What Is the Qualified Business Income Deduction?

screenshot of the Section 199A page on irs.gov

In 2017, there were major changes to tax law. The Tax Cuts and Jobs Act included reductions in tax rates for businesses and individuals, increasing the standard deduction and family tax credits, eliminating personal exemptions, and making it less beneficial to itemize deductions, limiting deductions for state and local income taxes and property taxes. 

With these reductions of tax rates for businesses, it was felt that this would be very fair for small businesses. Most small businesses are set up as pass-through entities. This is where the income tax is passed through the entity and the tax responsibility is left on the owner or owners as individual taxpayers. To level the playing field, Section 199A was added to the Act.

 

What Is Section 199A?

Section 199A details an individual taxpayer deduction for qualified business income. It is called the Qualified Business Income Deduction. This deduction allows eligible self-employed and small business owners to deduct up to 20% of their business income, REIT dividends, or qualified publicly traded partnership (PTP) income on their individual tax returns. The Qualified Business Income Deduction lowers your taxable income, which is the amount used to determine how much you owe in taxes. Unless changes to this law are made, it is to be available for tax years 2018-2025.

The 20% Qualified Business Income Deduction is calculated as the lesser of 20% of the taxpayer’s qualified business income, plus (if applicable) 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income or 20% of the taxpayer’s taxable income minus net capital gains. The 20% deduction reduces federal income tax but not Social Security or Medicare taxes. It also does not reduce self-employment tax.

 

Who Qualifies for the Qualified Business Income Deduction?

The 199A deduction is provided for sole-proprietorships, partnerships, S-corporations, trusts, or estates. Income from C-corporations, any trade or business whose principal asset is the reputation or skill of one or more of its employees or owners or services you performed as an employee of another person or business does not qualify. 

This does not mean that any business income from these entities qualifies for the 20% deduction. This deduction comes with significant qualifications. This is what they call an “above-the-line” deduction, so it does not matter if you take the standard deduction or if you itemize on a Schedule A. The deduction is only for pass-through entities and qualified business income from these entities. It is not available for wage income and can be limited by which type of business in which you are engaged, your taxable income, W-2 wages paid, and the unadjusted basis immediately after acquisition of qualified property.

The Qualified Business Income Deduction is the net number of qualified items of income, gain, deduction, and loss from any qualified trade or business. This includes but is not limited to the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans. The Qualified Business Income Deduction is the taxable income that comes from a domestic business. If a business has both domestic and foreign income only the domestic income qualifies.

 

What Does Not Qualify For the Qualified Business Income Deduction?

The Qualified Business Income Deduction does not include items such as:

  • Items that are not properly includable in taxable income
  • Investment items such as capital gains or losses or dividends
  • Interest income not properly allocable to a trade or business
  • Wage income
  • Income that is not effectively connected with the conduct of business within the United States
  • Commodities transactions or foreign currency gains or losses
  • Certain dividends and payments in lieu of dividends
  • Income, loss, or deductions from notional principal contracts
  • Annuities, unless received in connection with the trade or business
  • Amounts received as reasonable compensation from an S corporation
  • Amounts received as guaranteed payments from a partnership
  • Payments received by a partner for services other than in a capacity as a partner.
  • Qualified REIT dividends
  • Publicly traded partnership (PTP) income

There is a safe harbor rule for 199A purposes available to individuals and owners of pass-through entities who seek to claim the deduction under section 199A with respect to a rental real estate enterprise. Under the safe harbor, a rental real estate enterprise will be treated as a trade or business for the purposes of the Qualified Business Income Deduction if certain requirements are met.

Also, there are income limitations to qualify for the deduction.

 

2020 Qualified Business Income Deduction Income Thresholds

 

Filing Status Income Threshold (limit for the full deduction) Income Limit for a partial deduction
Single $163,300 $213,300
Head of household $163,300 $213,300
Married filing jointly $326,600 $426,600
Married filing separately $163,300 $213,300

 

If you are below these thresholds, it is very straightforward and you should qualify for the 20% deduction on your taxable business income. 

