By Jason Watson, CPA
Posted Wednesday, October 20, 2021

The computation can be maddening as we’ve demonstrated in the previous pages. So… we created fictitious tax returns for Fred Flintstone operating an S corporation (he bought Slate Rock and Gravel from Mr. Slate). You can see side by side the differences between 2017 and 2018, using the new tax brackets, the new standard deduction and the Qualified Business Income Deduction (QBID) along with Section 199A.

Our $25,000-a-year expensive tax software (UltraTax aka UltraPain) does a wonderful job showing the worksheet computations of the Section 199A deduction, line by line.

Here is a table for reference-

SSTB refers to specified service trade or business. The following link shows copies of the 2017 tax returns plus the 2018 tax projection worksheets (TPW as we call it) for our buddy Fred-

wcginc.com/8313

Caution: Our software is using a strict interpretation of the tax code. This is where the accountant has to be the accountant, and prepare the tax return.

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

Hopefully you are still with us and not in the fetal position sucking your thumb. To hammer these points home, the Section 199A won’t help everyone and the S corporation still has some shine (although perhaps less in some situations) as an overall tax reduction mechanism.

Here is a summary of the previous Section 199A side-by-side comparisons-

The far right column, S Corp Savings, is your net savings after forfeiting a part of the Section 199A deduction. The deduction reduction if you will.

American Jobs and Closing Tax Loopholes Act of 2010 (HR 4213)

Here is some chin-scratching fodder for your day. Back in 2010, the House created a bill that would disqualify small professional service S corporations (attorneys, doctors, consultants, etc.) from benefiting from the S Corp “loophole.” Thankfully the Senate saw this as discrimination since non-professional service businesses (construction, retailers, manufacturers, etc.) would still benefit from the “loophole.” The bill was rejected naturally.

Tax Cuts & Jobs Act of 2017

It appears specified service trades or businesses dodged another bullet. There was chatter similar to 2010 but eventually it gave way. Yes, some of the tax breaks disappear for attorneys, doctors, accountants and anyone else whose reputation or skill is the material income producing factor. However, it could have been way worse. Instead the crummy laws of 2017 and earlier are simply the high-water mark, and if you are phased out of the Section 199A deduction you are no worse off. Yeah, it doesn’t make you feel any better.

Thank you for hanging in there!

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

We might lose our minds the next time Congress acts over the holidays and ruins our eggnog. At least Wisconsin won the Orange Bowl which is nice. How does the Section 199A phaseout work?

NBI is short for Net Business Income, and W-2/DA is the limit based on the greater of 50% of W-2 wages paid, or 25% of W-2 wages paid plus 2.5% of unadjusted basis for depreciable assets. The dashed arrow is a specified service trade or business. The Y axis is the Section 199A limit. The Section 199A phaseout should be viewed as where you are going to “end up.” Quick example, step by step-

• Let’s say your taxable income is $340,000 which is exactly 25% over the $315,000 income trigger when compared to $415,000. Again, the trigger of the phaseout is based on taxable income and not just net business income.

• We determine your Section 199A upper limit based on net business income, with an adjustment for specific service trades or businesses.

• We next determine your Section 199A lower limit based on W-2 / depreciable asset calculation from above, with a similar adjustment for SSTBs.

• Next, we take the difference, multiply it by the percentage of taxable income that exceeds the trigger (in this example, 25%) and reduce the Section 199A deduction based on net business income by this amount. Tilt! A table is coming up.

Here is table that attempts to summarize what the heck we are talking about.

Since the taxable income trigger of $315,000 is exceeded by $25,000 and the phaseout range is $100,000 for married taxpayers, we are 25% into the phaseout range. We now have to split these up between non-service and service.

This gets really funky really fast. For the non-SSTB people, the math is straightforward. For the specific service trade or business people, we need to determine how much of the remaining phaseout range is available. In this case, 25% of the phaseout range is “used up” leaving 75% remaining.

Therefore, 75% of the NBI of $300,000 is $225,000. 75% of the W-2 wages paid of $100,000 is $75,000. These remaining amounts are the basis for the original Section 199A calculations of 20% of net business income, or $45,000 above… and 50% of W-2 wages paid, or $37,500 above.

Another way to look at this is 75% is the remaining Section 199A benefit for the SSTB people. Therefore 75% of the net business income limit of $60,000 is $45,000… and 75% of $W-2 limit of 50,000 is $37,500.

