section 199A deductions for its shareholders.
The deduction formulas, however, include a number of limitations. First, taxpayers don’t get to use the deduction to shelter income already preferentially treated (such as capital gains) or income already sheltered by other deductions. Further, high income taxpayers see their deduction limited.
For example, a single person with taxable income more than $207,500 and a married person with taxable income more than $415,000 see their Section 199A deduction limited to the greater of 50 percent of the W-2 wages paid by a business or 25 percent of the W-2 wages plus 2.5 percent of the undepreciated basis of property used in the business.
And then another example--and one that connects to the “cliff:” These same high-income taxpayers either don’t get or get phased out of a Section 199A deduction on business income from a specified service: healthcare, law, accounting, consulting, performing arts (so actors and musicians), athletes and then a handful of other high-income white collar businesses.
Falling Off the Section 199A Cliff
You may already know, but here’s something many of us (me included) missed or got wrong with Section 199A. In the case of a business conducting some “specified service” activity inside another larger entity, that specified service possibly erases the Section 199A deduction for the entire operation. That erasure is the “cliff.”