If you are above these limits, it gets confusing as to who qualifies and who does not. Above those limits, your ability to claim the deduction depends on the precise nature of your business. Even if your business qualifies, you may not get to enjoy the full 20% break as the deduction phases out for certain types of businesses.

 

Determining If Your Business is an SSTB

If the business owner’s taxable income is above the income limits, you will need to determine if the business is a specified service trade or business (SSTB). An SSTB is a trade or business involving the performance of services in the fields below:

  • Accounting
  • Actuarial science
  • Athletics
  • Brokerage services
  • Consulting
  • Financial services
  • Health services, such as performed by doctors and nurses
  • Investing and investment management
  • Law, including lawyers
  • Performing arts
  • Trading

Many businesses offer a multitude of services or products. A business will not be considered an SSTB if less than 10 percent of the gross receipts, (5 percent if gross receipts are greater than $25 million) of the trade or business are attributable to the performance of specified services. 

Many business owners are trying workarounds to restructure their businesses by splitting up their business into two or more entities with the same owner to separate the SSTB income and non-SSTB income and avoid missing out on part or all the Qualified Business Income Deduction. 

To prevent this workaround there are set rules that if a non-SSTB has 50% or more common ownership with an SSTB and the non-SSTB provides 80% or more of its property or services to the SSTB, the non- SSTB will by regulation be treated as part of the SSTB.

 

What If Your Taxable Income is Above the Threshold?

If your taxable income is equal to or higher than the threshold, your maximum possible deduction is subject to limitations. How much you can get will decrease based on your income. 

The deduction considers multiple factors, and the instructions will walk you through them. If the income is from a specified service trade or business (an SSTB), it does not qualify for the deduction once it passes the maximum threshold. 

If you are between the thresholds and an SSTB, the deduction will be phased out until it no longer exists. If you are not an SSTB and you go over the phase-in range, your deduction could be limited by your W-2 wages paid or the UBIA of qualified property held by a trade or business.

There are many more factors that affect a taxpayer’s qualifications for the deduction and factors that set limitations on the percentage one can deduct. The IRS has noted that 95 percent of small business owners will fall below the thresholds and not have to worry about the limitations. If you are below the threshold, you would use IRS Form 8995 (Qualified Business Income Deduction Simplified Computation). 

If your taxable income is more than the income threshold then you would use IRS Form 8995-A (Qualified Business Income Deduction). Both of these forms take you through the process of adding up your qualified business income, qualified REIT dividends, and qualified PTP income. This will determine the amount of your deduction.

 

Are You Taking Advantage of the Deductions Available to You?

I am sure many questions are still left unanswered. This is one of the most complex tax laws not only from the 2017 Tax Cuts and Jobs Act but in all of the tax codes. The IRS website provides a lot more information if you’d like to dig in further.

The Treasury Inspector General for Tax Administration has identified nearly 900,000 returns filed for 2018 that did not take the Qualified Business Income Deduction even though it appeared that they qualified. In my past articles, I have always recommended that a taxpayer seeks advice and assistance from a true tax professional. 

When it comes to the 199A deduction, it is imperative that a business owner has the correct tax professional assisting them especially if they are above the limitations. Enrolled Agents, CPA’s and Tax Attorneys can make sure you are not missing out on this valuable deduction and formulate strategies in the operation of the business that will increase the likelihood of you being able to benefit from the Qualified Business Income Deduction. Most importantly, as complex as it is, they can make sure that your tax return is filed correctly so that you get the correct deductions and don’t have to worry about a future IRS examination or an IRS audit.

 

What Can I Deduct on My Taxes?

a 1040 tax return

When filing your taxes there are many ways to reduce your tax bill or ways to get yourself a bigger refund. This can happen using different credits and deductions that are available. 

This article will discuss different tax deductions that can be used on your tax return to reduce your taxable income. I will start off by discussing the choice of either using the standard deduction or itemizing your deductions. I will also discuss above the line deductions which can be used in addition to the standard deduction.

 

What is a Tax Deduction?

