By Dr. James M. Dahle, WCI Founder
If your small business qualifies for the Section 199A deduction, your financial life just became much, much more complicated. I'm so sorry. If it makes you feel any better, I'm in the same boat.
There was a major business tax cut that went into effect in January 2018. Of course, the IRS didn't really issue all their regulations about it until January 2019, so we have all been guessing about how it would really affect us for over a year. Now we know and it is time to scramble to make changes that could reduce your current and future tax bills substantially.
The corporate income tax brackets were dramatically lowered. In order to keep other business structures (S Corp, partnership, sole proprietorships) on a competitive footing, a new deduction was added for those types of “pass-thru businesses.” This is the Section 199A or Qualified Business Income (QBI) deduction. The deduction is basically 20% of qualified business income plus REIT and Publicly Traded Partnership income. So if the business has $500K of qualified business income, that's a $100K deduction. In my case, I have a 42% marginal tax rate, so a $100K deduction is $42K back in my pocket. That's obviously a HUGE tax break. That's larger than what I get from maxing out my partnership 401(k) and defined benefit plan (a mere $31K tax break). Because it is such a huge tax deduction, one should be willing to bend over backward in an attempt to qualify for it and make it as large as possible.
In case you're not aware, Congress and the IRS seem to hate financially successful doctors and similar high-income professionals like the target audience for this blog. That's the only explanation I have for why they were excluded from this deduction compared to other small businesses. Thus many professionals who own businesses will find that their business does not qualify for this deduction at all. If that is the case, be consoled with the fact that your financial life did not become any more complicated. If you know you are in this category (only business income is from specified service businesses and your taxable income is over $207,500 ($415,000 married) you can ignore the rest of this post. Those without business income can also ignore the rest of this post.
For the rest of you, grab your beverage of choice, sit down, and prepare to wrap your mind around all the ways your financial life is about to change.
The 199A Deduction Explained in Simple Terms
Let's start with the basics of this deduction:
- The deduction is the lesser of 20% of qualified business income plus REIT/Publicly Traded Partnership income or 20% of your taxable income reduced by capital gains and qualified dividends (usually the first)
- If your taxable income is LESS than $207,500 ($415,000 married) for 2018 (goes up with inflation each year), your business income can come from any business you like and you do not need any employees to get the deduction.
- If your taxable income is MORE than $207,500 ($415,000 married) for 2018, there are three rules that will limit your deduction:
- Your business income cannot come from a specified service business and
- Your deduction can be no larger than 50% of the salaries paid by your business or
- Your deduction can be no larger than 25% of the salaries paid plus 2.5% of the original basis of property owned by the business. (this one is for real estate investors to still be able to get a big deduction even if they don't have many employees, named the Corker Kickback for Senator and real estate investor Bob Corker who changed his vote once this provision was added to the bill.)
- REIT and publicly traded partnership income is also eligible for the deduction (including mutual fund REIT income)
What is Qualified Business Income?
See page 51 of Pub 535 for the IRS interpretation of Qualified Business Income (QBI). I'll reproduce the most important parts here:
Determining your qualified business income.
Your QBI includes items of income, gain, deduction, and loss from any trades or businesses….within the United State. This includes income from
- partnerships (other than PTPs),
- S corporations,
- sole proprietorships,
It also includes other deductions attributable to the trade or business including, but not limited to,
- deductible tax on self-employment income,
- self-employed health insurance, and
- contributions to qualified retirement plans.
QBI doesn’t include any of the following:
- Items that aren’t properly includible in income
- Investment items such as capital gains or losses, or dividends
- Interest income, other than interest income properly allocable to a trade or business (interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business)
- W-2 income.
- Amounts received as reasonable compensation from an S corporation.
- Amounts received as guaranteed payments.
There are some important things to understand here.
First, only profits count. You have to subtract all of the business deductions, including salaries, health insurance premiums, and retirement account contributions.
Second, interest doesn't count. So income from money left in the business and invested doesn't count.
Third, guaranteed payments don't count. That apples to MANY physician partnerships including mine. Essentially all the pay to the partners in our partnership are guaranteed payments. Many times that can be changed by changing the structure of the partnership and its agreement. In our case, it turns out it can't.
What Are Specified Service Businesses?
IRS Publication 535 also clarifies this.
Specified service trade or business excluded from your qualified trades or businesses
Specified service trades or businesses generally are excluded from the definition of qualified trade or business income if the taxpayer's taxable income exceeds the threshold. Therefore, no QBI, W-2 wages, or UBIA of the qualified property from the specified trade or business are taken into account in figuring your QBI deduction.
Exception 1: If your taxable income before the QBI deduction isn’t more than $157,500 ($315,000 if married filing jointly), your specified service trade or business is a qualified trade or business, and thus may generate income eligible for the QBI deduction.
