The rollout of the Section 199A deduction has been cause for celebration for many businesses and business owners, but the calculation of the deduction isn’t easy, especially if taxable income is between the deduction threshold amounts. As a CPA or tax preparer, you need to be ready to help calculate the Sec 199A deduction for taxpayer’s taxable income between the Sec 199A income thresholds. Below, we’ll discuss what Sec 199A is, define “in-between” taxpayers, and show you how to calculate the deduction for those taxpayers.

A Quick Overview of Section 199A

Section 199A explains the Qualified Business Income (QBI) deduction, and is a new provision in the Tax Cuts and Jobs Act introduced in December of 2017 and applicable in the 2018 tax year and beyond. Sec 199A allows for a business income deduction of up to 20% of QBI for a variety of entities, including sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, trusts and estates. The idea behind Sec 199A is to level the playing field between non-corporate entities and C corporations, which receive a sizeable tax benefit based on income.

To qualify for the Sec 199A deduction, a business must be a qualified business. A qualified trade or business is any trade or business, with two exceptions:

1. Specified service trade or business (SSTB), which includes businesses involved in providing services in the following fields:

• Health
• Law
• Accounting
• Actuarial science
• Performing arts
• Consulting
• Athletics
• Financial services
• Investing and investment management
• Trading
• Dealing in certain assets
• Any trade or business where the principal asset is the reputation or skill of one or more of its employees.

2. Performing services as an employee

Calculating Qualified Business Income

QBI is calculated for each individual business, even if a taxpayer owns multiple businesses. Qualified businesses calculate QBI by taking the net amount of any qualified items of income, gain, dedication and loss, which is used to determine taxpayers taxable income. To qualify, items must be connected with a U.S. trade or business. There are a few exceptions to QBI, including dividends, short- and long-term capital gains and losses, and interest income not connected to the business. It also does not include compensation payments to the taxpayer for services to the business.

Defining the “In-Between” Taxpayers

The definition of the in-between taxpayer depends on if the QBI is from as SSTB or not. Below is a breakdown of the how the deduction limitation works depending on the type of business and the taxable income of the taxpayer:

Qualified Business that IS NOT an SSTB:

Married filing joint

• • • Under $315,000 of taxable income: full deduction can be taken
    • Deduction phase out starts: $315,000 of taxable income
    • Over $415,000 of taxable income limitations on deduction: 50% of the owner’s share of the W-2 wages paid by the business, or 25% of the owner’s share of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property.

All other taxpayers (married filing separate, head of household, single, etc)

• • • Under $157,500 of taxable income: full deduction can be taken
    • Deduction phase out starts: $157,500 of taxable income
    • Over $207,500 of taxable income limitation on deduction: 50% of the owner’s share of the W-2 wages paid by the business, or  25% of the owner’s share of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property.

Qualified Business that IS an SSTB

Married filing joint

• • • Under $315,000 of taxable income: full deduction can be taken
    • Deduction phase out starts: $315,000 of taxable income
    • Deduction phase out ends (no deduction allowed): Over $415,000 of taxable income

All other taxpayers (married filing separate, head of household, single, etc)

• • • Under $157,500 of taxable income: full deduction can be taken
    • Deduction phase out starts: $157,500 of taxable income
    • Deduction phase out ends (no deduction allowed): $207,500 of taxable income

How the Phase In of the 199A Deduction Works

For qualified businesses that are not SSTBs but are between the threshold amounts (see above), taxpayers are subject to a phase-in of the wage and capital limitation: 20% of QBI, less an amount equal to a “reduction ratio” multiplied by an “excess amount.” Let’s define these terms and walk through an example below:

Reduction ratio: The amount of taxable income in excess of the lower threshold ($315,000 for married filing joint and $157,500 for all other taxpayers) divided by $100,000 for joint filers and $50,000 for all other taxpayers.

Example: Sue’s taxable income from a non-SSTB trade or business is $380,000 and she’s filing a joint tax return. The reduction ratio would be ($380,000 – $315,000)/$100,000 which equals a ratio of 0.65. The higher Sue’s taxable income, the higher the reduction ratio.

Excess amount: The difference between:

• The deductible QBI amount of the qualified business with NO wage and capital limitation (the full 20% of QBI deduction)
• The deductible QBI amount of the qualified business with a fully phased-in wage and capital limitation

Example: Drawing off our example above, let’s say Sue has share of the business’s W-2 wages which is $60,000, and her share of the business’s unadjusted basis in its qualified property is $200,000.

The deductible QBI amount of the qualified business with NO wage and capital limitation would be $76,000 ($380,000 x 20%).