A tax deduction is a deduction that lowers a person’s or organization’s liability by lowering their taxable income. Deductions are typically expenses that the taxpayer incurs during the year that can be applied against or subtracted from their gross income to figure out how much they owed. There is always confusion about the difference between the deduction and a tax credit. Remember a deduction reduces your taxable income while a credit directly reduces your tax bill.

On a tax return, you can either take the standard deduction or you can itemize your deductions. You cannot do both. When making the decision to itemize your deductions or to take the standard deduction it is especially important that you evaluate your situation thoroughly to see which will better benefit you. 

It is much easier to take the standard deduction but if you qualify for many deductions the choice to itemize can equate to many tax dollars saved so take your time to review the different deductions that are available and which ones that you qualify for. If these deductions that you qualify for are greater than the standard for your filing status, then you have the answer to your question. 

Having a true tax professional to assist you in reviewing your situation to make this decision is recommended. I will start off with the standard deduction so you have the information on that choice to compare to the breakdown of the possible itemized deductions that you could qualify for.

 

What is the Standard Deduction?

The standard deduction is the portion of income not subject to tax that can be used to reduce your tax bill. Even if you have no other qualifying deductions the IRS allows you to take the standard deduction no questions ask. In the past, the decision to take the standard deduction or to itemize was much more difficult. In 2017, with the Tax Cuts and Jobs Act, the standard deduction was almost doubled making this decision much easier. This will remain in effect for 2018 through 2025. 

The amount of your standard deduction now is based on your filing status, age, and whether you are disabled or claimed as a dependent on someone else’s tax return. The standard deduction adjusts every year based on inflation. The allowable standard deduction for 2020 and 2021 is laid out below as seen on Nerd Wallet.

Filing status 2020 tax year 2021 tax year
Single $12,400 $12,550
Married, filing jointly $24,800 $25,100
Married, filing separately $12,400 $12,550
Head of household $18,650 $18,800

The standard deduction is higher for taxpayers who are 65 and older at the end of the year and/or blind. This extra deduction applies to taxpayers and spouses if married.  Increase the standard deduction by the following for each occurrence of the conditions above. 

For married filing jointly, married filing separately or qualified widow there would be an increase in the deduction by $1300 for 2020 and $1350 for 2021. 

For single or head of household filers, the increase would be $1650 for 2020 and $1700 for 2021. 

If a taxpayer is claimed as a dependent on someone else’s tax return is limited to the greater of $1,100 in 2020 or the individual’s earned income for the year plus $350.

 

Tax Deductions You Should Itemize

Itemized deductions are expenses that can be subtracted from adjusted gross income to reduce your taxable income and therefore reduce the amount of taxes owed. Such deductions would permit those who qualify the ability to pay less in taxes than if they had taken the standard deduction. Itemized deductions are listed on Schedule A of Form 1040. If you decide to itemize you must save all receipts in case the IRS decides to audit you because they can request proof. 

There are many different deductions that one may qualify for. If the amount of these deductions that you qualify for are more than the standard deduction and you have proof of all these deductions, then you should itemize.

State and Local Taxes

Taxpayers can deduct state and local real estate, personal property, and either income or sales taxes. For taxes 2018 through 2025 this deduction is limited to $10,000.

Mortgage Interest

Taxpayers can deduct home mortgage interest on the first $750,000 of mortgage debt. Homeowners can only deduct mortgage interest on home equity loans if the debt was used to buy, build, or substantially improve the taxpayer’s home that secures the loan. Homeowners may deduct mortgage interest on the primary and secondary properties.

Charitable Contributions

Taxpayers are allowed to deduct charitable contributions up to 60% of the adjusted gross income.

Medical Expenses

A taxpayer can deduct unreimbursed medical expenses that are more than 7.5% of their adjusted gross income for the tax year.

Long-Term Care Premiums

Long-term care insurance premiums are tax-deductible to the extent that the premiums exceed 20% of an individual’s adjusted gross income. There is a deduction limit based on your age and the insurance must be qualified.

Gambling Losses

A taxpayer can deduct gambling losses only to the extent of their winnings. You can not deduct more than you win.

IRA Contributions

A taxpayer can deduct qualified IRA Contributions from a Traditional IRA. The amount of the deduction may differ if a taxpayer or their spouse has a 401k as well.