Exception 2: If your taxable income before the QBI deduction is more than $157,500 but not $207,500 ($315,000 and $415,000 if married filing jointly), an applicable percentage of your specified service trade or business is treated as a qualified trade or business.
It then names some specified service businesses:
- Health, including physicians, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals. However, it excludes services not directly related to a medical services field, such as the operation of health clubs or spas; payment processing; or the research, testing, manufacture, and sale of pharmaceuticals or medical devices;
- Law, including lawyers, paralegals, legal arbitrators, mediators, and similar professionals.
- Accounting, including accountants, enrolled agents, return preparers, financial auditors, and similar professionals;
- Actuarial science, including actuaries, and similar professionals;
- Performing arts, including actors, directors, singers, musicians, entertainers, and similar professionals.
- Consulting,
- Athletics, including athletes, coaches, and managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, snowboarding, track and field, billiards, racing, and other athletic performance.
- Financial services….including services provided by financial advisors, investment bankers, wealth planners, retirement advisors, and other similar professionals. However, it excludes taking deposits or making loans, but does include arrange lending transactions between a lender and borrower
- Brokerage services, including services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee including services provided by stock brokers and other similar professionals. However, it excludes services provided by real estate agents and brokers, or insurance agents and brokers;
- Investing and investment management, in which a fee is received for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments. However, it excludes the service of directly managing real property;
- Trading, including the trade or business of trading in securities, commodities, or partnership interests;
- Any trade or business where the principal asset is the reputation or skill of one or more of its employees, as demonstrated by: – Receiving fees, compensation, or other income for endorsing products or services; – Licensing or receiving fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or – Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format. De minimis rule 1—If your gross receipts from a trade or business are $25 million or less and less than 10% of the gross receipts are from the performance of services in a specified service field, then your trade or business is not considered specified service trade or business, and thus may generate income eligible for the QBI deduction for the tax year.
So obviously, docs, dentists, attorneys and basically the main business for my entire target audience is specifically excluded. The only exception is if you have a taxable income below the limit. However, this is all about your personal taxable income, not the business itself, which is kind of wacky. So if there are two docs in a partnership making $200K each and one of them is married to a radiologist and the other is married to a stay at home spouse, the one married to the stay at home spouse gets this deduction and the other does not! It doesn't seem fair, but that's the way the law is written. Like I said, Congress and the IRS hate financially successful doctors.
The good news is that many docs have a side gig that qualifies. The White Coat Investor, LLC certainly qualifies for this deduction. You might think it does not because “the principal asset is the reputation or skill of one of its employees” but if you look at the de minimis rule 1, you can see that since less than 10% of WCI income is from appearing at events (most is ad and product sales), it still qualifies.
How Do You Actually Claim the Deduction
The deduction is a below-the-line (the line is now line 7-AGI) deduction on your 1040 that is calculated concurrently with the itemized vs standardized deduction. As you can see, it plugs in at line 9 on the second page of your 1040.
So where does line 9 come from? Take a look at the 1040 instructions for line 9. It all starts on page 34 of the instructions. The simplified worksheet is found on page 37 (instructions for it on page 35). This is for those whose income is below the phaseout limits. It looks like this:
QBI goes on 2 and is multiplied by 20% on line 5. Your REIT dividends go on 6 and are multiplied by 20% on line 9. Add them together on 10. Make sure that deduction is more than 20% of your taxable income less capital gains and dividends on lines 11-14, and your deduction is on line 15. Take that to Line 9 of the 1040. No big deal. Of course, I don't get to use that super easy worksheet to calculate mine. I have to use this one in Publication 535, on page 55. Just to keep things interesting, this two page form also has four schedules that go along with it which you may have to fill out too.
- Schedule A- For those with Specified service businesses in the phaseout range
- Schedule B- For those with multiple businesses who need to aggregate them to maximize the deduction
- Schedule C- For those with a business that lost money
- Schedule D- For those in agricultural businesses
Here is part I and II.
List the businesses in part 1. Your QBI goes on line 2. You multiply it by 20% on line 3. Line 4-11 is where you apply the 50% of salaries (or 25% of salaries plus 2.5% of basis) rule. Schedule A plugs into line 12. Line 14 is where Schedule D plugs in. Line 16 is the QBI component total. Now let's look at part III.
You only have to fill this section out if your taxable income is in the phaseout range ($157,500-205,000 single, $315,000-$415,000 married for 2018.) It's where the phaseout is calculated. Then we'll move on to section four where you add in any REIT or Publicly Traded Partnership income.
