[Editor’s Note: This guest post comes from CPA Stephen L. Nelson who previously guest blogged here about real estate investing in the two posts Real Estate Tax Loopholes for Unintentional Investors and Ten Tax Loopholes for Active Real Estate Investors. He is a managing member of a Seattle area CPA firm and has written dozens of books including Quicken for Dummies and QuickBooks for Dummies. Stephen knows more about the 199A deduction than anyone I know and has written the best book out there on the subject, Maximizing Section 199a Deductions. It's not cheap ($150) but it's a lot cheaper than missing out on this deduction that could be worth tens of thousands to some docs and other business owners. We have no financial relationship other than the usual affiliate fees I make any time you buy a book through a link on this website.]
Eleven Sec. 199A Tips for Physicians (and Other White Coat Professionals)
Congress passed a technical corrections act shortly after that original post. Tax accountants and attorneys have now pretty thoroughly digested the new law. And the IRS has begun to issue instructions about how the new deduction works.
Note: Typically, the new deduction equals the lesser of 20% of your sole proprietorship profits or of your share of a partnership or S corporation’s profits–or 20% of your taxable income after any capital gains or losses.
With all the information now available, self-employed physicians, as well as other “White Coat” professionals, want to make sure they’re maximizing the size of the Sec. 199A deduction they can take.
Sec. 199A Tip #1: Assume You Get the Deduction
A first tip: Assume you get the deduction or can get the deduction if you own your practice or you are a partner or shareholder in a group practice.
Yes, physicians, dentists, and basically every other “white coat” healthcare professional are potentially disqualified from using the new Sec. 199A deduction. But most won’t lose or completely lose the deduction.
To completely lose the Sec. 199A deduction on the business income earned in a professional practice, a single taxpayer’s taxable income must exceed $207,500. A married taxpayer’s taxable income must exceed $415,000.
Sec. 199A Tip #2: Don’t Count on a Full 20% Deduction
While most self-employed “white coat” professionals get to use the Sec. 199A deduction, many of these folks won’t get a full 20% deduction.
If a single taxpayer’s taxable income falls between $157,500 and $207,500 or a married taxpayer’s taxable income falls between $315,000 and $415,000, Sec. 199A phase-out rules apply.
In essence, the phase-out rules apply a sliding scale to move the deduction percentage from 20% to 0% as taxpayer’s taxable income goes from $157,500 to $207,500 or from $315,000 to $415,000.
Sec. 199A Tip #3: Understand Threshold Amount Equals Taxable Income
An important point that many taxpayers miss. The threshold amounts that cause a “white coat” professional to lose, potentially, the Sec. 199A deduction are taxable income amounts.
Keep this wrinkle in mind as you consider your own eligibility.
To determine your taxable income, you start with your total income.
But then you need to deduct the Form 1040 page 1 deductions for self-employment taxes, alimony (potentially), pensions, health insurance and health savings accounts.
These deductions, for a high-income self-employed taxpayer, should approach and may exceed $100,000.
And then you need to also deduct either the standard deduction or the total of your Schedule A itemized deductions, including state and local taxes (up to $10,000), charitable contributions, and mortgage interest.
These deductions for a high-income self-employed taxpayer could easily run another $25,000 to $50,000. Maybe even more.
Sec. 199A Tip #4: Ignore the W-2 Wages and Depreciable Assets Limitations
As you may have heard, the Sec. 199A deduction rules potentially limit the deduction a taxpayer receives based on the W-2 wages and depreciable assets of the business.
Specifically, if single taxpayer’s taxable income exceeds $207,500 or a married taxpayer’s income exceeds $415,000, her or his Sec. 199A deduction can’t exceed 50% of the W-2 wages paid by the business or the sum of 25% of the W-2 wages paid by the business plus 2.5% of the depreciable assets used in the business (whichever is more).
Gosh, confusing right? So some good news here. You can probably ignore this complexity–at least in regards to income you earn in your professional practice.
Here’s why: Any white coat taxpayer with taxable income above these thresholds will already be losing the Sec. 199A deduction on their professional practice income due to her or his status as a white coat taxpayer. The W-2 wages-based limitations for white coat taxpayers become, for the most part, redundant.
Sec. 199A Tip #5: Confirm Partnership Agreement Updated
Hopefully, if you’re a partner in a group practice, the partnership has already updated its partnership agreement for Sec. 199A.
If that hasn’t yet happened, gosh, you want to talk with your partners and get on this.
The big issue here? The qualified business income amount you use to calculate the 20% deduction only includes the business income amount shown in box 1 of your K-1. You do not get a Sec. 199A deduction for any guaranteed payments you receive from the partnership.
For example, suppose your group practice produces per partner profits of $200,000. Further suppose that the partnership makes a $15,000-per-month guaranteed payment to each partner, or $180,000, over the course of the year.
In this case, the Sec. 199A deduction equals 20% of the $20,000 that’s leftover from the $200,000 in profits after the $180,000 of guaranteed payments. This means a $4,000 Sec. 199A deduction and maybe $1000 to $1600 in federal tax savings.
