FAQ: Maximizing the Small Business Income Deduction!

Sole Proprietorship FAQ
Is there an easy way to estimate my ‘Small Business Income Deduction’ Sec. 199A tax savings?
If your family’s income comes entirely (or nearly entirely) from a pass-thru entity like sole proprietorship and your
taxable income is less than $157,500 a year (less than $315,000 a year if married and filing a
joint return), you can calculate your Sec. 199A deduction as 20% of your taxable income.
For example, if your taxable income equals $100,000, your 20% deduction equals $20,000.

How do I calculate my tax savings?
To estimate your tax savings from the Sec. 199A deduction, you multiply the deduction amount
by your “top” marginal (10%, 12%, 22%, 24%, 32%, 35%, 37%) tax rate.
For example, under the new law, most taxpayers pay a 12% “top” tax rate. If a taxpayer gets a
$20,000 deduction and pays the 12% tax rate, the tax savings equals 12% of the $20,000 or
$2,400 or you get 20% discount off the 12% rate, namely a discounted “top” rate of .2*12%=9.6%

How Much Does the Typical Sole Proprietor Save with Sec. 199A?
Say the average sole proprietorship makes $60,000 in her or his business (because $60,000
equals roughly the average household income in the United States).
In this case, the taxpayer probably calculates a taxable income under the new law as equal to
roughly $36,000, an amount calculated as the $60,000 in self-employment earnings minus the
new standard $24,000 deduction.
The Sec. 199A deduction gives the taxpayer a deduction equal to 20% of the $36,000, or $7,200.
That deduction saves the taxpayer $864 if the taxpayer pays the new “typical” 12% top tax rate.

Does a sole proprietor need to incorporate to use Sec. 199A deduction?
No, he or she doesn’t need to incorporate.
In fact, while forming a corporation may deliver other business benefits, a corporation may also
reduce your Sec. 199A deduction.

Can a sole proprietor use a limited liability company and get the Sec. 199A deduction?
Yes—and this approach allows for simpler accounting.
A single member (or one owner) LLC does its accounting and files its taxes the same way that a
regular “unincorporated” sole proprietorship does.
But again, a small business owner doesn’t need an LLC to use the Sec. 199A deduction.

What if a sole proprietor wants to incorporate or form an LLC?
Your business may gain significant legal benefits by incorporating—accordingly you may want
to explore this option with a local attorney and your accountant. Further, even though a Subchapter S election for an existing corporation or existing LLC may reduce your Sec. 199A deduction, the tax savings that flow from an appropriate Subchapter S election can be significant—something you may want to explore with your tax accountant.

Does a sole proprietor need employees to take the deduction?
Usually not. If a sole proprietor files his or her tax return as a “single taxpayer” and the
proprietor’s tax return shows taxable income of less than $157,500, the Sec. 199A deduction formula doesn’t require the business to pay W-2 wages.

If a sole proprietor files his or her tax return with a spouse as a “married joint return taxpayer”
and the tax return shows taxable income of less than $315,000, the Sec. 199A deduction formula
doesn’t require the business to pay W-2 wages.
As a taxpayer’s income moves above the $157,500 and $315,000 thresholds, the Sec. 199A
deduction formula begins to require W-2 wages or depreciable property.

Are “service business” sole proprietors disqualified from using Sec. 199A deduction?
Usually not.
A single taxpayer only loses her or his ability to use the Sec. 199A deduction on income from a
specified service business if her or his taxable income exceeds $157,500 (the deduction actually
slowly “phases out” as the taxable income moves from $157,500 to $207,500).
And married taxpayers filing a joint return only lose their ability to use the Sec. 199A deduction
on income from a specified service business if their income exceeds $315,000 (again, the
deduction slowly “phases out” as the taxable income moves from $315,000 to $415,000).
Most small service businesses, therefore, don’t lose the Sec. 199A deduction.

What kinds of service businesses risk disqualification?
The law potentially disqualifies traditional white-collar professional service businesses like
doctors and dentists, lawyers and accountants, anybody else who works as a consultant or
investment professional.
In addition, performers, athletes and then probably any one- or two-person businesses get
disqualified too.