This creates an “upper limit” and a “lower limit” which further creates the difference to apply the phaseout range percentage (in this example, 25%).

Finally, we choose the greater of the Section 199A based on net business income and the Section 199A based on W-2 wages paid. In our example, $60,000 and $45,000 respectively.

This is then reduced by the percentage of phaseout range multiplied against the difference. In this example, 25% of $10,000 and 25% of $7,500 for the specified service business.

This summarizes the Section 199A reduction and ultimate deduction.

This should make sense. Another way to look at this- let’s say your taxable income was exactly $415,000. You would be 100% into the phaseout range, so your Section 199A deduction would be reduced by $10,000 (100% of the difference of $10,000) for a non-service trade or business. This would also magically equal the Section 199A limit set by 50% of your W-2 wages paid or $50,000.

Extending this logic would suggest that a specified service trade or business who has $415,000 in taxable income would have his or her Section 199A deduction reduced by 100% since the remaining amount of the phaseout range is 0%.

Need a drink?

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

Big shot surgeon compared to the lowly goat herder (non-specified service trade).

*includes the S Corp W-2

There are several notables, takeaways and explanations-

Well, that’s a lie. There are only two. First, specified service trades or businesses got hosed in the Section 199A calculation. Being a goat herder raking in $600,000 as compared to a surgeon gets a $36,000 bump in tax benefit. If you give it careful consideration, how are these two businesses different? While we are being a bit facetious here, at the same time two business owners are experiencing different tax worlds based on titles. The goat herder could be operating with a staff and not relying his or her reputation or skill.

Second takeaway, although specified service industries such as accountants, doctors, attorneys, etc., are not enjoying the Section 199A deduction benefit, it still pays to be an S corporation. There is still a savings of $8,133 by being an S Corp for the big shot surgeon. You have an obligation as a citizen to reduce your taxes to the minimum allowed.

Please review our previous chapter for more information and expanded definitions of specified service trade or business.

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

Same online retailer but compared to an attorney (SSTB). Yuck!

*includes the S Corp W-2

There are several notables, takeaways and explanations-

Assumptions are $250,000 in business income prior to $87,500 in reasonable shareholder salary. Itemized deductions of $12,000 and both taxpayers are single. Same as previous example, but now we are comparing a non-specified service trade or business (online retailer) to an attorney.

Observe the differences in Line 16. Recall the Section 199A decision tree from earlier-

• If taxable income is less than $157,500 (single) / $315,000 (married) then the 20% deduction for your pass-through entity is fully available. In other words, your taxable income does not exceed the 24% marginal tax bracket.

• If taxable income is greater than $157,500 / $315,000 but less than $207,500 / $415,000 then a partial deduction is available. The phase-in of the limit is linear (more explanation later).

• If taxable income is greater than $207,500 / $415,000 then you are hosed. Sorry.

The attorney should absolutely be an S corporation and enjoy the $7,645 in tax savings. He or she simply won’t be enjoying the $18,551 savings of the online retailer. Surely the online retailer should be sued by the attorney to help equalize the balance of tax benefits and preserve the natural order. Attorneys are so proud. Same with doctors. Same with CPAs. Perhaps that we are all SSTBs. Our pride killed our deduction.

Remember that if a specified service trade or business has taxable income that is equal to or less than $157,500 for single taxpayers and $315,000 for married taxpayers, there is no phase-in of the limitations (or Section 199A phaseout). Said in another way, if the online retailer and the attorney both earned $150,000 from their respective crafts, the Section 199A savings would be identical.

Drive that point home please; an SSTB in the 24% marginal tax rate is the same as a non SSTB.

Let’s do one more! Drool… come on, it’s not that bad. No, Jason, really, it is that bad. For real.

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

Same online retailer (not a specified service business) showing single versus married.

*includes the S Corp W-2

There are several notables, takeaways and explanations-

Assumptions are $250,000 in business income prior to $87,500 in reasonable shareholder salary. Itemized deductions are $12,000 as a single taxpayer and $24,000 as a married taxpayer.

Note the spreads in Section 199A deduction benefit on Line 16 and the subsequent income tax benefit on Line 18. In the scenario where the taxpayer is single, he or she is phased out of Section 199A deduction because of income and subsequent W-2 limitations (Line 14).