Consider the case where a partnership just skips the guaranteed payments and instead just distributes $15,000 each month to partners. In this case, the Sec. 199A deduction equals 20% of the full $200,000. This means a $40,000 Sec. 199A deduction and maybe $10,000 to $16,000 in federal tax savings.
Sec. 199A Tip #6: Reconsider any Subchapter S Election
If you operate your practice as an S corporation, talk with your tax advisor about whether or not you should revoke your Subchapter S election or terminate your entity classification.
Most smart Subchapter S elections should still make sense. Especially if shareholder-employees save Social Security taxes due to the Subchapter S status.
Shareholder-employees saving only Medicare or net investment income taxes (NIIT), however, face a more complicated riddle. The Subchapter S election in these cases saves less payroll tax or NIIT.
CPA and author Stephen L. Nelson
Further, because Subchapter A shareholder-employee wages don’t count as qualified business income, the S election reduces the size of the Sec. 199 deduction.
Note: If you think you may need to look at unwinding an S election, I’ve got a long discussion at my blog: Sec. 199A and S Corporation Dissolutions.
Sec. 199A Tip #7: Understand Sec. 199A Deduction Partner and Shareholder Specific
An obvious point once you think about it–but an important one to consider as you personally try to maximize your Sec. 199A deduction. The business income that flows out of a partnership or S corporation drives the size of the taxpayer’s Sec. 199A deduction.
But all the other stuff going inside the individual 1040 tax return matters too. Remember that.
You may have partners making $500,000 a year or more whom you assume can’t use the deduction but who in fact will be able to add a $60,000 Sec. 199A deduction to the return. (This person just needs big deductions on their 1040.)
You may have partners making $100,000 a year or less whom you assume easily qualify for the deduction but who don’t because they earn lots of investment income or married a high-wage spouse.
Sec. 199A Tip #8: Update Any Self-Rental Agreements
If you own or own a part of a professional practice (something like an S corporation or partnership) that rents a building you own and you get disqualified from the Sec. 199A deduction on your professional practice earnings, look at updating the rental agreement for your building.
The Sec. 199A deduction applies to rental property income–even if it doesn’t apply to income earned in a “white coat” professional practice due to the professional’s high taxable income.
In this situation, paying a higher rent on the office building used in the professional practice may create or increase a Sec. 199A deduction.
Sec. 199A Tip #9: Account for Non-professional Services and Products
Some “white coat” business owners don’t only operate professional practices. They also sell non-professional services or ancillary products that while connected to their profession aren’t actually “part” of the professional service.
An optometrist might sell eyeglasses. A plastic surgeon may provide a health spa. I had a dentist a while back who sold expensive electric toothbrushes.
If you own a professional practice that delivers non-professional services or sells products, make sure your accounting system tracks revenues and costs with enough granularity.
You should break apart your total income into income from your professional services (potentially disqualified from Sec. 199A treatment) and income from your other “non-professional” services and products (probably qualified for Sec. 199A treatment).
Note: The conference report on the new tax law, in talking about the Sec. 199A deduction, discussed this. In one paragraph, for example, the report noted that something like a spa treatment that purports to be healthy doesn’t cause that service to rise to the level of a healthcare service.
Sec. 199A Tip #10: Look Over Your Investment Portfolio
Mostly, Sec. 199A affects your active business income. But the new deduction changes the rules for some types of investments. You want to keep these changes in mind going forward.
For example, you can use the 20% Sec. 199A deduction to partially shelter REIT dividends and qualifying partnership income from income taxes. (This may change where you locate these investments.)
The deduction math dials down the benefits of using like-kind exchanges (since a “like kind” exchange pushes down the original basis value of the real estate and that can push down the Sec. 199A deduction on real estate income.)
The deduction only applies to domestic income and not to equivalent foreign income. So, a Florida condo in a rental pool possibly generates the deduction but a Bahama condo doesn’t. Similarly, a domestic REIT gives you the deduction, but a foreign REIT doesn’t.
Finally, the way the math of the deduction works, you possibly want to deleverage investments producing qualified “Sec. 199A” business income to increase their income and the Sec. 199A deduction you get. For example, if you sell bonds or CDs and then pay down a rental property’s mortgage, your net investment income may not change. But because you generate more qualified “Sec. 199A” business income, you would enjoy a larger Sec. 199A deduction.
One quickly falls down the rabbit hole on this kind of stuff. You don’t want to go overboard.
But do consider the Sec. 199A deduction as you move game pieces around the investment game board.
Sec. 199A Tip #11: Watch Out for Additional Guidance
One last, quick maybe obvious point: The IRS will surely end up providing lots of additional guidance on this new deduction. So watch for that. Or confirm your tax advisor watches.
Buy Maximizing Section 199a Deductions Today!
What do you think? Will you be getting the 199A deduction? Why or why not? What questions do you have about it? Comment below!
