Let’s be honest. Taxes are complicated. Unfortunately, they only become more complicated for high net worth individuals as you expand your investments and grow your wealth. However, understanding key tax forms is the first step in getting the IRS to work to your benefit, specifically in terms of deductions. Recently, eligible taxpayers were offered a break in the form of a new qualified business income deduction. Here’s everything you need to know about the 199a deduction to see if you are qualified to reduce your taxable income and learn more about how the tax break can help you.
First things first, what is the qualified business income deduction - also called Section 199a? Enacted for tax years beginning after December 31, 2017, the deduction was created to allow certain taxpayers to deduct up to 20 percent of their qualified business income (QBI), plus an additional 20 percent of qualified real estate investment trust (REIT) dividends as well as qualified publicly traded partnership (PTP) income. That’s a lot of information, so let’s break it down a little further.
The 199a deduction can be a huge benefit to taxpayers and their companies, but the complication lies in the need to capture incredibly specific information regarding QBI to accurately calculate the deduction. The IRS states that QBI is defined as “the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.” Typically, this includes things like the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans like SEP and SIMPLE.
This definition might seem fairly straightforward, but figuring out what your QBI is can get tricky very fast, mostly due to the list of items that do not qualify. You can see the complete list here, but a few of these include:
As stated earlier, qualifying taxpayers are allowed to deduct 20 percent of their QBI, but REIT dividends and PTP income are not included in this calculation. Each is potentially eligible for an additional 20 percent deduction, so make sure you have clear records handy when determining the source of your income.
The 199a deduction is primarily available to non-corporate taxpayers such as individuals, including some owners of sole proprietorships, partnerships, and S corporations. Additionally, some trusts and estates may also be able to take the deduction. It is important to note that income earned through a C corporation or by providing services as an employee is not eligible for the deduction. Additionally, any items included in your income must be connected with a U.S. trade or business to qualify for the 20 percent deduction. While this may clear up some questions surrounding the deduction, you might still need some clarification as to what qualifies as a trade or business in the eyes of the IRS.
Depending on your taxable income, the QBI component of the 199a deduction is subject to plenty of limitations including the type of trade or business you own. According to the IRS, a trade or business is defined as “any activity carried out for the production of income from selling goods or performing services.” The rules get complicated quickly when you consider income from white-collar professional services rendered by people like athletes, performers, and investment professionals. When in doubt, it’s best to reach out to your accountant or contact your financial advisor.
One of the first questions people had when Section 199a was first introduced was whether or not rental properties could be counted as QBI. After all, plenty of high net worth individuals have grown and accumulated the majority of their wealth through alternative investment opportunities in real estate, such as purchasing rental homes or apartment complexes. However, the question was quickly cleared up and it was determined that any kind of real estate income that originates in a tangible property qualifies as business income.
So what exactly is a pass-through income shelter? The easiest way to explain this is to break down both terms:
Pass-Through Entity: these include sole proprietorships, partnerships, and S corporations that are not subject to corporate income tax.
Income Shelter: any legal strategy that helps to reduce the amount of income taxes an individual owes.
Although many people believe that tax shelters have a negative connotation, they are simply a strategic way to make sure you’re able to retain as much of your wealth as possible. It should be noted that pass-through entities can file a business tax return, but tax is not assessed on the entity, rather the business profits and losses are taxed on the personal tax returns of the owners or the partners. This also applies to other items of income like real estate investment trust dividends.
All in all, it’s no secret that no one enjoys doing their taxes, especially when new rules and regulations are incorporated. However, to get the most out of your taxes this year and lower your taxable income by a substantial amount, diving into your QBI, REIT, and PTP can be incredibly influential to your yearly earnings.
Our best piece of advice when it comes to calculating your 199a deduction? Measure twice and cut once! The trickiest element to this deduction is determining which sources of income can be incorporated into which components, which means attention to detail and taking your time will help make filing your taxes more manageable.
If you think you might need additional resources or support collecting and compiling this information before April, our wealth management experts at the Mile Marker Club are happy to help!