Self-Employment Expenses

A self-employed taxpayer can deduct 50% of the amount that they are paying in self-employment taxes.

Student Loan Interest

A taxpayer can deduct up to $2500 of the interest paid on a student loan from their taxable income.

Casualty and Theft Losses

Any casualty or theft loss incurred because of a federally declared disaster can be reported on a Schedule A. Unfortunately, only losses of more than 10% of the taxpayer’s adjusted gross income are deductible.

Moving Expenses

If a taxpayer is in the military and the move is permanent and was ordered by the military then they can claim a deduction on unreimbursed moving expenses. They can claim travel and lodging expenses, the cost of moving household goods, and the cost of shipping cars and pets.

Educator Expense Deduction

If a taxpayer is a schoolteacher or other eligible educator, they can deduct up to $250 spent on classroom supplies.

 

Tax Deductions That Have Been Limited or Eliminated 

Many commonly used and well know deductions have been recently eliminated or limited. In the past, an employer could reimburse a taxpayer up to $20 a month tax-free for bicycle commuting expenses. There were also employer-related deductions for parking, transit, and carpooling. The 2017 Tax Cuts and Jobs Act suspended these benefits. 

Another common deduction was the expenses from a move. In the past when a taxpayer relocated for a new job, they could use the expenses not only from the cost of moving their possessions but the cost of travel as well. Beginning in 2018 this deduction is only allowable for specific situations and only allowable for taxpayers in the military. 

Also, in the past, a taxpayer that made alimony payments was able to receive a deduction for alimony paid and the person receiving the alimony would include the money as taxable income. With any divorce decree beginning in 2019 the payer will no longer receive a deduction and the spouse receiving no longer must claim alimony as income. 

The medical expense deduction has not gone away but the threshold has changed so that the expenses must exceed 7.5% of your adjusted gross income. In years past the threshold was 10%. 

The Tax Cuts and Jobs Act also set limitations on SALT Tax deductions. SALT Tax is state and local taxes. In the past the amount that a taxpayer could deduct was unlimited. Now the SALT deduction is limited to $10,000. 

 

Understand Which Tax Deductions You Are Eligible For

In conclusion with the rise in the standard deduction and the limitation in many of the itemized expenses the decision of which method to utilize has gotten easier but it is still difficult. Also, with the many recent changes, it is especially important that you understand what you are eligible for and what you are not if you are thinking about itemizing overtaking the standard deduction. Unless a taxpayer has mortgage interest and property taxes, significant charitable gifts, or a major medical event it would probably make more sense to take the standard deduction. 

As I always recommend when filing taxes and tax planning, it will always benefit a taxpayer to consult with somebody that has the knowledge and licensing to correctly advise them. An Enrolled Agent and a CPA (Certified Public Accountant) are the tax professionals that have the educational background to best advise a taxpayer.

 

Understanding Tax Returns

tax return

The tax return season usually causes headaches to many individuals, self-employed and corporations alike. Buzz words like tax returns, Form 1040, Form 1040X, Form 1120S, and Schedule A only come to confuse things some more. This comprehensive guide sheds light to key must-knows so you begin to have a clearer idea of tax preparation, tax returns, and what is required from you. 

 

What Is a Tax Return?

A tax return or income tax return is a document that you need to file with either the state tax board or the IRS (Internal Revenue Service) which reports your income, as well as your deductions (i.e., your business profits and losses) and other details about your tax liability or tax refund. A tax return allows you to:

  • Request a refund for tax overpayment.
  • Schedule tax payments.
  • Calculate your tax liability

Tax returns are filed annually for any business or individual with capital gains, interest, wages, and other reportable income/profits for the previous year, with the deadline being April 15. A tax return has the following three major sections:

  1. Income – It lists all your income sources. You need to report royalties, self-employment income, dividends, and wages, usually using a W-2 form. 
  2. Deductions – Things like interest deductions on specific loans, alimony paid, and contributions to retirement plans are typical examples of deductions that decrease tax liability. The final list, though, varies among jurisdictions. In general, the majority of business operations-related expenses are deductible (for business owners). You can also choose to itemize your deductions instead of using the standard deduction for your filing status.  
  3. Tax credits – These refer to the sum of the owed taxes or the amounts that reduce tax liabilities. More than often, education, pensions, and the care of dependent seniors and children are also attributed tax credits. However, they, too, vary among jurisdictions. 