I’m glad at least somebody understands this… But considering how many tax professionals can’t grasp the backdoor Roth, I worry many will miss the mark on this needlessly complex law
https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=2ahUKEwi_xMrjoMPeAhVs7YMKHTmABjsQFjABegQIBBAB&url=http%3A%2F%2Frurl.us%2FEQzz3&usg=AOvVaw1cOYEexRQxuRZzcm6-s4AF …..,,,
I think this misses 1 big point for those truly IC/locum docs who can ramp up or ramp down income. Your effective marginal tax rates can be so extreme to discourage working this month in particular near holidays. See my POF article quote below https://www.physicianonfire.com/tax-reform-physicians/
“By taxable income (post all other deductions)
$165k to $315k: 19.2%
$315k to $400k: 47% (32% + lost deduction)
$400k to $415k: 50% (35% + lost deduction)
$415k to $600k: 35%
For every dollar earned of taxable income from $400k to $415k you only get to “keep” 50 cents! If you include FICA taxes, you keep less than half even before state taxes! It is not very encouraging to work another shift in November if you get to keep less than half of your compensation.”
The more complicated taxes get, the more situations like this with ridiculous marginal tax rates crop up. The ACA cliff and Social Security taxation are two other wacky areas.
Especially true in the case of a moderate earning spouse of a high-earning pro, because many of these apply, plus the big part of FICA kick back in, too. In a high income tax state, it can easily approach 60+%. In this case, I would BEG their employer to make them a 1099 contractor in an effort to be able to really load up on 401k.
Great information. But didn’t see anything about deductible business expenses that may further reduce taxable income and maximize the deduction amount. Getting as close to $315,000 taxable income for marrieds seems to be the sweet spot.
If you’ve got deductible business expenses, you should always take them. Not much to discuss there.
I agree with SportsDoc and Stanton Elseroad that folks at risk of losing Section 199A deduction due to high taxable income want to look at loading deductions onto tax returns to push their taxable incomes below phase-out ranges. I’ve said that a lot and should have said so again here.
BTW, the FICA (and really the Medicare surtax) thing can be addressed with an S corporation. But that’s another topic.
Regarding SB’s comment that finding CPAs who understand the law may be tricky, you should now be able to ask your tax adviser about this. She or he has had lots of time to “get up to speed.” Also as noted above, the technical corrections and the regulations are “out”… lots of CPAs were waiting for those to appear before making the big investment in learning this part of the new tax law.
Stephen – thanks much for the guest post on this topic. I’m an owner in a small practice, setup as an S corp and have really tried to figure out if we’d be better off as a partnership in this new QBI deduction world. Our CPA didn’t think it would make a difference. The critical part that perhaps you can help me understand:
As an S corp clearly we need to pay “reasonable salary” and let’s just say that’s $250k per year. If setup as a partnership, is there not a corollary that the partnership needs to make guaranteed payments something akin to a “reasonable salary”, or can the partnership, as you suggest make no guaranteed payments and instead only make profit distributions, to maximize the QBI deduction?
Also, I can’t recall where I read it, but there is this issue of “any payment described in §707(a)” indicating that the Service intends that there are additional partnership income items that otherwise might be lumped into “distributable share of profits” rather than guaranteed payments, which are also excluded from QBI. From page 40 of the proposed regs:
e. Section 707(a) payments
Section 199A(c)(4)(C) provides that QBI does not include, to the extent provided
in regulations, any payment described in section 707(a) to a partner for services
rendered with respect to the trade or business. Section 707(a) addresses
arrangements in which a partner engages with the partnership other than in its capacity as a partner. Within the context of section 199A, payments under section 707(a) for
services are similar to, and therefore, should be treated similarly as, guaranteed
payments, reasonable compensation, and wages, none of which is includable in QBI.
Any guidance on this?
(I posted this S corp v Partnership question on the WCI forum recently if you want to have a look at the discussion that occurred there: https://www.whitecoatinvestor.com/forums/topic/partnership-advantage-over-s-corp-practice-setup-with-199a-deduction/
I have w2 income of 150k and also another 150k of 1099 income from moonlighting. Wife made 75k for the year, do I qualify for this deduction? And how does this work?
Hi Ben,
So your total income equals $375K ($150K plus $150K plus $75K).
But what we need to know to answer your question is what your taxable income equals.
Let’s assume you and your wife save $30K using 401(k)s etc… and that you two have $30K of personal deductions due to state taxes, mortgage interest and charity.
In this case, your taxable income equals $315K because $375K minus $60K of deductions equals $315K.
This means you don’t need to worry about whether or not your 1099 income comes from a specified service trade or business (like medicine or dentistry etc). And that you don’t need to worry about your sole proprietorship 1099 business having wages.
Your Section 199A deduction, therefore, equals the lessor of 20% of the $150K in 1099 income… or 20% of the $315K in taxable income. The former is less, so your Section 199A deduction in this example equals 20% of $150K or $30K.
BTW, if your $150K 1099 income is actually the gross income and you have, say, $10K, of expenses and therefore $140K of actual profit, you’ll get 20% of the $140K, or $28K as the Section 199A deduction.
It’s all about your taxable income. You’ve only provided your total income. But even all that puts you in the phaseout range, so I think you’ll be able to get at least part of the deduction for your $150K of business income. Maybe all of it. That could be a deduction of $15K a year, saving you perhaps $5-6K on your taxes.
