The Sec. 199A deduction phase-out calculations confuse lots of people. They even confuse smart accountants, as several readers of my Maximizing Sec. 199A Deductions monograph have told me.
Accordingly, I want to give a high-level overview of how the phase-out math works.
But first let me quickly review how the deduction works, so we all start on the same page.
Sec. 199A Deduction in a Nutshell
The Sec. 199A deduction gives unincorporated businesses, S corporations and real estate investors a special “bonus” deduction equal to, tentatively, the lesser of 20 percent of business income or 20 percent of their taxable ordinary income.
For example, say you make $100,000 a year in an incorporated business but with the new standard deduction your taxable income equals $76,000. Assume all your taxable income is ordinary income, so no capital gains or anything.
In this case your Sec. 199A deduction equals the lesser of 20% of $100,000, which equals $20,000… or 20% of $76,000, which equals $15,200.
That means your deduction equals $15,200.
Sec. 199A Deduction Phase-out Calculations Usually Don’t Matter
The good news…
For most business owners and investors, the Sec. 199A Deduction phase-out calculations don’t matter.
For example, single taxpayers with taxable income less than $157,500 and married taxpayers with taxable income less than $315,000? Those folks don’t get “phased-out.” They can ignore this phase-out nonsense.
Further, single taxpayers making more than $207,500 and married taxpayers making more than $415,000 also don’t need to worry about the phase-out calculations.
Instead, taxpayers earning above these $207,500 and $415,000 taxable income thresholds apply a couple of simple rules:
Rule #1: High-income Service Businesses Disqualified
If the taxpayer earns her or business income in a specified service business—basically a white-collar professional, athlete, performer or one-person business—she or he doesn’t get the Sec. 199A deduction.
Another way to say this same thing? For high income specified service business income, the Sec. 199A deduction equals zero.
That’s a pretty easy—if an unpleasant—rule.
Rule #2: High-income Taxpayers Need Wages and Property
And then a more complicated rule for these high income taxpayers…
The taxpayer’s Sec. 199A deduction can’t be more than either 50% of the business’s W-2 wages or 25% of the business’s W-2 wages plus 2.5 percent of the business’s depreciable property.
Suppose, for example, that a business pays $100,000 in wages and holds $2,000,000 in depreciable property.
In this case, the business calculates what amount equals 50% of its W-2 wages (that value is $50,000) and what amount equals 25% of its W-2 wages plus 2.5% of its depreciable property (that value is $75,000).
Whichever value is more—$75,000 in this case—the Sec. 199A deduction can’t be bigger than that.
A little bit of math, sure. But pretty easy to understand and even to calculate.
Unfortunately, things get tricky for taxpayers with taxable incomes that fall into the phase-out ranges (again, that’s between $157,500 and $207,500 for single taxpayers and between $315,000 and $415,000 for married taxpayers.)
Sec. 199A Deduction Phase-out Calculations for Specified Service Trades or Businesses
For specified service trades or businesses, the phase-out works like this: At the start of the phase-out range (so either $157,500 or $315,000) the taxpayer or taxpayers get a deduction equal to the full 20% of the business income.
At the end of the phase-out range, the taxpayer gets a deduction equal to 0% of the business income.
And as a taxpayer’s taxable income “slides” from the threshold amount up through the phase-out range, the percentage proportionally “slides” down to zero.
The actual law doesn’t put the formula into a table, but if it did, the table would look something like what appears below:
You see what I mean by the percentage “sliding down” from 20% to 0%, right?
At $157,500 if single or $315,000 if married, someone gets the full 20% deduction. At $207,500 if single or $415,000 if married, someone gets zero deduction.
Note that $182,500 taxable income for a single person and $365,000 in taxable income for a married person sits exactly half way through the phase-out range. So at that income level, the 20% deduction gets “half” phased out, and equals 10%.
A quick tangential comment: If you need more detail on the “specified service trade or business” rules, you may be interested in my Maximizing Sec. 199A Deductions e-book monograph.