The example is used to show the limitations of Section 199A due to income based on marital status. However, note that by electing S Corp tax status the Section 199A benefit is identical (Line 16). The difference then becomes the income tax benefit of this deduction which is a factor of marginal tax rates (Line 17).

For couples who are not married, there might be a reason to be legally married without altering your relationship definition just to grab some additional Section 199A benefit. Vegas baby!

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

New day, different problem. This is an online retailer earning $200,000 in business income.

*includes the S Corp W-2

There are several notables, takeaways and explanations-

Assumptions are $200,000 in business income prior to $70,000 in reasonable shareholder salary. Married taxpayer with $24,000 as a standard deduction (Line 11), with and without an additional $100,000 in taxable income (Line 9) such as a spouse or pension.

Note the spreads in Section 199A deduction benefit on Line 16 and the subsequent income tax benefit from Section 199A on Line 18. This is an interesting example since the extra household income increases the Section 199A deduction significantly.

However, when self-employment taxes and payroll taxes are added back, there is still a material savings even when Social Security limits are reached under the non-S Corp scenario.

If this example had $10,000 in self-employed health insurance premiums the net S Corp benefit (Line 23) would be $9,483 without additional household income (Line 9) and $7,099 with additional household income of $100,000.

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

Same situation as before, but with $10,000 in health insurance premiums (Line 8).

*includes the S Corp W-2

There are several notables, takeaways and explanations-

Assumptions are $100,000 in business income prior to $35,000 in reasonable shareholder salary. Married taxpayer with $24,000 as a standard deduction (Line 11) and no additional taxable income.

$10,000 has been added as self-employed health insurance premiums. This could easily be $7,000 in health insurance premiums and $3,000 in health savings account (HSA) contributions too. Both are considered a taxable fringe benefit when paid by the business (but later deducted $1 for $1 on your individual tax return).

Note the decrease in payroll taxes on Line 3. This is because less wages are being subjected to Social Security and Medicare taxes when considering health insurance, HSA, etc. as a form of Officer Compensation (reasonable shareholder salary). As a result, Box 1 of the W-2 will show $35,000 but Box 3 and Box 5 will only show $25,000. Form 1120S, Line 7, Officer Compensation will also show $35,000.

In this example, having the S corporation pay for self-employed health insurance increases the savings by approximately $1,800. Recall the language from IRS Fact Sheet 2008-25-

The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.

If this is blowing your mind, please read our chapter dedicated to reasonable shareholder salary for further explanations of how self-employed health insurance and HSA contributions reduce Social Security and Medicare taxes.

Note that the Section 199A benefit (Line 16) is higher with an S corporation versus a non-S Corp by leveraging the self-employed health insurance / HSA aspect of an S Corp.

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

Joe Public earning $100,000 with and without additional taxable income.

*includes the S Corp W-2

There are several notables, takeaways and explanations-

Assumptions are $100,000 in business income prior to $35,000 in reasonable shareholder salary. Married taxpayer with $24,000 as a standard deduction (Line 11), with and without an additional $60,000 in taxable income (Line 9) such as a spouse or pension.

Notice how under an S corporation scenario (the second and fourth columns) the adjusted gross income (Line 10) is higher than a garden variety LLC or sole proprietorship. This is because issuing a W-2 is limiting the amount of Social Security and Medicare taxes paid, and subsequently deducted to ultimately determine taxable income. This has always been the case before and after the Tax Cuts & Jobs Act of 2017. No change.

Taxable Income Before Section 199A Deduction (Line 12) is used for illustration purposes only. The Section 199A deduction will eventually reduce adjusted gross income to arrive at taxable income for income tax purposes (a deduction from AGI). Our illustration is purely for the difference between a non-S Corp and an S Corp. It is not an income tax calculation.

Lines 13, 14 and 15 compute the various Section 199A calculations and will be used to determine any limitations. In this example, since taxable income is below $315,000 the only two limits are Section 199A based on business income (Line 13) and Section 199A based on taxable income (Line 15). The Section 199A based on W-2 limitation is not used.

Line 16 is the selected Section 199A benefit depending on the calculation and income limitation rules.

Notice that under a non-S Corp scenario the limiting factor (or as nerdy military types say, limfac) is Section 199A based on taxable income whereas the S corporation scenario the limiting factor is Section 199A based on net business income. This should make sense.