Good questions Jacoavlu. And it’s impossible to give a good “rule of thumb” here. But let me share some additional comments:
1. Usually, the S corporation gambit and Section 199A deduction “play well” together if the S corporation election made sense in the first place.
2. Though S corporation shareholder-employer wages do theoretically reduce the qualified business income used in the Section 199A deduction–and so superficially seem to make an S corporation less attractive–any wages indirectly sheltered by pension, self-employment health insurance, alimony, personal deductions etc end up not mattering to the Section 199A deduction anyway. In end, then, an S corporation shareholder employee doesn’t lose as much Section 199A deduction as one might first guess.
3. With an S corporation, some deductions such health insurance and employer pension matches move to the corporation return which means they save both income taxes and payroll taxes. (This doesn’t happen with a partnership.) This feature of an S corporation is often missed by folks.
4. No tax law requirement exists that a partnership make guaranteed payments. So all partnerships should have long before now looked at updating their partnership agreements to see about dialing down guaranteed payments and dialing up distributions.
5. Regarding the Section 707(a) payments stuff, that refers to payments that are essentially like guaranteed payments and so need to treated as guaranteed payments for purposes of Section 199A. The easiest way to understand this part of the Section 199A statute and the regulations is by looking at what it prevents a partnership from doing: A partnership that used to pay Jacoavlu the partner $200K in guaranteed payments can’t “fix” the Section 199A problem by saying they’re now paying that $200K to Jacoavlu the independent contractor.
Stephen – thanks much for the reply.
In our case, the S corp isn’t really saving us much via avoidance of medicare tax on distributions as that K-1 income is only $25-$50k per year, after $250k salary. Hence my interest in a partnership setup, as the QBI deduction would be much larger.
I wasn’t aware of the issue of health insurance and profit sharing (and HSA contributions I believe) having advantage in an S corp over partnership. Those monies may amount to $60-$65k per year, so S corp setup saves about $2k per year there via medicare tax savings I believe?
I need to go do some spreadsheet work…
Jacoavlu, yup, that’s right about the HSA. So you’re saving the 3.8% Medicare surtax on the employer pension match, the HSA, the self-employed health insurance, and then the leftover “distributive share” reported in box 1 of the 1120S K-1….
The tricky part about (for example) converting to a partnership is you guys might be able to move your Section 199A deduction from 20% of $50K to 20% of $200K.
That would mean going from a $10K Section 199A deduction to a $40K Section 199A… and maybe that change produces $10K of income tax savings. But you’d probably see your Medicare taxes rise by $4K.
And these two wrinkles: The Section 199A deduction is temporary (through 2025). And converting an S corporation to a partnership would for tax purposes be a corporation liquidation and trigger a bunch of taxes potentially.
Hmm… In our case as a partnership we would probably be able to optimize to a QBI of $300k (if $0 guaranteed payments is allowed). But profit sharing + health insurance + HSA contributions would move from pretax (FICA exempt) to pretax (not FICA exempt), correct?
I don’t believe a liquidation in our case would trigger a bunch of taxes. Buy-in was near zero. Would liquidation be essentially long term gains tax on basis, found on the 1120S shareholder basis worksheet as “end of year stock basis.”
So, yes, that’s correct regarding taxation of profit sharing, health insurance, etc. That’s why I think/guess you increase your payroll taxes by roughly 3.8% of roughly $100K (so $4K-ish) if you convert from an S corporation to a partnership.
Also, keep in mind you get 20% of either QBI or your taxable income, whichever is less. If you get a K-1 showing $300K in box 1 but you have $100k of deductions, you end up with 20% of $200K and not 20% of $300K
If you liquidate the S corporation, the gain equals the difference between the fair market value of the assets inside the S corporation and their adjusted basis. Fixed assets like equipment probably have modest FMV and zero adjusted basis, but the FMV of something greater than zero creates ordinary income. (This should probably also create a new depreciation deduction.) Something like goodwill becomes more problematic I think.
As an Scorp owner, are health insurance premiums tax deductible?
yes, but it’s not quite straightforward. The S corp should establish the insurance. The S corp pays the premiums or reimburses you, that amount is included in your W2 box 1 compensation (but not box 3 or 5), and then you will deduct the amount on your personal return. 1040 line 29 last year. Basically the same with HSA contributions for a >2% S corp shareholder.
End up at a similar result for a sole proprietorship or partnership.
Hmmm…I might have to start running my health insurance and HSA through my corporation.
Stephen thanks for this timely article. As a part time 1099 doc nearing retirement this 199A deduction is a nice bonus. I will be in the 24% MFJ tax bracket and would like to fill up the rest of the space by converting some of my trad 401k into the Roth account (my solo plan allows a yearly inplan rollover). Would it be correct that as long as my total income doesn’t exceed $315K I will get the full deduction?
The Section 199A deduction formula looks at your taxable income.
So, and ignoring capital gains, if you make (say) $200K in profit as a 1099-er and you have (say) $50K in deductions, your Section 199A deduction equals the lesser of 20% of the $200K (so $40K) or 20% of the $150K of taxable income (so $30K).