Line 27 is your QBI component. Lines 28-31 is your REIT and PTP income. Total them up on 32. Make sure it's more than 20% of taxable income less LTCGs/dividends on lines 33-36. The deduction is on line 37 which goes to line 9 of the 1040. Not the worst worksheet I ever saw. Way easier than doing your own direct real estate property taxes. And if your K-1s are correct, Turbotax handles this with ease.
The Section 199A Deduction and Your Retirement Accounts
Okay, we're over 2000 words into this post already and I haven't yet gotten to the point of the post–what those who qualify for the deduction should do with their retirement accounts. The fact that employer contributions to retirement accounts are specifically excluded from QBI (they're an expense, not income) means that tax-deferred retirement account contributions are now much less valuable than they used to be, unless they lower your taxable income to a place where you now qualify for this deduction. Read that sentence again. It's the whole point of this post:
Now, let's talk about all the ways this fact can affect you.
Using Tax-deferred Contributions to Get the Deduction
The first way to use retirement account contributions is to lower your taxable income. For example, if two married self-employed doctors have a taxable income of $430K but have the option to contribute $130K to tax-deferred retirement accounts like individual 401(k)s and defined benefit/cash balance plans, they should do so. By doing so, they lower their taxable income from $430K, where they don't qualify for any 199A deduction at all to $300K where they will qualify for a deduction. Obviously, the amount of the employer contributions to those retirement accounts is subtracted from the QBI before the deduction is taken, but any deduction beats no deduction.
Using Roth 401(k) Contributions to Increase QBI Deduction
A sole proprietorship or partnership (or an LLC filing as either of those) may be able to increase their QBI deduction by making their “employee contribution” to the business 401(k) a Roth contribution instead of a tax-deferred contribution. This is because this deduction is taken on Form 1040 Schedule 1 Line 28 where employee and employer contributions are lumped together. Since this line is subtracted from QBI, having a smaller number on that line makes for more QBI and a larger deduction.
Note that this does not matter for an S Corporation (or an LLC filing as an S Corporation) since employee contributions to retirement accounts show up on the W-2 and employer contributions show up on the 1120S (Corporate return). Also keep in mind that although employee contributions can be Roth (tax-free), tax-deferred, or after-tax (not the same as Roth because earnings are fully taxable upon withdrawal), employer contributions are always tax-deferred.
The Mega Backdoor Roth IRA
So in reality, if your business qualifies for a QBI deduction, tax-deferred contributions to retirement accounts (except tax-deferred employee contributions for S Corps) are not as valuable as they used to be because they reduce your QBI deduction. They are essentially 80% as good as they used to be. They're still good, but not AS good. Because they're not as good, it is possible you should not be making them.
For most high-income professionals in their peak earnings years, tax-deferred retirement contributions are a no brainer. They are MUCH more likely to be able to take out their retirement savings at a lower marginal tax rate than they saved putting the money in. It takes unusual circumstances (like being a super saver, having pensions, and having a lot of rental income) for that to not be the case. You just have to have a ton of side income in retirement or an absolutely monstrous IRA for this to work out badly for you. And even if it works out badly, you still win because you have tons of money in retirement. It's the old “economic utility” argument. If you end up with very little income in retirement, contributing to tax-deferred accounts was the right move. If you end up with tons of income in retirement then the additional taxes you end up paying over your lifetime didn't affect how you lived your life.
Let's look at my case to illustrate why you might not want to make tax-deferred retirement contributions anymore. Katie and I are in the 37% federal tax bracket and used to be in the 39.6% bracket. In 2017 when we contributed to the WCI individual 401(k), we saved 39.6% of the contribution in taxes. However, those same contributions in 2018 are only going to be worth a 37% * 80% = 29.6% deduction. While it is no big deal if we contribute at 37% and pull the money out at 37%, it would really suck to contribute at 29.6% and then pull the money out at 37%, or 40%, or 45% if the top marginal tax rate goes up. In fact, it would kind of stink to put money in at 29.6% and pull it out at 32%. In 2019 the 32% bracket starts at a taxable income of $321,450. While we would have nowhere near that much taxable retirement income if we retired today, we don't plan to retire today. If we stick with this WCI thing for another decade and it continues to be very successful and we continue to save a ton of money each year, it is entirely possible for us to have that much taxable income in retirement. Obviously, there are a lot of variables in the equation:
- how much we continue to make,
- how well our investments do,
- how many Roth conversions we do going forward,
- how long we work for,
- how much we spend,
- how tax rates change, and
- how that money is invested in retirement.
So if one decides that it is no longer a good idea to make tax-deferred contributions (and I'm not sure whether it is or not for us), what should one do? One could just quit using the retirement account and invest in taxable instead. But there is a better option–the Mega Backdoor Roth IRA. For those who are not familiar with the Mega Backdoor Roth IRA, there are several variations but the basic idea behind it is that instead of making tax-deferred employer contributions, you make after-tax (but not Roth) employee contributions to the 401(k). Then, you convert those to either a Roth 401(k) or a Roth IRA. Since you got no deduction going in, there is no tax cost to the conversion.