This 90 page monograph digs into details about how the new tax deduction works using dozens of simple examples. It provides brief descriptions of tactics (some simple, some not) that taxpayers may need to use to maximize their Sec. 199A deductions. Finally, the monograph covers two topics tangentially related to the pass-thru entity deduction: Whether a business owner should “unincorporate” and whether S corporations should “revoke” their Subchapter S status
Sec. 199A Deduction Phase-out Calculations for Low W-2 Wages or Depreciable Property
Low or zero W-2 wages or depreciable property also cause a single taxpayer with income between $157,500 and $207,000 or a married taxpayer with income between $315,000 and $415,000 to lose a chunk of the Sec. 199A deduction.
The calculations get a little more complicated. Unfortunately. But if you break down the calculations into half a dozen simple steps, the math makes sense.
Let me step you through how this works.
Step 1: Calculate the tentative “20%” deduction.
For example, if the business income equals $400,000, 20% of that equals $80,000. So that $80,000 potentially equals the tentative Sec. 199A deduction amount.
Step 2: Calculate the W-2 Wages or Depreciable Property Limitation.
For example, if the business paid $100,000 of wages and had zero depreciable property, the 50% of W-2 wages limitation amount equals $50,000.
Step 3: Calculate the difference between the tentative deduction and limitation
For example, if the tentative Sec. 199A deduction equals $80,000 but the W-2 limitation equals $50,000, the difference between the two amounts equals $30,000.
Step 4: Calculate Phase-out Percentage and Amount
Next you need to calculate the percentage that describes how far into the phase-out range a taxpayer’s taxable income is.
Let’s call this value the “phase-out percentage.”
If a married taxpayer’s taxable income equals $410,000, for example, the couple’s income is $95,000/$100,000ths, or 95%, into the $100,000 phase-out range that goes from $315,000 to $415,000.
Step 5: Calculate Phase-out Amount
To calculate the phase-out amount the taxpayer loses, you need to multiply the phase-out percentage (calculated in step 4) by the difference between the tentative deduction and the limitation (calculated in step 3.)
For example, if the phase-out percentage equals 95% and the difference between the tentative deduction and the limitation equals $30,000, the phase-out amount equals $28,500.
Step 6: Deduct the Phase-out Amount from Tentative Deduction
To finally calculate the real final deduction, you subtract the phase-out amount (calculated in step 5) from the tentative deduction amount (calculated in step 1).
If the tentative deduction equals $80,000 for example and the phase-out amount equals $28,500, the real Sec. 199A deduction equals $51,500.
Once you grind through the math, the phase-out calculations make sense. The math works the way you and I would predict if we were just “guessing.”
Two other things to keep in mind though, since you’ve trudged through this discussion.
First, the Sec. 199A law says those threshold amounts, $157,500 and $315,000, do need to be adjusted for inflation. So you want to keep that in mind. Also note that the $50,000 “phase-out range” for single people and the $100,000 “phase-out range” for married people do not get adjusted for inflation. Just so you know…
Second, let me mention again the rule that your Sec. 199A deduction can’t be more than 20% of taxable income taxed as ordinary income. The amount calculated using the phase-out arithmetic may be further limited to that value.
Other Resources You Might Find Useful
The Sec. 199A deduction interacts with the optimal S corporation salary for shareholder-employees, so if you’re ready to think about that issue, maybe peek at this blog post: S Corporation Shareholder Salaries and the Sec. 199A Deduction
Determining whether a one-person business gets disqualified as a “specified service trade or business” is tricky, but I’ve got some additional information about that riddle here: Sec. 199A Pass-thru Entity Deduction and the Principal Asset Disqualification.
Finally, if you’re still learning the law, you may benefit by reading our blog’s Sec. 199A “primer” (available here: Pass-thru Income Deduction: Top 12 Things Every Business Must Know) and then skimming through the dozens of reader comments, questions and answers.