A Comprehensive Guide to Understanding Section 199A Deduction and Qualified Business Income

The Section 199A deduction, introduced by the Tax Cuts and Jobs Act (TCJA) in 2017, offers significant tax benefits for pass-through business owners. This deduction allows eligible taxpayers to claim up to 20% of their qualified business income (QBI), potentially reducing their overall tax burden. Whether you’re a sole proprietor, S corporation shareholder, or partner in a partnership, understanding the intricacies of Section 199A is crucial for maximizing your tax savings. This comprehensive guide delves into the qualifications, calculations, and reporting requirements for the QBI deduction, as well as the treatment of Section 199A dividends from REITs.

What is the Section 199A Deduction?

Section 199A was added to the tax code under the TCJA in 2017. Under this newly created section, pass-through business owners can claim a deduction of up to 20% of their “qualified business income” (or “QBI”) so long as they meet the requirements under the new code section. The QBI deduction is claimed on the business owner’s personal income tax return, after all other deductions are claimed.

Eligibility Requirements for the QBI Deduction

Taxpayers  who earn income from a qualified business or trade qualify for the deduction. Generally, these are any business that are not structured as a C-Corporation. A select type of domestic businesses who earn income from pass-through businesses can deduct up to 20% of QBI, in addition to 20% of income from a publicly traded partnership and income from a real estate investment trust (REIT). However, there are limitations on both the business and the income.

Qualified businesses must meet certain requirements. They must be a domestic business (meaning located and formed in the United States) and either a sole proprietorship, S corporation, or partnership, qualify. In some cases, estates and trusts will also qualify.

QBI includes gain, income, loss, and deductions associated with the business or trade that qualifies. There are some exceptions. Certain investment income, compensation for services to the trade or business, and guaranteed income does not qualify as QBI.

There are income limitations for both single and joint filers. These limits are increased every year for inflation. If you file a joint return, you can’t make more than $315,000 ($340,100 in 2022) in taxable income or $157,500 ($170,050 in 2022) for a single return to qualify for the deduction. The deduction is gradually phased out for joint returns with income between $315,000 ($340,100 for 2022) and $415,000 ($440,100 for 2022). Similarly, the deduction is phased out for single filers between $157,500 ($170,050 for 2022) and $207,500 ($220,050 for 2022). When someone’s income is above the thresholds, the deduction allowed is based on whether or not you are considered a service business or trade that is specified.

What Qualifies as a Trade or Business Under Section 199A?

Qualified businesses and trades include all trades and businesses with pass through income, but those considered”‘specified service’ trades or businesses” have specific limits. These types of businesses are specifically enumerated fields, and include those that are dependent upon skill or reputation. Some of these include lawyers, accountants, athletes, consultants, and investors. While these professionals are eligible for the deduction, their income must fall within certain thresholds or they are phased out of the deduction.

Calculating the Qualified Business Income Deduction

To calculate the deduction for QBI, you will need to determine both your  total QBI and your taxable income. Your allowable deduction will be equal to the lesser of the two multiplied by 20%.

To calculate the QBI, add up the profits from the profit or loss from the business section of your return, supplemental income & loss section of your return, and profit or loss from farming. QBI also includes profits shown on K-1s. For a partnership, the profit is associated with box 20, code Z. For an S corp, the profit is associated with box 17, code V. For a trust, it is box 14, code I. If you have qualified business income from multiple entities, you will take the total amount across all of them.

Then you should calculate your taxable income. Add up all of your income and subtract capital gains, qualified dividends, other non-business deductions such as health savings accounts, etc., and the standard deduction or itemized deduction. Your total taxable income should be the number you would enter on line 15 of your tax return.

The next step is to multiply the smaller value between the estimated QBI and the estimated taxable income by 20%. The last step is to multiply the qualified business deduction amount by your marginal tax rate which is based on income and filing status.

There are also special rules for special situations. In the higher tax brackets, businesses will need a lot of W-2 wages or a lot of depreciable property.

In this scenario, the qualified business deduction is 20% of the net qualified business income or the greater of 50% of the W-2 wages from the qualified business or trade or the total of 25% of the wages and 2.5% of the basis (unadjusted) prior to any depreciation of qualified property.

Filing Section 199A: Forms and Procedures

The deduction of qualified business income is a below-the-line deduction found on Form 1040, line 10. The deduction will be subtracted from your adjusted gross income to determine your taxable income. You must attach Form 8995-A or Form 8995 to your 1040.

Understanding Section 199A Dividends and Their Tax Implications

The dividends that qualify under Section 199A are paid by REITs. A REIT is a Real Estate Investment Trust, which is a type of company or business that owns, manages, and/or finances certain types of income-producing real estate ventures. Many public buildings such as malls, office buildings, etc. are owned by REITs. Investors own stock in the REITs, which then pay out dividends to the investors. These dividends are listed on Form 1099-DIV in box 5.

Are Section 199A Dividends Taxable?

Section 199A dividends are included in taxable income. However, these dividends qualify for the qualified business income deduction which is a federal income tax deduction of up to 20%. With 199A dividends, you can claim the qualified business income deduction regardless of your income level and you are not required to be involved in a qualified business or trade. Section 199A dividends are not considered qualified dividends and are taxed at the taxpayer’s ordinary income tax rate.

How is Section 199A Dividends Reported?

Section 199A dividends are reported in three places on the federal return. The ordinary dividend total from Form 1099-DIV, box 1a, are reported on Form 1040, line 3b. Next, 199A dividends are reported either on Form 8995, line 6, or Form 8995-A, line 28. The qualified business income deduction from Form  8995 or Form 8995-A flows through to Form 1040, line 13.

Corvee tax planning software will help you find ways to benefit the most from QBI. If you’re interested in learning more about what the new 199A deduction is and how it fits into your tax plan, reach out to Corvee.