In order for this to happen, the 401(k) must allow for two things:
- After-tax contributions
- In-service conversions or rollovers
Most plans, including most off-the-shelf individual 401(k)s from places like Vanguard, Fidelity, or eTrade, do not allow both of those to occur. So if you want to do this, you need a customized 401(k). The least expensive individual 401(k) allowing a Mega Backdoor Roth option that I know of can be found at My Solo 401k. However, I have had two very smart people point out that you don't get anywhere near as much support there as you would if you paid thousands to a separate Third Party Administrator and an Advisor. I like the fact that they actually know what a Mega Backdoor Roth IRA is and just incorporate it routinely. I also like the fact that they only charge $795 the first year and $125 every year after that (and they'll even do your 5500EZ for that.) I have no financial relationship with them but am considering using them if we end up going this route.
At any rate, the point of all this is that if you have this option, you just do $37K as an employee after-tax contribution instead of a tax-deferred contribution and then convert it to a Roth IRA. Since that contribution is an employee contribution, not an employer one, it isn't an employer expense and thus doesn't reduce QBI, increasing the QBI deduction.
Consider Dropping Your Defined Benefit Plan
For similar reasons, it may no longer make sense to use a Defined Benefit/Cash Balance Plan (DBP). Those contributions reduce your QBI just like employer tax-deferred contributions to a 401(k). Plus, DBPs are generally less attractive than a 401(k) anyway given their higher costs and other associated hassles. Katie and I had considered starting a personal DBP this year for WCI, LLC but this has certainly given us pause for the reasons discussed above.
The Balancing Act For S Corps
This is all even more of a balancing act for an S Corp. The S Corp needs enough salary paid out so the deduction isn't limited by the 50% of salaries rule. But every dollar of salary is subject to payroll taxes. You also need a certain amount of income to max out a 401(k), and that amount is much higher for making employer contributions rather than employee contributions. I mean, you can max out a $56K 401(k) contribution that is $19K tax-deferred and $37K after-tax on a salary of, well, $56K.
I told Katie if we go down this Mega Backdoor Roth route that we should cut her salary to $56K. We would have to increase mine to stay clear of the 50% of salaries rule, but that would save us $132,900 – $56,000 * 12.4% = $9,536 in Social Security taxes (half of which would be deductible of course). Naturally, you also have to make sure you're paying a salary you can justify to the IRS as reasonable. Set it too low and they'll nail you. Lots of moving parts here. When we did the math last year, we determined that it made sense for our salary to be 28.6% of the total of our salary plus QBI. That allowed us to max out our 401(k)s (actually far more than we needed for that), minimized our Medicare taxes, and maximized our 199A deduction. Bear in mind that number could be very different for you, especially if you have other employees or have less income than us.
What's the Deal with REITs?
REIT income is also eligible for this deduction. One of my private real estate fund investments actually changed its structure to a REIT in 2018 for just this reason. Even REIT income from a REIT mutual fund is eligible for this deduction. It probably isn't enough to justify moving the classically very tax-inefficient REITS out of a tax-protected account into a taxable account, but if you were holding them there anyway, this will boost your after-tax returns a bit.
Not Everyone Needs to Change Their Retirement Plan
I'm sure this post just gave lots of people a ton of anxiety about their retirement plans. Here is a list of people who should not feel anxious and should just keep doing the tax-deferred contributions they have been doing:
- Those who won't qualify for the QBI deduction anyway
- Those who don't own a business
- Those who only have specified service business income and have taxable income way over the phaseout range
- Those whose K-1 income is mostly in box 4 (guaranteed payments)
- Those who will only qualify for a QBI deduction by maxing out their tax-deferred contributions
- Those who get some other tax benefit from lowering their taxable income such as the child tax credit or college tax credits
Everyone else will need to run the numbers, probably with the assistance of a tax professional. Still confused? Try Jeff Levine's post on this topic at Kitces.com. He made a lot of nice graphics that may help explain the concepts better than my words did.
What do you think? Will you be getting the 199A deduction? Do you plan to make any changes to your retirement accounts as a result? What do you plan to do? Comment below!
I really needed this. It has helped me pull my head out of the sand a bit.
I know others will find it helpful. They have been asking me. I will now just send them a link to this post.