Line 18 is the income tax benefit based on the Section 199A calculation. Remember we are thinking in terms of taxes, so the Section 199A calculation must be put into an income tax savings context based on marginal tax rates.

Next, we add self-employment taxes to the non-S Corp (Line 19), and income taxes and payroll taxes to the S Corp (Lines 20 and 21) to arrive at the cash in your pocket difference by being taxed as an S corporation. In this example, an S corporation is saving $8,089 for no additional household income and $6,152 with $60,000 in additional income. Of this savings, the bulk remains because of self-employment tax savings.

Fun! Moving on…

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

We created a handful of examples on the follow pages with two intentions. One, to demonstrate how the Section 199A deduction is calculated and Two, to show that an S Corp remains a critical tax reduction vehicle. Brace yourself for nauseating spreadsheets that are only meaningful to the spreadsheet designer. We hope our commentary and explanations make sense, and that the logic of the step-by-step iteration becomes clear. We might be dreaming…

Side By Side Comparisons of Section 199A

If you are reading this in a bound book, we have intentionally made it so the explanation is on the right side and the ridiculous explosion of numbers is on the left. If you are reading the PDF version you might have to print the pages or arrange for side-by-side viewing.

By Jason Watson, CPA
Posted Wednesday, October 20, 2021

We are going to walk you through a handful of examples comparing non-S Corp scenarios such as sole proprietorships, single-member LLCs (disregarded entity) and other pass-through environments (partnerships) to those same situations being taxed as an S corporation. We will demonstrate the benefits of the Section 199A deduction, and how it plays into the “Should I elect S Corp?” question.

Aside from the usual suspects such as not earning more than $30,000 in net business income after expenses,  or operating in Tennessee, New Hampshire or New York City, every scenario provides an additional benefit by electing S Corp status on top of the Section 199A deduction. Here is a link to our S Corp Questionnaire to help determine if an S Corp election makes sense-

wcginc.com/8103

Section 199A Calculation

There are four variables you need to assign values to, a definition to consider, one tax bracket to memorize and two phase-out numbers to understand. Get some flashcards!

Taxable Income

You need to determine the amount the entire household reports as taxable income, not just the business income. See Line 15 of your Form 1040 from 2020 to gain perspective of where you are. Write down 20% of this number.

W-2 and Depreciable Assets

You need to calculate the total amount of W-2 wages the business pays including staff wages. Write down 50% of this number. You need to calculate the unadjusted basis immediately after acquisition (the value immediately after purchase before depreciation) of any depreciable assets the business owns. Write down 2.5% of this number (this becomes important for real estate investors).

Qualified Business Income

Take your net business income after expenses, and write down 20% of this number.

Specified Service Trade or Business

Does your business survive on the reputation or skill of its owner(s)? Are you an accountant, actuary, attorney, consultant, financial advisor, medical doctor, paid athlete or performing artist? See our previous chapter on Section 199A deduction analysis.

End of 24%

The 24% tax bracket ends at $157,500 for single taxpayers and $315,000 for married taxpayers. The next tax bracket leaps to 32%. The 24% to 32% jump is clearly intentional and draws a line in the sand between middle class and upper middle class in our opinion. The Section 199A benefit might erode (phase out) after the 24% marginal tax bracket depending on your situation. Tax brackets are indexed each year.

Phase Out Range

The income phase out period is $50,000 for single and $100,000 for married.

Section 199A Deduction Limits

We explained the decision tree elsewhere in our book, however we want to illustrate the iteration in a different way. The question becomes, “How do I figure out my Section 199A deduction?” Besides using expensive tax software and professional advice, you can consider this flowchart.

If your taxable income is in the 24% marginal tax bracket or less, stop. You are done and can select the lower of 20% of your qualified business income or 20% of your taxable income.

Assuming now that your taxable household income is in the 32% marginal tax bracket or above, you must worm in some additional Section 199A limitations based on the following-

Non Specified Service Business

You must now consider the Section 199A deduction based on W-2 wages or depreciable assets, and use the most restrictive of all Section 199A calculations. If you are in the income phase-out range (or the deduction limitation phase-in range, however you want to view the nomenclature), there is a linear, sliding scale of limitation based on W-2 wages and depreciable assets.