At the end of the fiscal year and after filing your tax return, you will be able to tell whether you owe taxes or have overpaid taxes (hence, need to be refunded). If you choose not to get your overpaid taxes amount back, it will roll into the next tax year. Now, if you owe taxes, you can pay your debt in monthly (or quarterly) installments or as a single payment. As for self-employed individuals, most of them can reduce their tax burden by making advance payments every quarter

 

What Types of Tax Returns Are There? 

Of the many federal income tax return forms, the most commonly used ones are:

Form 1040 (for Individuals) 

Form 1040 is a long form, which means additional paperwork needs to be filed due to the many tax credits that show up only there. You can consider choosing this form if you (1) itemize deductions, (2) have other income to report, (3) have more complex investments to report, and (4) your earnings are larger. Nevertheless, this extra work that needs to be done with Form 1040 is offset by the extra savings specific credits can produce for you (i.e., taxes paid on a foreign country). Plus, you have a wealth of deductions ready to be claimed directly on the form (no adjustment needed) which enables you to reduce your gross income (i.e., alimony payments, incurred moving expenses, and self-employment taxes). This, in turn, can help you lower the income sum that will be eventually taxed. 

You should file Form 1040 if:

  • You have received income from a property sale.
  • You are self-employed.
  • You itemize deductions. 
  • Your combined incomes (for joint filers) or your personal income is over $100,000.

Important note: If your current situation is different from that of the previous year(s) (i.e., you can make itemizing more profitable for you because you now have more deductions), you will probably need to file a different form. There is no obligation to continue using a particular income tax form just because it suited you in the past. 

Form 1040X (for Individuals)

This is a form you need to file if you (1) found out that you qualify for credits or deductions you didn’t take or (2) have spotted an error on a tax return or (3) your tax return is missing some income. In other words, Form 1040X can be considered your formal claim for a refund. 

Preparing a Form 1040X does not necessarily require the completion of a new tax return. You only need to update the numbers that should be altered. Remember that you can amend your taxes if you have prepared your original tax return using Form 1040, 1040-SR, 1040A,1040NR-EZ, 1040NR, 1040EZ-T or 1040EZ. For business owners with net operating losses in one of the next two tax years, Form 1040X can help carry back these losses. Any refunds will show after 8-12 weeks from the time you made the amendment. 

To prepare Form 1040X, you need any documentation that relates you to the changes you have made (i.e., proof of payment for a newly claimed deduction) and a copy of your original tax return (the one you wish to amend). Beware, though, that you can file an amended tax return either within 24 months of actually paying the tax for that year or within 36 months of the original filing deadline. Depending on the circumstances, you may have more than three years, though (i.e., incapacitated individuals). 

Form 1040EZ (for Individuals)

The Form 1040EZ is the simplest IRS form (a single page), but limits your options when it comes to ways you can save on your tax bill as it restricts you to claiming the tax break called EITC (earned income tax credit), which has been designed to help out individuals with a low income. That being said, you should file it if:

  • Your interest income is below $1,500.
  • Your combined incomes (if a joint filer) or single income is no more than $100,000.
  • You are married but filing jointly, or single.
  • You have no dependents.
  • You are younger than 65. Note that in case you file a joint return, your spouse should also be below 65 years old. 
  • You are not legally bound during the previous tax year (this applies to your spouse, as well, if filing jointly). 

Form 1120 (for C-Corporations)

C corporations, as well as LLCs that file as corporations need to file their income taxes via the Form 1120. After successfully completing Form 1120, you will have a pretty good idea of how much the corporation will be called to pay in taxes. Remember that you will be required to pay quarterly estimated taxes rather than all the money in one lump sum. 