Thanks. I am done with federal and it took me forever to figure out this section. I have been mulling it over before I have transferred everything to state. I needed this. It must have taken you forever to write. I used the 5500 post and confirm the backdoor done right post to double check my taxes. I am amazed at how easy it is in TT to miss the back door contribution amount. I did this year, but caught it on my double check when I used your outline. I also found your state of the blog post interesting when you said you still think the blog is the favorite part of the business and what people think about your articles. I will be curious if this one will turn into one of the classic posts with 1000 plus comments. The first thing I did was check my k1 to see if the QBI was in there. My first stop when I wake up on MWF is the blog. Then off to the MWF dialysis shift! I found this QBI super time consuming this year, but in some odd nerdy way enjoyable. I guess that is the nephrologist in me.
Yikes. This stuff makes my head hurt! Given the complexity of this deduction, 2018 may be the last tax year that I use Turbo Tax and look things over myself.
Thanks for the epic post. I’ll be tucking this one away for review for next year!
TPP
First I want to thank you for the work you do on this website and the podcast you produce. Even though I am not a physician I find it very helpful and insightful. Also it helps me understand what my son, who is a physician, is going through and dealing with.
Second, could you or possibly your readers help me with a QBI question?
If I have a commercial rental property held within an S corporation, will the rents from this building qualify for the QBI deduction? Other than the rent from this building there are no other business transactions taking place nor proceeds generated within this S Corp. The proceeds from the rental are +/- $36k per year.
Thanks.
Why would you hold a rental property in an S Corp instead of an LLC?
But at any rate, no, I don’t think just sticking unearned income into an S Corp automatically turns it into earned income. QBI is earned income.
Looks like under some instances the proceeds from a rental can qualify for the QBI deduction although it can be rather complicated but what isn’t anymore. See this article.
https://www.kitces.com/blog/irs-notice-2019-07-199a-qbi-deduction-250-hours-safe-harbor-rental-real-estate-business/
Sure. If you spent 250 hours a year as a real estate professional. I don’t think that’s the case for most people with “a rental.” At least it isn’t 750 hours like usual I guess.
This question is regarding the “Qualified income component worksheet.” If the taxable income is too high, I get a reduction ratio of 1.0. The reason my taxable income is so high is because of my high ordinary business income on box 1 of my k1. This number is also the section 199A income. If the 199A income is very high does that mean I cannot get this 20 percent deduction? The high 199A income is phasing me out even though I am not a qualified service business. It seems as though it only benefits people below the 414,000 income limit. Is this right?
Just a high income doesn’t phase you out if it isn’t a specified service business. But not having employees does…
What if the only employees are the S Corp owners (50/50 multi member S Corp)? Would we qualify for qbi then? (2.4m profit and trying to decide what w2 to take to maximize qbi)
Owner salaries count for QBI calculations. Take too little salary and you leave QBI deduction on the table. Take too much and you pay too much in Medicare tax you didn’t have to pay. This all assumes your salary is reasonable by IRS standards as well.
So if the business makes $2.4M, there is a salary at which you maximize QBI. That is the salary you want. Slightly higher better than slightly lower since QBI is a bigger deduction than Medicare tax is a penalty.
When doing the calculation, the two numbers you care about are 20% (20% of profit = QBI deduction) and 50% (the deduction can be no more than 50% of salary paid). So if you pay yourself $400K in salary, then you have $2M in profit. 20% of that is $400K. However, you can only take a QBI of $200K due to the 50% limitation. So you want to pay yourself a higher salary. If you pay $800K in salary, you have $1.6M in profit. 20% of that is $320K. But 50% of $800K is $400K. You’ve paid yourself too much. If you pay yourself $600K in salary, you have $1.8M in profit and so the QBI deduction is $360K, but you’re limited to a deduction of $300K due to the 50% of salary limitation. Again, you’ve paid yourself too little. At $700K, you have $1.7M in profit and a QBI deduction of $340K and half of the salary is $350K so you get all $340K. So that’s about where you want to be. It’s tough to get it exactly right so we just try to get close. Obviously you want to make sure $700K in salaries is enough to max out your retirement accounts and meet the IRS definitions of reasonable salary:
https://www.irs.gov/pub/irs-news/fs-08-25.pdf
That clears it up, so pay each owner $350k to get salary to $700k total. There isn’t a personal income limit maximum also? The workaround is to take a high W2 to get around that?
Not that I know of. It gets trickier when you have other employees of course.
So Dr. T is a partner in an S Corp. IN 2018 he contributed the annual maximum of $55k to his 401k profit sharing plan. He did it all as deferred tax, no ROTH (although he does backdoor Roth for him and his wife). His S Corp gave 100k of QBI and their total taxable income was 300k. Thus he got the federal QBI deduction for the full amount of his s Corp QBI.
Does he change anything for 2019, assuming income is expected to be the same?
Depends. There are a lot of moving parts there.
I would be interested in an answer/any insights into this Dr. T situation as well if possible. Thanks in advance.
