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S Corp Section 199A Deduction Examples
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-
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!
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).
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