Understanding the Section 199A Business Income Deduction
The purpose of Section 199A deduction or Pass-through deduction is to provide some relief to small businesses by allowing the deduction of as much as 20% of income. This article will provide you with an overview of this deduction, and some watch-outs in claiming it.
An Overview of Section 199A deduction
Passed by Congress in 2004, the domestic production activities deduction was intended to offer tax relief for businesses that produce most of their goods or work inside the U.S. rather than overseas. This deduction is no longer in use as it was replaced in 2017 by the Qualified Business Income Deduction (also known as Section 199A deduction) that was introduced via the Tax Cuts and Jobs Act (TCJA) of 2017.
What is Domestic Production Activities Deduction?
Also known as the Section 199 deduction, the domestic production activities deduction was in effect from 2005 through 2017. This deduction applied to both small and large businesses that manufactured, grew, extracted, produced, developed, or improved goods inside the U.S. Using Form 8903, qualifying companies were able to claim the domestic production activities deduction based on a complex formula and set of rules.
What is The Section 199A deduction?
When the legislation known as the Tax Cuts and Jobs Act of 2017 was enacted on Dec. 22, 2017, the Section 199 domestic production activities deduction was no longer available. In its place, Congress created the Section 199A deduction (note the “A”), also known as the Qualified Business Income Deduction, which no longer only applies to domestic manufacturing companies.
This newly passed qualified business income deduction gives businesses with pass-through income - S corporations, sole proprietorships, some rentals, and non-publicly traded partnerships (PTP) - the ability to deduct as much as 20% of qualified business income, or QBI. This provision of the tax law is meant to provide some relief to small businesses that did not benefit from the cut to the corporate rate.
How is the Sec 199A deduction calculated?
The deduction is the least of:
- Twenty percent of ordinary taxable income less net capital gains, or
- Twenty percent of qualified business income plus twenty percent of qualified REIT dividends and partnership income (publicly traded)
What are the Limitations on Sec 199A Deduction
As with many tax benefits, this small business tax deduction is limited above a certain income level. In the case of the 199A pass-through, the limits begin at $326,600 if married ($163,300 if others). These limits include the following factors:
- UBIA - unadjusted basis immediately after acquisition - of any qualified property the business holds
- W-2 wages the business has paid
- The types of businesses that are allowed to take the deduction
The phase-out leads to ineligibility for the deduction (2020 tax year) at $426,600 for married and $213,300 for others.
What is Qualified Business Income?
QBI is the net taxable income attributed to qualified businesses, although there are some exceptions. Only items included in taxable income are counted. In addition, the items must be effectively connected with a U.S. trade or business. Dividend income, interest income, capital gains, and losses are excluded, as is income from outside of the US.
Sec 199A deduction - Eligibility Limitations
There are a few businesses that do not qualify, including C corporations. Also, businesses exceeding the $213,300 / $426,600 limits cannot claim the deduction when the business is one of the following:
- Law
- Health
- Performing arts
- Actuarial science
- Athletics
- Consulting
- Investing
- Financial services
- Trading
- Investment management
- Any business if the principal business asset is skill or reputation of one of the employees
As with most of the United States tax laws, this deduction can be complicated. It will, however, save many small businesses a significant amount of money. Consult with a tax professional to determine how you can benefit.
It is important to emphasize that those types of businesses are not limited to taking the full deduction as long as the taxable income of the individual taking the deductions is below a taxable income threshold.