The Qualified Business Income Deduction (Section 199A)

Section 199A allows many owners of pass-through businesses to deduct up to 20 percent of their qualified business income, along with certain other items, from taxable income. It applies to sole proprietors, partners, and S corporation shareholders, and it can be a significant part of an owner's tax calculation. It was introduced with the 2017 tax law, was originally scheduled to expire, and was later made permanent by legislation, with certain adjustments to thresholds and a minimum deduction for some taxpayers. Confirm the current-year rules with your advisor.

What Counts as Qualified Business Income

Qualified business income generally means the net amount of income, gain, deduction, and loss from a qualified trade or business within the United States. It excludes certain items such as capital gains and losses, dividends, and interest not connected to the business. Wages paid to an S corporation shareholder-employee are not qualified business income, and guaranteed payments to partners generally are not either. That is why owner compensation affects the calculation.

The Basic Calculation

The deduction is generally the lesser of two amounts: 20 percent of qualified business income, or 20 percent of taxable income minus net capital gain. Taxpayers with taxable income below a threshold generally receive the deduction without additional limitations. Above the threshold, limitations phase in.

Wage and Property Limits

For taxpayers with taxable income above the threshold, the deduction from a trade or business may be limited to the greater of 50 percent of W-2 wages paid by the business, or the sum of 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of qualified property. The limit phases in over a range of income above the threshold. Businesses with little or no W-2 wages and little qualified property may see their deduction limited or eliminated at higher incomes.

Specified Service Trades or Businesses

A specified service trade or business includes fields such as health, law, accounting, consulting, financial services, and certain others, with an exception for engineering and architecture. Owners in these fields may lose some or all of the deduction as taxable income rises above the threshold. Owners of other businesses are not subject to the service restriction, although the wage and property limits still apply. Whether a particular activity is a specified service business can be a nuanced question.

Planning Considerations

Planning around the QBI deduction tends to focus on a few themes:

• Owner compensation. Reasonable compensation reduces qualified business income for S corporation owners, but wages count toward the wage limit. The optimal balance depends on income level.
• Taxable income management. Retirement contributions, business deductions, and timing of income can affect where you land relative to thresholds.
• Entity structure. The type of entity and how activities are grouped can matter.
• Aggregation. Certain related businesses can be aggregated for the purposes of the limits, which may benefit some owners.
• Rental real estate. Rental activity can qualify as a trade or business in some cases, with a safe harbor available. Facts and record-keeping matter.

A Simplified Example

Suppose an owner of a non-service business has 100,000 dollars of qualified business income and taxable income well below the threshold. The deduction would generally be 20 percent of qualified business income, or 20,000 dollars, subject to the taxable income cap. If the same owner had taxable income well above the threshold, the wage and property limit would apply, and the deduction could be lower depending on wages and qualified property. This example is illustrative and simplified.

Interaction with Other Items

The deduction reduces taxable income but not adjusted gross income. It does not reduce self-employment tax. Certain states do not follow the federal deduction. Also, the deduction is taken on the personal return, so it is not a business-level deduction.

Documentation and Reporting

Reporting requires careful computation of qualified business income by trade or business, W-2 wages, and qualified property. The calculation is generally completed with the tax return. Keep support for wages and property, and track losses from prior years that carry forward and reduce future qualified business income.

Questions to Ask

1. Is my business a specified service trade or business?
2. Where does my taxable income fall relative to the thresholds?
3. How do my salary and retirement contributions affect the deduction?
4. Are there aggregation opportunities?

Also see Salary vs Distributions: Planning the Owner Pay Mix for the compensation link.

Common Mistakes to Avoid

Owners sometimes assume the deduction applies to all income on their return. It applies only to qualified business income and is capped by taxable income. Others overlook the effect of losses, since a loss from one business can reduce the deduction for another and carry into future years. Another common mistake is failing to review the deduction after changing salary or entity type, which can shift the result meaningfully. A short annual review when preparing estimates helps avoid these surprises.

Coordinate with Your Estimated Payments

Because the deduction reduces taxable income, it affects the estimated tax you owe each quarter. Ask your advisor to include it in your projections so payments are neither too high nor too low.

Educational purposes only. This page is general education and is not tax, legal, or accounting advice. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.