As would I, but neither of us are going to get it without knowing a whole lot more about Dr. T’s finances and future tax rates. While it stinks to have his deduction reduces by those tax-deferred contributions, if he changes them all to after-tax contributions, he’s liable to not get the 199A deduction at all (or at least be in the phaseout range.) So it’s complicated. If it were me, I’d probably just keep making the tax-deferred contributions, but there are situations I can imagine where someone might do something else in that situation and not be wrong.
Are you assuming that if Dr T chose to not do tax deferred retirement savings that that money would all turn into distributions from from the S Corp, thus increasing the QBI deduction? What if his partnership maximizes business distributions at 100k and therefore skipping the tax deferred contribution simply raises his salary/w-2 income?
Yes.
W-2 income isn’t QBI. Just the distribution.
You stated, “If you know you are in this category (only business income is from specified service businesses and your taxable income is over $207,500 ($415,000 married) you can ignore the rest of this post.”
I think you’re saying I don’t qualify for the QBI deduction but I want to be certain.
I am a Psych NP. I have an S Corp which pays me $148K of W-2 so I can max out my Solo 401K. Being that I am the only employee of my S Corp for the medical services I provide, you are saying I do not qualify for the QBI deduction, correct?
Clarification:
You stated, “If you know you are in this category (only business income is from specified service businesses and your taxable income is over $207,500 ($415,000 married) you can ignore the rest of this post.”
I think you’re saying I don’t qualify for the QBI deduction but I want to be certain.
I am a Psych NP contracting as a 1099. I have an S Corp which pays me $148K of W-2 so I can max out my Solo 401K. Being that I am the only employee of my S Corp for the medical services I provide, you are saying I do not qualify for the QBI deduction, correct?
I don’t know. You didn’t tell me your taxable income or marital status. You certainly are in a specified service business though.
I’m married with taxable income of $228,536. Perhaps I qualify after all being that my taxable income is less than $415K?
Thanks for the analysis! I don’t think I saw this in your article but I believe I read that this 199a deduction is slated to expire after 2025, so if you plan on making any changes, it’s also worth considering what the 2025 expiration may mean for your future planning as well.
My other personal experience with the deduction (and a tip for other TurboTax people) is that after an update, I suddenly owed more taxes as if I did not qualify for the deduction. The fix was to go back into the income section for each qualified business and go through the questions to determine qualification status.
Good tip. 7 years seems like forever when it comes to tax law to me. I mean, it was only 9 years ago that the Backdoor Roth IRA came into existence and I’ve been doing it most of my career.
Thanks for this post. It is very clear and timely. I think I’ll bookmark it.
With partners in an LLC, my spouse owns a medical office building. It has generated a rental income loss, due mainly to accelerated depreciation. We expect it may turn a small profit soon. In the meantime, the accountant has carefully coded this as a section 199A rental income loss on the K-1. According to the worksheet above, it looks like a loss can be carried over to next year? But only one year, to offset possible gains in the future? This does not look like a capital loss carryover that you can carry over indefinitely.
If this is the case, it seems to limit the benefit of owning rental property–last year we were able to call it a non-passive activity loss and use it to offset ordinary income.
Not sure that’s really 199A income, but I’m not a CPA. At any rate, the loss doesn’t get you the 199A deduction. That’s for income.
I am part of an S Corp private practice. My K1 has an attached statement with 199A income and values in box 17, code V, W and X but then goes on to state that the corporation is not subject to the business interest expense limitation. Why would this be listed if the business/I do not qualify for the deduction?
I don’t know if you qualify or not, but I have those codes on my partnership K-1 and I don’t qualify for the deduction for that business. The person preparing the K-1 doesn’t know your taxable income so they have to put those codes on there.
You stated, “If you know you are in this category (only business income is from specified service businesses and your taxable income is over $207,500 ($415,000 married) you can ignore the rest of this post.”
I think you’re saying I don’t qualify for the QBI deduction but I want to be certain.
I am a Psych NP contracting as a 1099. I have an S Corp which pays me $148K of W-2 so I can max out my Solo 401K.I’m married with taxable income of $228,536. Being that I am the only employee of my S Corp for the medical services I provide, you are saying I do not qualify for the QBI deduction, correct? Perhaps I qualify after all being that my taxable income is less than $415K?
No, if you are married with taxable income under $315K you don’t need employees and you can work in a specified service business. You should get a 20% deduction of your QBI. How much is your QBI? (i.e. how much does your S Corp make above and beyond $148K? 20% of that is your deduction.)
Thanks for this analysis. I am on the partnership track for the LLC that owns the medical office building of our practice and leases it out to the practice. Let’s say if I get 100k from this as rental income from the LLC as a part of my share and we have household W2 income of 430k, can I qualify for this 199A deduction on the 100k rental income?