Real Estate Investor FAQ
Does Sec. 199A deduction work for rental property investors?
Yes. The investor needs rental properties that general taxable income, however.

Will a Sec. 199A deduction from real estate reduce my taxes?
Yes, if you’re paying income taxes on your real estate profits… but remember that many real
estate investors lose money “on paper” because of real estate-related write-offs like depreciation.
Tip: Check your tax return… if it includes an 8582 form that indicates you have a bunch of prior
year passive suspended losses, your real estate investment probably doesn’t generate taxable
income and in that case won’t lead to a Sec. 199A deduction.
If you are actually generating taxable income from one or more rental properties, however, the
Sec. 199A deduction should save you taxes.

Does Sec. 199A deduction work for “flippers?”
The Sec. 199A deduction potentially works for “flippers” who report the profit they earn from
buying, renovating and then selling homes on the Schedule C tax form inside their 1040 return.
The Sec. 199A deduction doesn’t work, however, for “flippers” who report the profit they earn
from flipping on Schedule D. The reason is that the Schedule D treatment treats the profit as
capital gains and capital gains get excluded in the Sec. 199A formula.

Is there an easy way to estimate my Sec. 199A tax savings?
Yes, if your situation is a simple one.
If your family’s real estate income amounts to only a portion of your family’s income—say
because your family income also includes a W-2–and if your taxable income is less than
$157,500 a year (less than $315,000 a year if married and filing a joint return), you can calculate
your Sec. 199A deduction as 20% of the bottom-line real estate income shown on Schedule C or
on Schedule E
For example, and keeping the math simple, if your real estate income equals $10,000, your Sec.
199A deduction equals $2000.

How do I estimate my tax savings?
To estimate your Sec. 199A deduction tax savings, you multiply the Sec. 199A deduction by
your “top” tax rate. Under the new law, most taxpayers pay either a 10% or 12% tax rate. So if a taxpayer
gets a $2000 deduction and pays the 10% tax rate, the savings equals 10% of the $2000 or $200.

Do I need to incorporate or form a limited liability company to get Sec. 199A deduction?
No, you don’t.
You can put real estate into a limited liability company as long as the limited liability company is not taxed as a corporation. Note, though, you typically never want to put real estate into a regular corporation or a
Subchapter S corporation.

S Corporation and S Corporation Shareholder FAQ
Do I need to operate as an S corporation in order to use Sec. 199A deduction?
In most cases, no.
The only time you may need to operate as an S corporation is when your taxable income is high
enough that the W-2 wages limitation kicks in. (This means your taxable income rises above the
$157,500 threshold if you’re single and above the $315,000 threshold if you’re married.)
In this special case, a taxpayer who cannot use or fully use the Sec. 199A deduction because she
or he lacks W-2 wages and lacks depreciable property may benefit from operating a business as
an S corporation.

How much does the Sec. 199A deduction save a Subchapter S corporation shareholder?
If your S corporation distributive share (the value that appears in box 1 of the S corporation K-1)
represents only a portion of your income, you can roughly estimate the Sec. 199A deduction by
multiplying the box 1 amount by 20%. You can then roughly estimate the Sec. 199A tax savings
by multiplying the Sec. 199A deduction by your “top” tax rate.
If the S corporation qualified business income (probably the amount shown in box 1 of the K-1)
equals $100,000, for example, the Sec. 199A deduction equals $20,000.
And if the Sec. 199A deduction equals $20,000 and your “top” tax rate equals 22%, the
estimated tax savings equal $4,400, calculated as .22 times $20,000.

What salary should an S corporation shareholder-employee use to maximize savings?
You shouldn’t let the Sec. 199A deduction play into the salary you set for a shareholder-employee.
The requirement to set reasonable compensation for shareholder-employees stands independent
of the Sec. 199A deduction.
However, and just so you know, because a taxpayer calculates the Sec. 199A deduction as 20%
of the lesser of either the qualified business income or the taxable income, setting the W-2 wages
to anything less than the total deductions has no impact on the Sec. 199A deduction.
Restated another way, if a taxpayer’s return includes $30,000 of deductions, the W-2 wages
“pulled out” of qualified business income and then paid out to the shareholder as wages only
begins to diminish the Sec. 199A deduction after W-2 wages exceed $30,000.

