Section 199A of the Internal Revenue Code, which was enacted as part of the Tax Cuts and Jobs Act, created a new 20% tax deduction on the qualified business income of business owners who conduct their business as a sole proprietorship or through a passthrough entity, such as a partnership, LLC or S corporation. Very generally, and subject to certain limitations, a business owner’s section 199A deduction on qualified business income is equal to the lesser of, (i) 20% of the business owner’s qualified business income, or (ii) 20% of the business owners’ taxable income, excluding net capital gains.
The potential benefit under section 199A can be significant. If fully applicable, the 20% deduction reduces the highest effective US federal income tax rate on a business owner’s qualified business income from 37% to 29.6%. While there are several technical requirements that must be considered in applying the 20% deduction, section 199A is broadly applicable. Many different types of entrepreneurs and small business owners operating in the ‘new economy’ – for example, third-party merchants on websites like Amazon, Etsy and eBay, ridesharing drivers on Uber and Lyft, and delivery service partners for Amazon – may be eligible for the 20% deduction.
The discussion below provides a general overview of the requirements of section 199A. Each section in the discussion below presents an important question in the section 199A analysis, explores how to answer that question, and provides a general explanation of its impact on the applicability of the 20% deduction under section 199A.
Is my business a “Qualified Trade or Business?”
In order to generate qualified business income eligible for the section 199A deduction, a business owner must be engaged in a qualified traded or business. Under section 199A, a “qualified trade or business” generally means any trade or business other than the trade or business of being an employee and, for taxpayers with taxable income above a certain amount, a specified service trade or business.
Am I engaged in a trade or business?
As an initial matter, an activity must be a “trade or business” in order to be a “qualified trade or business” for purposes of section 199A. An activity is a trade or business only if it is conducted with continuity, regularity and a profit motive. This requirement demands consistent work, but not full-time work. A part-time activity, such as an activity that is operated during the evenings or weekends, may be considered a qualifying business provided that it is profit motivated. For instance, an online vendor that consistently works to fill orders on a part-time basis may be considered to be engaged in a qualifying business. The “trade or business” requirement is most likely to create section 199A issues for hobbyists or for those with sporadic workloads, such as freelancers or gig-economy workers. For example, producing and selling a few paintings a year online may not constitute a qualifying business, depending on factors such as the profitability of the sales and whether the seller has other sources of income.
Am I engaged in a trade or business as an employee?
The trade or business of performing services as an employee is not a qualified trade or business for purposes of the section 199A. In contrast, a business owner who performs services as an independent contractor, through a single-member LLC, or as a partner of a partnership, may be considered engaged in a qualified trade or business for purposes of section 199A. In general, the specified service trade or business (SSTB) exception to the definition of qualified trade or business targets professional services businesses. Depending on the amount of the business owner’s taxable income in relation to the taxable income thresholds discussed below, the SSTB exception may reduce or eliminate the section 199A deduction for income earned for work in the fields of health, law, accounting, actuarial science, consulting, financial services, and brokerage services. Entrepreneurs that create a product or work with their hands typically will not be engaged in an SSTB. For example, neither the inventor that sells her product on a third-party merchant website, nor the independent delivery driver that is hired to deliver her invention, would be considered to be engaged in an SSTB.
SSTB. Does my business generate “qualified business income?”
The 20% deduction under section 199A generally is calculated based on a business owner’s qualified business income. Qualified business income generally includes the net income from a qualified trade or business, excluding most types of passive investment income, such as interest, dividends and capital gains. For an owner of a partnership, the owner’s qualified business income may include her share of the partnership’s income generated from any qualified trade or business conducted by the partnership. Similarly, with respect to an S corporation shareholder, qualified business income may include her share of the S corporation’s income generated by a qualified trade or business conducted by the S corporation. On the other hand, income from W-2 wages received as an employee and other compensation-type income, such as a guaranteed payment received by a partner of a partnership, is excluded from qualified business income under section 199A.
Am I subject to limitations based on my taxable income?
A business owner with taxable income over $157,500 per year (or $315,000 per year if married and filing jointly) is subject to additional limitations that may reduce or eliminate the amount of the business owner’s section 199A deduction. The taxable income threshold considers all of the owner’s income from all sources, not just the business for which they are claiming the section 199A deduction. Phase-in rules may partially limit the amount of the available deduction to business owners with taxable income between $157,500 and $207,500 (or $315,000 to $415,000, if married and filing jointly). The threshold amounts are subject to adjustment for inflation for taxable years beginning after 2018.
Business owners not over the taxable income threshold
For business owners with taxable income below the taxable income threshold, the section 199A deduction on qualified business income is equal to the lesser of, (i) 20% of the business owner’s qualified business, or (ii) 20% of the business owner’s taxable income, excluding net capital gains.
Business owners over the taxable income threshold
For business owners with taxable income above the taxable income threshold, there are two limitations that potentially reduce the benefit of section 199A. First, if the business owner is engaged in an SSTB, the SSTB exception to the definition of qualified trade or business may reduce or eliminate the section 199A deduction with respect to the income from such SSTB. Second, the potential benefit of section 199A with respect to each qualified trade or business of the business owner would be subject to a limitation based on, (i) the amount of the W-2 wages with respect to the trade or business, and (ii) the unadjusted tax basis in qualified property used in the trade or business.
While there are several technical requirements that must be satisfied, section 199A is broadly applicable and should be considered by any business owner or entrepreneurs who conducts a qualified trade or business as a sole proprietorship or through a passthrough entity. For a business owner with taxable income below the taxable income threshold, the main considerations generally would be conducting a qualifying business that generates qualified business income. A business owner with taxable income above the taxable income threshold, or planning on growing beyond the taxable income threshold, would also need to consider the implications of the SSTB exception and the applicability of the limitation based on W-2 wages and the unadjusted tax basis of qualified property.