If you decided to convert $50k of your 401(k) to Roth, your business income and your taxable income both equal $200K and now the Section 199A deduction equals $40K.
You could get “crazy” and convert as much 401(k) as necessary to push you up to the $315K taxable income threshold. In this case, assuming your 1099-er income equals $200K and assumining your deductions equal $50K, you’d be able to convert $165K of 401(k) money to Roth money. Your taxable income for the year would equal $315K which would mean you don’t need to worry about being in a specified service trade or business (like medicine). Your Section 199A deduction would equal the lesser of 20% of your $200K in business income (so $40K) or 20% of your $315K of taxable income (so $63K)… therefore your Section 199A deduction would equal $40K.
BTW, Physician On Fire and I did blog post on this “gambit” which perhaps against our better judgement we called a “front door Roth conversion”… that discussion appears here:
https://www.physicianonfire.com/tax-free-roth-conversions/
Thanks for the detailed reply. Your example is exactly what I was considering so I have a reference now for my CPA. I forgot about your previous post on PoF so I appreciate the link. Front door Roth conversion is a fine name for the process.
Excellent post! Do you think an “administrative stipend” is classified as non-professional income? I work clinically (professional income), but also get paid a separate stipend as associate medical director. The work is managerial/administrative in nature (case reviews, performance improvement, patient complaints, etc).
Seems squirrelly to me. That sounds very professional. Curious what others think.
Danny, so three interesting issues pop up in your question…
First, is being a medical director a “service in the field of health.” To answer a question like that, one needs to go to the regulations–specifically Reg. Sec. Proposed §1.199A-5(b)(2)(ii). Here’s what they say, “…the term ‘performance of services in the field of health’ means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.”
That says to me you aren’t providing health services when you’re working as a medical director because the services aren’t be provided *directly to a patient.*
Second, remember that this “specified service trade or business” stuff only matters when a single person’s taxable income rises about $157,500 or when a married person’s family income rises about $315,000. E.g., if your family’s total income equals $500,000 (all from self-employment) but with deductions you guys push that down to $315K of taxable income, you get the Section 199A deduction on $315K.
Third, the 1.199A-5 regulations say that incidental services (potentially like being a medical director) may get “lumped together” with your other health services and so because of this lumping rule counted as health services. This happens in general when these incidental services amount to five percent or less of the total combined gross receipts (so in your case, the total income earned from practicing medicine and then also being a medical director.)
Here’s a link to a longer discussion of this complexity:
https://evergreensmallbusiness.com/section-199a-trade-or-business-concept-deconstructed/
But this note: This “trade or business” definition stuff is where the accountants are going to run up the hours starting next year. The Treasury estimated that for pass-through entities, figuring out which trades or businesses a taxpayer is in adds about 3 hours to the return. (BTW, in total tax accountants need to do about 25,000,000 more hours of work this coming tax season due mostly to this issue of identifying trades or businesses.)
So just to be clear – the phase out at $415,000 where you get nothing is on your personal income, not the business income, correct? So if one has an S Corp that has say $300,000 in ‘profit’ but you’ve earned for example $1,000,000 from other sources (w-2, interest etc) you get nothing? I understand you could have personal deductions to get the number down but let’s just assume the $1,000,000 is after all of that. Thanks
Scott, I’m not sure I understand your question, but let provide a handful of examples… one of which should give you the answer you’re looking for.
Also, this assumption: Assume that you get $1,000,000 in W-2 income from a job and that everything else mentioned below is in addition to this…
Example 1: You invested in your brother’s boat building business and you get a K-1 from that business that shows $300K. Assume the boat building business has lots of W-2 wages. In this case, you get the Section 199A deduction on the $300K
Example 2: You invested in your sister’s boat building business and you also get a K-1 from that business that shows $300K. However, sis doesn’t employ people, she uses 1099 contractors. Further, she only uses rented equipment. In this case, because you’re above the $415K threshold, you need wages and property to get the deduction and you have none… therefore, no Section 199A deduction.
Example 3: You invest in a surgical center and earn $300K as your share. Because this is a specified service business and your income is way above $415K, you get no Section 199A deduction.
Stephen,
Thanks for the reply. Let’s assume the $1,000,000 is from being a doctor. And let’s assume that the $300,000 is also from being a doctor. Is there no tax break?
Sorry… no break.
Maybe to clarify, using your example of $1,000,000 W2 income, and borrowing from your optometrist example and non-professional real estate example. How would this scenario play out?
$1,000,000 W-2 income
$50,000 in optical ownership K-1 distributions (lots of W-2 employees)
$50,000 in non-professional real estate investments K-1 distributions, no W-2 employees
Obviously the W-2 income is out, but do the optical K-1 distributions and real estate K-1 distributions qualify? To what extent on each?
Thanks!
You’re right…the W-2 income doesn’t give taxpayer any Section 199A deduction.