I’m not sure. You might be able to aggregate it with the practice OBI and be able to count it. Someone smarter than me will have to answer that one.
But aggregating it with your practice income is going to make it specified service income and you probably make too much (can’t tell because you told me your W-2 income not your taxable income) to get that.
I used discount solo 401k to set up my customized solo 401k to achieve mega backdoor Roth IRA. They charge an initial $575 to set up the plan and documents, and then an annual fee of $100. They don’t do the 5500EZ form for you (but that’s only needed once balance is > $250K). So far I’ve had a good experience with them, and I know others have as well.
Thanks for sharing your experience. That is a little cheaper than the one I listed.
WCI- would the Cityvest DPL investment count as QBI or as a REIT? I thought when I looked it wasn’t set up as a REIT but I can’t find what i thought I saw again. It seems as REITs are suddenly more favorable many of these versions of crowdfunding aren’t structured that way.
Thanks!
Neither DLP nor the CityVest DLP Access Fund is set up as a REIT.
So is S corp W2 income subtracted to get QBI? Total S corp income is 400K, pay salary of 100k and expenses/deductions are 25K making the QBI 275K ?
Yes.
Ha… Literally just yesterday, I sent you an email trying to contribute as a “guest post” on this exact subject… although your article utterly overpowers mine. Slightly bummed though you probably won’t need my guest post anymore.
Anyway, I wanted to clarify/ask…
For an S corp, QBI will not change regardless of whether ROTH or tax-deferred “employee” contributions are made… correct? This is because the “employee” 401k contribution shows up on W2 (not corporate return). In fact, this will also be the case for anyone with a side business (qualified business income) but contributes to the 401k through an employers plan (W2 income).
That’s right and that’s a strategy I’ll be using this year (for my wife actually.)
So if you’re in the phase out zone from $315000 to $415000 what’s the decision tree look like as to whether or not contributing to an individual 401k makes sense. I suppose it’s how far long the phase out range you are. This year we were around $345k and my 1099 income was around $55k so either way it’s not a huge difference
Complicated huh? I don’t think there is a rule of thumb there. Gotta run the numbers with your own assumptions.
Check out this more in-depth look at the 199A and how it affects retirement contribution planning: https://www.kitces.com/blog/199a-qbi-deduction-reduction-small-business-owner-retirement-plan-contributions-roth/
Get some coffee and a clear head…it took me half a dozen reads and I think I may have understood 30-50% of it. Complicated….
You mean the one I linked to in the last couple of lines of the article?
Sorry if this a stupid question but this is my first year of working and paying taxes. What exactly counts as “taxable income” when looking to see if you qualify? I’m a very simple situation this year (single, only “income” is from my own dental practice, no real estate or other part time jobs) but I have “income” that is W2 wages from my practice but then as an S Corp I thought the remaining business net profit is also my “income”? Do I add these together and that is my “taxable income” or is just the W2 wages “taxable income”?
i.e. W2 wages of $150,000, net profit of S corp is $90,000. What amount do I use as my “taxable income” to determine if I qualify? (I do have an accountant doing my taxes and I reached out to him today for an explanation – he was out of office at the moment, just looking for another explanation)
Your taxable income is the final number you use every year to calculate your tax rate. It is your total income minus deductions.
In the example you provided, the total GROSS income would be$240,000. To determine your TAXABLE income you would need to subtract business expenses (CE?), any tax-deferred retirement savings, and any other deduction you may qualify for (including standard deduction vs. itemized deductions). So, your taxable income will always be less than your gross income… and can often be significantly less depending on which deductions you take.
Thanks for the clarification
Line 10 of the 1040 is labeled “taxable income.” That’s what we mean.
It’s basically total income minus total deductions.
Thanks for the clarification
I changed position last year and had quite big capital gains from wrong selling MLPs (Qualified PTP ordinary income)
Long term capital gains is 355K and Ordinary income (from MLP Sales recapture) is 175K. and then there are other income as 70K. (so total income would be around 600K)
Does it mean simply I can’t have any QBI deduction since income is over 415K? I mean Worksheet 12 – A won’t be applied to calculate deduction since income is over 415K? I don’t have any wage or salary from pass through company except this MLP Sales which should be qualified for deduction. (none of them are related with SSTB)
Depends on whether any of it was a specified service business and how much employees were paid and property is worth. You say it isn’t related to SSTB but you don’t say whether the business with the OBI has employees or not.
Just in case,
Here is what I saw from IRS site. PTP income is not related with W2 wages or UBIA but still I couldn’t find the limitation on this based on income. also I input all this info in TT but nothing changed in my return.
https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-provision-11011-section-199a-qualified-business-income-deduction-faqs”
2. Eligible taxpayers may also be entitled to a deduction of up to 20 percent of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. This component of the section 199A deduction is not limited by W-2 wages or the UBIA of qualified property.”