Should I stop using an S corporation as a way to bump my Sec. 199A deduction?
Probably not—if the S corporation election made sense in the first place.
The S corporation gambit probably saves you several thousand dollars of payroll taxes annually.
If your S corporation income (including your shareholder-employee wages) roughly
approximates the reasonable compensation you need to pay yourself as a shareholder-employee
anyway, however, you probably are not saving money or saving much money with the S
corporation option. You may want to dissolve the S corporation, give up on the opportunity to reduce payroll taxes
using the S corporation, and then ratchet up your Sec. 199A deduction—something you can do
with a sole proprietorship.

Partnership and Partner FAQ
How do I estimate my Sec. 199A deduction and savings?
If your share of partnership profits (as shown in the various boxes that appear on the K-1 you
receive) represents only a portion of your income, you can roughly estimate the Sec. 199A
deduction by multiplying the total of all the bits of income that represent something other than a
capital gain (so probably at least the amounts shown in K-1 boxes 1, 2, 3) amount by 20%. With
this deduction estimate in hand, you can roughly estimate the Sec. 199A tax savings by
multiplying the Sec. 199A deduction by your “top” tax rate.
If the partnership’s qualified business income (say the amount shown in box 1 of the K-1) equals
$100,000, for example, the Sec. 199A deduction equals $20,000. You can estimate the tax
savings by multiplying the Sec. 199A deduction by your “top” tax rate. With a “top” tax rate
equal to 22% and a $20,000 tax deduction, for example, the actual tax savings equal $4,400.
If your share of partnership profits (as shown in the various boxes that appear on the K-1 you
receive) represents all or nearly all of your income, you can roughly estimate the Sec. 199A
deduction by multiplying your taxable income, net of any capital gains, by 20%. With this
deduction estimate in hand, you can roughly estimate the Sec. 199A tax savings by multiplying
the Sec. 199A deduction by your “top” tax rate.
If the partnership’s qualified business income (say the amount shown in box 1 of the K-1) equals
$100,000 and your personal deductions total $50,000, for example, your taxable income equals
$50,000. In this case, you calculate the Sec. 199A deduction by multiplying the $50,000 of
taxable income by 20% to calculate a $10,000 deduction. You can estimate the tax savings by
multiplying the deduction by your marginal tax rate. With a marginal tax rate equal to 12% and a
$10,000 tax deduction, the actual tax savings equal $1,200.

Should a partnership adjust partner guaranteed payments?
Probably the partnership should at least consider doing this…
The guaranteed payments a partnership pays to partners don’t count as qualified business
income.
For this reason, partnerships should consider changing the way partnership profits gets calculated
and allocated so as to pay out less profit in the form of a guaranteed payment and more profit in
the form of a distributive share accompanied by distributions.
However, just so you know, because a taxpayer calculates the 20% deduction as the lesser of
either the qualified business income or the taxable income, setting the guaranteed payments a
partner receives to anything less than the total deductions the partner shows on her or his tax
return saves no tax.
Restated another way, if a taxpayer’s return includes $50,000 of deductions, guaranteed
payments “pulled out” of qualified business income and then paid out to the partner only begin to
diminish the Sec. 199A deduction after guaranteed payments exceed $50,000.

What if the partnership’s partners have Sec. 199A deduction limited by W-2 wages?
If a partnership’s partners find their Sec. 199A deductions limited because the partnership pays
no or low W-2 wages and further owns limited depreciable property, the partnership may be able
to create wages by paying partners as employees.
Possibly the most eloquent way to do this is to set up a tiered structure where partners don’t
directly own their interests in the partnership but rather own S corporations that own their
partnership interests.
Because tax law requires these S corporations to pay their shareholder-employees’ wages, this
tiering may create the needed W-2 wages. Consult your tax advisor for more details.

This FAQ is not intended to replace the services of a competent legal, tax, or business advisor. If legal or other expert assistance is required, the services of a professional should be sought.

Leave a Reply

Your email address will not be published.