With all that’s happened in 2020, it’s easy to forget about your Section 199A deduction.
You may remember that the Tax Cuts and Jobs Act (TCJA) gave many pass-through businesses the Section 199Adeduction as a no-effort, do-nothing 20 percent tax deduction based on defined business income.
For example, with defined qualified business income of $100,000 and defined taxable income of $100,000, you qualify for a $20,000 Section 199A deduction that you claim on your Form 1040.
One thing to be aware of is that tax planning that reduces your business income can also reduce your Section199A deduction. For example, you buy $40,000 of equipment and expense it. Now, your qualified business income is $60,000 ($100,000 – $40,000) and your 199A deduction is $12,000 ($60,000 x 20 percent).
Your planning for the Section 199A deduction requires more attention if your qualified business income is more than $163,300 (or $326,600 on a joint return).
In this article, we bring you three Section 199A strategies you can implement before December 31, 2020, that can help you obtain your best deduction.
First Things First
If your taxable income is above $163,300 (or $326,600 on a joint return), then your type of business, wages paid, and property can reduce and/or eliminate your Section 199A tax deduction.
The combinations can create confusion, but you can lessen the confusion by using the 2020 Section 199A calculator
If your deduction amount is less than 20 percent of your qualified business income (QBI), then consider using one or more of the strategies discussed below to increase your Section 199A deduction.
Strategy 1: Harvest Capital Losses to Reduce Taxable Income Capital gains add to your taxable income, which is the income that
- determines your eligibility for the Section 199A tax deduction,
- sets the upper limit (ceiling) on the amount of your Section 199A tax deduction, and
- establishes when you need wages and or property to obtain your maximum deductions.
If the capital gains are hurting your Section 199A deduction, you have time before the end of the year to harvest capital losses to offset those harmful gains.
Susan is single. She has QBI of $100,000 and taxable income of $180,000, of which $50,000 is net capital gain. Her business is an out-of-favor specified service business with $50,000 in wages and no qualified property.
If Susan takes no action, her Section 199A deduction is $13,320 because she is above the threshold and in the phase out range.
If Susan harvests $16,700 in capital losses—say, from her stock portfolio—she is now below the threshold($180,000 – $16,700 = $163,300), and her Section 199A deduction increases to $20,000, as the calculator shows.
By using the capital gains offset strategy, Susan has obtained a total federal tax cash benefit of $4,108 from the capital loss, as follows:
- $2,505 in cash from the reduced capital gain taxes (15 percent of $16,700)
- $1,603 from the additional Section 199A deduction (24 percent of $6,680 [$20,000 – $13,320])
Calculating the Section 199A deduction by hand is not for sissies—in fact, it’s pretty much not for anyone.
When drawing up strategies as we did above, make sure to use the calculator. Doing the Section 199A in your head or by hand is not only difficult but time-consuming and often confusing—and it often comes out incorrect. The calculator is a big help. (Click here to access the calculator.)
Strategy 2: Make Charitable Contributions to Reduce Taxable Income
Since the Section 199A deduction uses taxable income for its thresholds, you can use itemized deductions to reduce and/or eliminate threshold problems and increase your Section 199A deduction.
Charitable contribution deductions are the easiest way to increase your itemized deductions before the end of the year.
Consider doing one or both of the following:
- Donate appreciated stock, as we discuss in 2020 Last-Minute Year-End Tax Strategies for Your Stock Portfolio
- Prepay (before December 31) your planned 2021 charitable contributions so you can claim them as deductions this year.
If you need a really large charitable contribution deduction to make this work, you should read Use a Conservation Easement Donation to Create a $63,000 199A Deduction.
Let’s assume Susan (from our example above) decides to donate appreciated stock to her favorite charity instead of harvesting losses in her stock portfolio.
She donates appreciated stock with a value of $16,700 and built-in long-term capital gain of $8,000 to her favorite charity.
If the donation increases her itemized deductions by $16,700, then her taxable income drops by $16,700. Now she is even with the threshold, and her Section 199A deduction increases to $20,000 (20 percent of $100,000 QBI).
With this strategy, Susan saves $6,947 in 2020 federal income taxes from the stock donation:
- $5,344 from the $16,700 charitable contribution (32 percent x $16,700); and
- $1,603 from the additional Section 199A deduction (24 percent of $6,680 [$20,000 – $13,320]).
Susan also eliminated $1,200 in future capital gain taxes (15 percent of $8,000) because with the stock donation, she disappeared the capital gain from her portfolio.
Strategy 3: Buy Business Assets
Thanks to 100 percent bonus depreciation and Section 179 expensing, you can write off the entire cost of most assets you buy and place in service before December 31, 2020.
This can help your Section 199A deduction in two ways:
- The big asset purchase and write-off can reduce your taxable income and increase your Section199A deduction when it can get your taxable income under the threshold.
- The big asset purchase and write-off can contribute to an increased Section 199A deduction if your Section 199A deduction currently uses the calculation that includes the 2.5 percent of unadjusted basis in your business’s qualified property (UBIA). In this scenario, your asset purchases increase your UBIA, which in turn increases the deduction you already depend on.
Take a look at Tax Reform: Wow, New 20 Percent Deduction for Business Income for what counts as qualified property.
Jim, who is single, runs his medical practice in an S corporation. He has taxable income of $213,300,and the S corporation has QBI of $100,000, wages of $120,000, and UBIA of $20,000.
If Jim takes no action, his Section 199A deduction is $0, because his taxable income is at the upper threshold of$213,300 and his business is an out-of-favor specified service business.
Let’s say that before December 31, 2020, Jim buys and places in service medical equipment costing $30,000 thathe had previously planned to buy over the next one to two years.
Assuming Jim fully expenses the property, he saves $12,467 in federal income taxes:
- $9,779 from the $30,000 equipment write-off. (The savings from the $30,000 write off comes from two tax brackets: 35 percent of $5,950 plus 32 percent of $24,050).
- $2,688 from the Section 199A deduction. Note that the $30,000 of expensing reduces both Jim’s taxable income and his QBI. We use the calculator to see that Jim now has an $8,400 Section 199Adeduction. His tax benefit is 32 percent of that, or $2,688.
If your taxable income is over $163,300 (or $326,600 on a joint return), you could face a reduced or eliminated Section 199A deduction.
In such cases, consider using one or more of the three strategies described in this article to reduce your taxable income and increase your Section 199A deduction. The three strategies are:
- Harvest capital losses if you have capital gain income that’s causing the trouble.
- Make charitable contributions to increase your itemized deductions and reduce your taxable income—and consider donating appreciated long-term-gain stock to come out even better.
- Buy and place in service before midnight on December 31, 2020, business assets that you can expense 100 percent to lower your taxable income. (This also lowers your QBI, but if you need it to gain the Section 199 deduction, it’s a good strategy..)
Final point. This can get confusing. Be sure to use our 2020 Section 199A calculator to run the numbers so you can identify your correct Section 199A deduction.