This is the reason I believe income above threshold could get deduction.
Q10. In 2018, I am single and will report taxable income over $207,500. My only income is from an SSTB. Am I entitled to the deduction with respect to the SSTB?
A10. No. The same is true for a married couple filing a joint return whose taxable income exceeds $415,000. However, you may be entitled to a deduction for QBI earned from another trade or business that is not an SSTB or from qualified REIT dividends or qualified PTP income.
Best article on WCI in a good while. This type of stuff is why I started reading and continue to follow.
Glad you liked it. It was a lot of work.
Thanks for the reply.
MLPs I sold are like MMP, PAA and others. I don’t know the meaning of OBI but I am sure they have employees (not me. I am just limited partnership) also I am not sure if their property value matters here but I guess individual company values more than 1B.
Ordinary business income. Does the K-1 they sent you have something under 17 V/W? That’s where the rubber meets the road.
Yes K1 sent those info, but I believe those are 1st part of QBI not 2nd part (REITs, PTPs)
TT seems to have the a bug not to ask those QBI questions unless you change some info to activate QBI questions.
https://ttlc.intuit.com/questions/4689809-how-does-turbotax-add-ptp-ordinary-gain-into-the-qbi-deduction-it-does-qbi-ded-for-reit-divs-and-in-k-1-box-20ad-but-not-for-ordinary-gains-from-non-sstb-ptp-sales
Interesting. I’ll have to look at that when I finish my taxes. I have some REIT income that should qualify for the deduction. With Turbotax, you can always do a manual override in forms mode (desktop version only.)
Hi, going to make this simple. Let’s say I am a sole prop doc with only 1099 income and married and by using a combo of DBP, 401k, and if my spouse works for me (no other employees) with the LLC we can somehow have enough deductions to get to that 315k magic number to qualify for the QBI fully:
1) without the QBI the federal tax on that 315 net income would be roughly 58k
2)with the QBI 315 x .20 (63k deduction) would give u a 252 net income and the fed tax on that would be 43k
Now I am guessing that new 252 net income isn’t going to lower my state, fica,local taxes as those will still be based on the original 315 net income number?
Please correct me if I am wrong. It seems for physicians if they even qualify the maximum they are going to get back in their pocket is 15k even though the deduction of 63k sounds high it equates to a 15k fed tax savings which is of course still a great thing I am just keeping it in perspective and feel everyone should know what the MAXIMUM they are going to get in their pocket will be unless of course they have non service related businesses.
Yes, no discount on payroll taxes or state income taxes the way you’re calculating a net income.
The real money is in the non-service businesses like WCI, LLC. Our 199A deduction is much more than $15K.
If the taxpayer is currently living in a State that has a high income tax, and plans to live in a State that has no income tax after retirement, then the decision of whether to make deductible retirement plan contributions or, instead, don’t make such contributions (and take a larger QBI deduction) gets further complicated. In such cases, the deductible contributions to a retirement plan will permanently avoid State income tax because withdrawals from the plan during retirement won’t be subject to any State income tax.
In New York City, the combined State and City income tax rate is about 10%. So, a $100 deductible retirement plan contribution reduces NY taxes by $10. However, if that contribution is not made, QBI will be $100 higher, so the QBI deduction will be $20 higher. In a 30% Federal income tax bracket, that deduction is worth $6. So, it seems smarter to make the retirement contribution and take a smaller QBI deduction. If you currently live in a low or no tax State, it may be smarter to forgo the retirement contribution to get a larger QBI deduction. Any thoughts?
Absolutely if moving to a much lower cost state tax deferral is much more valuable.
If you decide to do a Roth conversion before retirement, you will still be subject to state/local taxes.
Strategy for those in the phase out bracket ~$300-400k? Traditional vs Roth 401k? For example, if QBI is $350k?
Generally traditional in the phaseout range.
I’m still missing something even after rereading this. Why is the tax deferred contribution to a retirement plan effectively reduced to 80% of that amount When you qualify for this deduction? I understand that a 401k contribution would lower the QBI and you lose the deduction on that amount, but I’m not mathematically connecting the dots here
You answered your first question with your final statement. That’s exactly it. Your QBI gets smaller because employer retirement account contributions are a business expense.
If you contribute to 401k then you get a deduction for 100% of that amount. However, at the same time, your QBI goes down by that same amount. Since the 199A deduction is 20% of QBI… the net change is 80%.
Would speaking for a pharmaceutical company be considered “consulting” and therefore a service business? Also if I’m reading this correctly, my clinical trials research earnings should qualify for a non service business.
The rules get a bit vague don’t they. Only a few professions are specifically named, and neither consultant nor trials research are specifically named.