In other words, the deeper into the phase-out range you are, the limiting effect of W-2 / depreciable assets becomes stronger. No need to hurt ourselves with the calculus at this point.

Specified Service Trade or Business

If you are an SSTB, then you must now reduce your Section 199A deduction on a linear, sliding scale that reaches $0 as you move along the phase-out range (which is $50,000 for single taxpayers and $100,000 for married taxpayers). W-2 wages or depreciable assets come into play, but in a different way (near the end we provide an example of the phaseout). Your Section 199A simply ends after $207,500 (single) and $415,000 (married).

Remember that being designated an SSTB only affects you if your taxable household income exceeds the 24% marginal tax bracket.

Section 199A Examples

Here are some random examples to illustrate various Section 199A qualified business income deductions.

Note: The $157,500 and $315,000 numbers represent the end of the 24% marginal tax bracket. These are 2018 numbers (base year) and are indexed each year.

• Wilma makes $100,000 in net business income from her sole proprietorship but also deducts $5,000 for self-employed health insurance, $7,065 for self-employment taxes and $10,000 for a SEP IRA. These are not business deductions- they are adjustments on Form 1040 to calculate adjusted gross income. Her deduction is the lessor of 20% of $77,935 (net business income after deductions above) or 20% of her taxable income, which could be less (see Pebbles below).

• Barney owns three rentals with net incomes of $20,000 and $5,000, with one losing $8,000 annually. These are aggregated to be $17,000. He would deduct 20% of $17,000.

• Barney has passive losses that carried forward and are “released” because he now has net rental income, those passive losses are taken first. With using the same example above with $10,000 in passive loss carried forward, Barney’s deduction would equal $17,000 less $10,000 or 20% of $7,000.

• Pebbles earns $100,000 from her pass-through business but reports $80,000 of taxable income on her tax return due to other deductions such as her itemized deductions. Her Section 199A deduction would be $16,000 since it limited by the lessor of 20% of $100,000 or $80,000.

• Mr. Slate operates an online retailer S corporation which pays $100,000 in W-2 wages and earns $400,000 in net qualified business income. Because he is considered a “high earner” by exceeding the income limits, his deduction is limited to 50% of the W-2 or $50,000 which is less than 20% of $400,000.

• If Mr. Slate instead operates as a sole proprietor and earns $500,000 but does not pay any W-2 wages, his deduction is the lessor of 50% of the W-2 wages (or $0 in this example) or 20% of the $500,000. If he paid out $200,000 in wages and had $300,000 in net business income, his Section 199A deduction would be the lessor of 50% of $200,000 or 20% of $300,000.In other words, he would deduct $60,000 ($60,000 is less than $100,000, even in Canada). He would want to create an LLC, tax it as an S corporation and pay out W-2 wages to maximize his Section 199A deduction.

• If Mr. Slate instead operates as a specified service trade as defined previously, he would completely phase out of the Section 199A deduction by exceeding the income limit of $207,500 and $415,000. This is the specified service trade “gotchya.”

• If Mr. Slate was married and operated a specified service trade, and the taxable income considering all income sources (spouse, investments, etc.) exceeded $315,000 but was less than $415,000, there would be a sliding scale of deduction eligibility. Silly rabbit, tax reform doesn’t mean tax simplification.

• Fred… yes, we can’t neglect Fred… is single and operates an S Corp as an accountant. Days of busting up rocks for Mr. Slate are in the rear-view mirror. He earns $100,000 in net qualified business income after paying $50,000 in W-2 wages to himself.He is a clearly a specified service trade but because he earns less than $157,500 total ($150,000 in this example) he can take advantage of the full Section 199A deduction of 20% of $100,000. The question of reasonable salary is not being entertained here… focus on the W-2 to income relationship.

• Betty becomes a slumlord and earns $500,000 in rental income. No W-2 since she is operating the properties as an individual (and converting passive income into earned income vis a vis a W-2 would be silly). Let’s say she purchased the properties for a $1,000,000 (unadjusted basis). The math would go like this-20% x $500,000 is $100,000 (straight calculation).

50% of $0 is $0 (W-2 limit calculation).

2.5% of $1,000,000 is $25,000 (depreciable asset limit calculation).

Section 199A is limited to the lessor of $100,000 as compared to the greater of $0 (W-2) and $25,000 (depreciable assets).