The deductible QBI amount of the qualified business with a fully phased-in wage and capital limitation would be the greater of:

• 50% of W-2 wages ($60,000 x 0.5 = $30,000) or,
• The sum of 25% of W-2 wages ($60,000 x 0.25 = $15,000) plus 2.5% of the unadjusted basis of the qualified property immediately after its acquisition ($5,000 = $200,000 × 0.025), for a sum of $20,000 ($15,000 + $5,000).

The greater is $30,000 (50% of W-2 wages)

Difference: $46,000 ($76,000 less $30,000)

The reduction ratio is then applied to this amount to determine the reduction of the wage and capital limitation:

In Sue’s case, the reduction of the wage and capital limitation is $29,900 ($46,000 x 0.65). Therefore, 20% of QBI ($76,000), less an amount equal to a reduction ratio multiplied by an excess amount ($29,900) is $46,100 total Sec 199A deduction.

For qualified businesses that are SSTBs but are between the thresholds (see “Qualified Business that IS an SSTB” above), taxpayers must calculate an “applicable percentage,” which is then multiplied by the Qualified Business Income, the W-2 Wages, and the unadjusted basis of all qualified property. We then use the phase-in of the wage and capital limitations used for non-SSTBs: 20% of QBI, less an amount equal to a “reduction ratio” multiplied by an “excess amount.” Let’s define the terms and walk through the same example as above, with the assumption that the business is an SSTB.

Example:

Sue’s taxable income from as SSTB trade or business is $380,000 and she’s filing a joint tax return. Her share of the business’s W-2 wages is $60,000, and her share of the business’s unadjusted basis in its qualified property is $200,000.

Applicable Percentage

100% (1.0) less the ratio of taxable income in excess of the lower threshold ($315,000 for married filing joint and $157,500 for all other taxpayers) divided by $100,000 for joint filers and $50,000 for all other taxpayers.

In Sue’s case:

• 1.0 – [($380,000 – $315,000)/$100,000] = 0.35
• Note the applicable percentage is 1.0 less the reduction ratio calculated above (0.65)

QBI + W-2 Wages + Unadjusted Basis of Qualified Property

• $380,000 x 0.35 = $133,000 QBI includable amount
• $60,000 x 0.35 = $21,000 W-2 includable amount
• $200,000 x 0.35 = $70,000 Unadjusted basis of qualified property includable amount

Reduction ratio

• The amount of taxable income in excess of the lower threshold ($315,000 for married filing joint and $157,500 for all other taxpayers) divided by $100,000 for joint filers and $50,000 for all other taxpayers. The reduction ratio includes all QBI, not just the includable amount.
• For Sue, the reduction ratio would be ($380,000 – $315,000)/$100,000 which equals a ratio of 0.65 (same as we calculated in the previous example).

Excess amount

When calculating the excess amount for SSTB’s, we need to make sure we use only the includable amounts.

The difference between:

• The deductible, includable QBI amount of the qualified business with NO wage and capital limitation (the full 20% of QBI deduction)
• The deductible, includable QBI amount of the qualified business with a fully phased-in wage and capital limitation

The deductible, includable QBI amount of the qualified business with NO wage and capital limitation would be $26,600 ($133,000 x 20%).

The deductible QBI amount of the qualified business with a fully phased-in wage and capital limitation would be the greater of:

• 50% of includable W-2 wages ($21,000 x 0.5 = $10,500) or,
• The sum of 25% of W-2 wages ($21,000 x 0.25  = $5,250) plus 2.5% of the unadjusted basis of the qualified property immediately after its acquisition ($1,750 = $70,000 × 0.025), for a sum of $7,000 ($5,250 + $1,750).
• The greater is $10,500 (50% of W-2 wages)

Difference: $16,100 ($26,600 less $10,500)

The reduction ratio is then applied to this amount to determine the reduction of the wage and capital limitation:

• In Sue’s case, the reduction of the wage and capital limitation is $10,465 ($16,100 x 0.65)
• Therefore, 20% of QBI ($26,600), less an amount equal to a reduction ratio multiplied by an excess amount ($16,100) is $10,500 total Sec 199A deduction.

Dig Deep Into the 199A Deduction

Sec 199A can provide a huge benefit to tax clients if implemented correctly. However, while calculating and providing this deduction to taxpayers is conceptually easy, it becomes more tricky when it comes to the actual execution. This piece is meant to give you a general overview of how to calculate the 199A deduction for taxpayers with qualified business income, but it is in no means comprehensive. To provide the best service to your clients, it’s recommended you spend some time going over the Sec 199A deduction and really understanding the intricacies and nuances of the provision. To get a comprehensive overview of Sec 199A and what it means for taxpayers in 2018, check out Surgent’s Update on Section 199A: What We Now Know in Light of NEW IRS Guidance (S19U).