To file Form 1120, you need to enter:

  • Your total income.
  • The date you incorporated.
  • Your EIN (Employer Identification Number).
  • Your capital gains and earned royalties. 
  • The COGS (Cost of Goods Sold).
  • The gross receipts.
  • The total assets held by your corporation.
  • Any interest and dividends earned.
  • Your tax deductions
  • The business tax credits for which you want to apply. 

Form 1120-S (for S-Corporations)

If you are a corporation with an elected S status, you need to file a Form 1120-S tax return annually. In this case, the reported income usually flows through directly to you, the business owner. This means that these companies do not need to pay tax at the corporate level since any reported income is taxed on the business owner’s Form 1040 tax returns. For that reason, the individual does not pay additional taxes on their Form 1040 returns. 

Form 1065 (for Partnerships) 

This is typically filed by partnerships once a year and contains information related to their income, credits, deductions, losses, and more. The particularity of Form 1065 is that it has no federal tax (most of the time, at least). This is because the partners report income flows on their personal tax returns. 

 

What is a 1040 Schedule A?

Those considering to itemize their taxes will need to attach an IRS Schedule A to their Form 1040 so they can claim itemized deductions on their tax returns. For those not familiar with what itemizing taxes is, let’s say that instead of taking the flat-dollar standard deduction, you can choose from the many individual tax deductions out there at tax time. If the amount of your itemized deductions exceeds the standard deduction sum, you save money. for your reference, the standard deductions for 2020 tax year were as follows:

  • Single filing status ($12,400).
  • Married or filing jointly ($24,800).
  • Married or filing separately ($12,400)
  • Head of household ($18,650)

Schedule A is divided into the following sections (each having several subsections):

  • Medical and dental expenses.
  • Casualty and theft losses (in a disaster area declared as such by the federal government or of certain property that produces income).
  • Gifts to charity.
  • Interest you paid.
  • Taxes you paid.
  • Other itemized deductions (i.e., gambling losses, amortizable bond premiums, etc.).
  • Total itemized deductions.

As soon as you have tallied the itemized deductions you wish to claim, you should enter them (the total sum) on your Form 1040. Also, expect to be asked to provide:

  • Form 1098 to show the interest you paid for the year (ask your mortgage lender for it).
  • Your sales tax records.
  • Your state income tax records.
  • Your property tax bills.
  • Any charitable donations records.
  • Receipts for medical expenses that have not been reimbursed. 

 

What is a Schedule C? 

An IRS Schedule C (headlined Profit or Loss From Business (Sole Proprietorship)) is usually filed by self-employed individuals who need to report how much money they lost or made in their business. Schedule C must be completed and then attached to your income tax return. In the majority of cases, you will also be required to fill out Schedule SE (Self-Employment Tax) along with the five-part Schedule C. 

Note that sole proprietorships are companies that do not have a Partnership or Corporation status. They are small businesses operated and controlled by their owners rather than a legal business entity. It does not matter if you have employees or not (or even an office). As long as you get paid for work that you do, you run a sole proprietorship, provided that you earn at least $400 of net profit annually. 

 

What is a Schedule E? 

Schedule E is prepared by those that have income reported on a Schedule K-1 from an S corporation or partnership, receive royalties, build their own home, or earn rental income. You will need to report both your personal tax return and the gross income and losses from these activities. Depending on the type of activity you do, you should include different things. 

For example, for rental income, you need to report prorated rents when you bought the property, the refunds you have received for utilities, and the rental income. As for some of the expenses, these can include marketing and advertising costs (i.e., the cost to advertise on certain publications or sites), travel costs needed to maintain your rentals, cleaning and maintenance costs, repairs, depreciation expenses, and more. 

 

How Long Should You Keep Your Tax Returns? 

According to the IRS, just how long you need to keep your tax returns depends on several factors, such as the event, the type of expense, and the action the document records. Generally speaking, it is best to maintain a record of your tax returns for three years after you filed the return or, at least, until the period of limitations for the particular tax return (the item of credit, deduction income shown on the tax return) ends. 

However, we strongly advise taxpayers to keep records of their tax returns indefinitely if they have filed a fraudulent return or do not file a return at all. That being said, keeping copies of your filed tax returns will make preparing future tax returns much easier for you, in case you want to file an amended return.