The K-1 from the optometry practice probably doesn’t produce any Section 199A deduction. Optometry isn’t specifically called out in the list of health services. But surely it counts because optometrists provide services to patients. The one possibility here though: If the optometrist also sells glasses, that slice of the business will generate a Section 199A deduction if it gets big enough. E.g., if eyeglasses amount to 30% of the business, 30% of the $50,000 K-1 box 1 number–so $15K in this example–plugs into the Section 199A formula. That gives a $3,000 Section 199A deduction.
The real estate partnership, as you hint, has a problem assuming it’s not a publicly traded partnership: The example taxpayer needs to look at the phase-out rules because her or his taxable income is way over $415K. Without W-2 wages in the partnership, the Section 199A calculations limit the Section 199A deduction to 2.5% of the un-depreciated basis of the depreciable property the partnership holds. E.g., if the partnership holds $3,000,000 of depreciable property and this partner holds a 10% share, her or his share of the depreciable property equals $300,000. And her or his Section 199A deduction can’t exceed 2.5% of $300,000 or $7,500. Accordingly, the taxpayer gets a $7, 500 Section 199A deduction rather than 20% of the $50,000 which would be $10,000.
Note: The way depreciable assets plug into the formula gets complicated. If you want more detail, this blog post explains: https://evergreensmallbusiness.com/real-estate-investor-sec-199a-deduction/
P.S. The distributions don’t matter… it’s the distributive share reported in box 1 and 2 typically that feed into the Section 199A calculation.
P.P.S. I almost forgot. The W-2 wages and depreciable property stuff don’t limit the deduction for qualified publicly traded partnerships.
Great, thank you so much for the explanation. Yes, the optical income is exclusively from glasses/contact sales so at least that should get some 199A benefit.
It seems unfair that some business owners in certain industries, including healthcare services, now pay higher income taxes than other business owners, but at this point, c’est la vie.
Thanks for the great post!!
Does section 199a apply to surgery center K1 income ?
Yes, but if a partner or shareholder has a taxable income that exceeds $207,500 if single and exceeds $415K if married, that income won’t generate a Section 199A deduction. Also, if a single partner or shareholder has a taxable income that falls between $157,500 and $207,500 or a married partner or shareholder has a taxable income that falls between $315K and $415K, the Section 199A deduction from the surgery center will get limited.
Thank you that’s very helpful!
Mr. Nelson, thank you so much for such a great piece. If you don’t mind, I would like to share my math and see if it is correct. Many of my colleagues will have similar math and I want to make sure we all get it right.
Spouse makes $100k. She maxes her 401k (18,500) and HSA ($3,450) plus the standard deduction ($12,000) making her taxable income $66,050.
I am self employed independent contractor. This year I will bring in $465k with the following deductions:
defined benefit plan $175k
employer portion 401k $9,600
Business expenses $20k which include health benefits.
Business profit equals $265k
The business will distribute/profit share 100k to me as well as pays me a w2 wage of $160k from which I deduct employee portion of my 401k ($18,500), HSA ($3,450), and standard deduction ($12,000) making my taxable income excluding capital gains $126,050. Add in my profit sharing of 100k bringing me to $226,050.
Add in my wife’s taxable income of $66,050 and our total taxable income is $292,100 which allows us the 199a deduction.
The deduction is the lesser of:
a) 20% of the corporations profits which is $100k or a $20k deduction
or
b) 20% of my taxable income which is $226,050 or a $45,210 deduction
In this scenario I would receive a $20k 199a tax deduction. Is my math correct?
What would happen if I have $22901 of capital gains this year making the total taxable income $315,001?
Slightly Insecure, I agree with your math. You basically get 20% of the $100K.
Also, regarding the capital gains pushing you $1 into the phase-out range, the truth is, you won’t notice that. But *technically* what will happen is you don’t get 20% of the $100K, rather you’ll apply two limitations.
First, because of the specified service trade or business limitation, you’ll need to reduce the 20% by 1% of the 20% meaning you drop to 19.8% of $100K and not 20% of the $100K.
Second, because of the W-2 wages and depreciable property limitation, you may need to cut up to another 1% of the 20% if you lack W-2 wages and depreciable property. In your example, fortunately, you have all the wages you need so this doesn’t matter.
Awesome and thank you. I hope all these different examples help people figure out their own situation. I also hope turbotax 2018 has been properly updated for 199A deduction. I look forward to playing with the scenarios
Turbotax 2018 is not yet updated. I purchased yesterday. There’s nothing yet there with the QBI deduction
Hopefully they get it figured out before April when I buy it!
I believe your math needs a slight correction:
“The deduction is the lesser of:
a) 20% of the corporations profits which is $100k or a $20k deduction
or
b) 20% of my taxable income which is $292,100 or a $58,420 deduction”
This highlights the advantage of a sole proprietor over an s-corp for taxable income below 315k MFJ.
sole prop deduction would be
Lesser of:
a) 20% of the schedule C ($465K – 20K = $445K) which equals $89K deduction
or
b) 20% of taxable income ($292,100) which equals $58,420 deduction
If capital gains raise taxable income to 315K then deduction would be
Lesser of:
a) 20% of the schedule C ($465K – 20K = $445K) which equals $89K deduction
or
b) 20% of my taxable income ($315K) which equals $63K deduction
But, since I am an S-corp I am able to do a defined benefit plan which is giving me a $550k tax deduction over 5 years.
I wish our tax code was simpler. I may need to use a CPA again to figure out the best way to go. I wonder if there is a CPA that will give me tax advice for a one time fee? I just hate relying on someone else to do my taxes. I have had so many bad experiences over the years.
I have a defined benefit plan as a sole proprietor.
Stephen – is there a technical corrections bill expected soon that is to address some remaining uncertainties with the QBI deduction, and to address the issue of partnership “guaranteed payments?” Our CPA indicated so.
The technical corrections act came out in April (the big fix there was dealing with the grain glitch).
I don’t expect any follow-up technical corrections at this point. I’ll respond to the regulations question in reply to emailed comment.
Via email:
Thank you for the article on the Section 199A deduction. I wanted to point out that professionals need to be careful with tip #8 and #9. It appears that Mr. Nelson’s book may have not been updated for the proposed regulations issued by the IRS in early August 2018 which provide additional guidance on the Section 199A deduction area of the TCJA.
The strategy of “cracking” Specified Service Trade or Business services from services that are not “SSTBs”, has been severely limited although not entirely eliminated by the proposed regulations.
Updated Rule:
A trade or business that has 50% or more common ownership with an SSTB and provides 80% or more of its services or property to that SSTB (the “50/80 rule”) is considered to be part of that SSTB, even though it is operated as a separate entity. Even if the separate entity provides less than 80% of its property or services to an SSTB, if the separate entity has 50% or more common ownership with one or more SSTBs, the income of the separate business is considered to be SSTB income.
Self-Rental Example:
Physicians who own the office building in which their practice is located may be able to obtain a Section 199A deduction for part of the rental income. In many cases, the office building is already owned by a flow-through entity (e.g., an LLC) owned by the same physicians who own the medical practice, and leased by the LLC to the medical practice. If the medical practice uses all of the office building, it will not meet the requirements of the 50/80 rule because of the common ownership and because more than 80% of the building is used by the medical practice. However, if the medical practice leases less than 80% of the office building (and the remainder is leased by an unrelated party), the income of the LLC for the portion of the building leased to the medical practice would be treated as income from an SSTB under the 50/80 rule. However, the balance of the net rental income would be QBI and qualify for the Section 199A deduction. There is no bar against the LLC that owns the medical office building owning another rental property. If the “80%” part of the 50/80 rule presents a problem because of the percentage of the medical building occupied by the medical practice, adding a second rental property to the LLC, which is occupied by parties who are unrelated to the medical practice and its owners, could provide a way to reduce the percentage of the LLC’s property used by the medical practice to less than 80%. Physicians who own less than 50% of a separate entity that owns the office building in which their practice is located should be able to take the Section 199A deduction for the income from the building.
I hope that this information has been informative and helpful and your readers can use it in their finances to help lower their tax burden.
The monograph has been updated for the proposed regulations–and fyi I update it whenever additional guidance comes out: I.e., I updated for the conference report, for the technical corrections act, for the proposed regulations, etc.
Regarding the definition of a trade or business, which is what reader points to, that’s really not an issue with tip #8. See the earlier reader questions from Charlie and Danny and my responses. (That link to a blog post about “deconstructing the Section 199A trade or business definition” also explains what “cracking” is and why it doesn’t work.) But someone does need to carefully apply the regulations.
Regarding self-rental tip #9, that emailed comment is constructive criticism. I wrote this guest blog post after the technical corrections but before the proposed regulations… and then I updated it when the proposed regs came… but probably I should have more fully explained how Reg. Sec 199A-5 works. The rules for connected trades or businesses get tricky. Especially for SSTBs.
Oops, in my scrolling up and down and up and down, I got the tip numbers wrong in my response to the emailed comment. Let me try this again.
First, I think Tip #9 works as per the proposed regulations. See questions from Danny and Charlie and my answers. And for people who want to fall down the rabbit hole, click that link to my blog post about deconstructing the Section 199A trade or business definition. As I said one place above, this work of breaking a business into multiple businesses is the big hassle of dealing with the Section 199A deduction. (It was in the proposed regs, BTW, that the IRS estimated this deduction adds about 25,000,000 hours of new preparation work mainly due to this identification of separate trades and businesses.)
Second, Tip #8 does work…but as reader who emailed comments constructively pointed out, the rules are pretty restrictive if you have an SSTB and the affiliated entity provides 80% or more of its services or property to SSTB and the affiliated entity shares 50% or more common ownership. Still, someone should look at updating self-rental agreements… I think an update might make sense when the ownership the affiliated entity shares with the SSTB is less than 100% and when the affiliated entity provides less than 100% of its property and services to the SSTB. And an update surely makes sense if the shared ownership is less than 50% and the affiliated entity provides less than 80% of its services or property to SSTB.
Finally, just to make this point gain, the monograph fully reflects the proposed regulations… and then when the final regulations come out (soon I hope) I’ll update the monograph again and provide updates to everyone who earlier purchased.
Is income received from a limited partnership on a K1 schedule eligible for a potential section 199A deduction? Similar to passive rental income for instance.
I don’t think so.
Great information here. This being my first year of self employment, I’m looking forward to see the results of this deduction. Thanks for the info!
Me too!
Excellent article and the links provided. Thank you.
I receive K1 as a partner in LLP. In the past all our income has been reported as gueranteed payments. We write ourselves one check a month. We were told that it is too late to split our revenue into salary and profit sharing and take advantage of the pass through deduction in 2018 . We need to write 2 checks, otherwise IRS would get suspicious. Couldn’t one check be designated for both salary and profit sharing? We are the ones that compile the finacial reports for the year. So can we designate the split at the end of the year?
Mechanically I don’t know if one or two checks are required, but you’ll probably need to re-write the partnership operating agreement to reduce or eliminate guaranteed payments and shift income to distribution of profit.
Can we make the partnership operating agreement retroactive to Jan 1, 2018?
Also we were told we have to pay ourselves a reasonable salary otherwise IRS would get suspicious.
(It is definitely in our best interest to have our salary as low as possible in relation to profit. How low can we go?)
I’m not a lawyer so I don’t know. Is your taxable income less than $415k? If not then there’s no point to do anything. You don’t get any QBI deduction anyway, assuming you’re a doc.
I think it’s quite late in the year to try to do this. But you could call your lawyer and ask.
I don’t think you need to have an S Corp election to get this deduction which seems to be what you’re referring to. A sole proprietor making $200K would be eligible, no distributions/profit sharing required.
I know a sole proprietor gets the biggest deduction but there are 3 of us in LLP.
Great discussion. Stephen, can you please clarify when you say “when a partnership skips gueranteed payment” ? Can LLP go from 100% gueranteed payments to 100% profit sharing? If we should have both components what split do you recommend? (I want to update our partnership agreement. Is it too late to update it for 2018? Only one check is written per pay period.)
Thanks to jacoavlu for Forum link. I like the comment that this is a CPA job security act. Also says I should set the gueranteed payments to at least 56K, 2019 retirement contribution limit. Is that enough? (As far as our contract it just says we each get 1/3 of profits with out using any accounting technical terms.)
All my questions have been answered by our accountant. I would like to point out an error in the forum link mentioned above. You do not need to set guaranteed payments to 56K to take advantage of retirement contribution limit. Your total income, which can be 100% distribution of profits in partnership case, is used to calculate retirement. As Stephen says, “No tax law requirement exists that a partnership make guaranteed payments,” as long as your operating agreement supports it.
Glad you got it done.
We’re you able to do things retroactive to maximize a QBI Deduction for 2018?
What forum link are you referring to?
The link that you posted in comment #5 on this page. Comment #2 on the forum.
After a lot of back and forth and our accountant consulting a tax attorney, we will be reporting 100% of our income as distribution of profits. Our partnership agreement does not set a guaranteed payment and only talks about a share of the profits. After all that hard work, l just have to make sure my joint taxable income falls at 315K or less to take advantage of the maximum pass through deduction. They don’t make this easy.
Assuming we qualify for the deduction, can my family use the deduction for both my 1099 earnings AND a second deduction for our rental property LLC? We haven’t as of yet opened separate bank accounts / EINs for the rental LLC.
Read the specific rules regarding rental properties, but possibly. I know some real estate investments do qualify and yours may be one of them. The devil is in the details and you didn’t provide any.
I’m just finishing emergency medicine residency and starting a hybrid career with projected income of 50-70k of IC work in addition to 150-200k as a W2 employee through a consulting firm. I’m planning to structure as a sole proprietor with no employees.
My total taxable income for this year will definitely be less than 150k and may well be in the coming years. I’m trying to minimize taxes/maximize income this year, and I’m projecting this following:
Gross income:
6 mos residency salary plus W2 moonlighting: 45k
Attending 1099/IC Income: 50-60k
Consulting W2 Income: 75k
Total projected gross income: 170-180k
Deductions:
Employee (personal) contribution to residency W2 401k: 19k
Attending “employer” 1099/IC contribution to separate solo 401k: 20% of ~50k = 10k
Taxable income so far 141-151k.
I’d like to take advantage of the 199a deduction, if possible, and I think I qualify. I’ll be married, filing separately (spouse’s taxable income is in the 500k range), but I understand the married income limit is for married filing jointly – right?
Thus, can I take the 199a deduction for around 10k from my IC income as 20% of 50k?
Anything I’m missing?
I don’t think you will qualify for the 199A deduction. Maybe this year on $50K of income, but definitely not by next year. But run the numbers and see. I assume you’re filing separately for some student loan benefit or something eh? You’re not JUST doing it trying to get the 199A deduction are you? If so, are you sure you’re not losing more by filing MFS than you’re gaining on the 199a?
Hah, I’m very much not certain that MFS is otherwise superior. I guess the tax benefit for filing jointly is typically superior, then?
Penny wise, pound foolish on my part. Thank you!
Usually, but the situations where it might not be are often like yours. Usually best to just run the taxes both ways and take the lower bill.