If you are a business owner, your federal tax return will be due on May 17, 2021. For many of you, the most important 2020 federal income tax deduction will be the annual deduction available under Internal Revenue Code section 199A to individuals and certain types of trusts that have ownership interests in “pass-through businesses.” You must claim this deduction on Line 13 of your Form 1040. Under section 199A, which became effective on Jan. 1, 2018, pass-through businesses include sole proprietorships, S corporations and entities, including LLCs, that are taxable as partnerships under IRC Subchapter K. Employees are ineligible for the section 199A deduction. For some New Hampshire business owners, maximizing their section 199A deduction can mean the difference between business success and business failure.
I published a brief introduction to section 199A in this column several months ago, but since it’s tax time, I want to repeat briefly the points I made then and to make a few new points.
■A major factor in determining your section 199A deduction is a dollar amount described in the section as your “threshold amount.” If you’re married filing jointly, your threshold amount for 2020 is $315,000. For most individuals filing separately, it’s $157,500.
■A second major factor is whether, if your taxable income equals or exceeds your threshold amount, you are within or beyond your section 199A “phase-in range.” The phase-in range for married taxpayers is $100,000. For individual taxpayers, it is $50,000.
■More than a few tax scholars have written that section 199A is “overwhelmingly complex” — indeed, they are arguably the most complex provisions in the 200-plus pages of the Tax Cuts and Jobs Act of 2017 and in the many hundreds of pages of section 199A regulations under the section. Having written a 350-page book about the section, I can only agree.
■However, if your taxable income is less than your section 199A threshold amount for 2020, computing your section 199A deduction is likely to be fairly simple: It will be 20% of your share of the net business income of your business, capped at 20% of your taxable income less capital gains. This computation rule will apply whether your business is what section 199A calls a “specified trade or business” (an SSTB) or any other type of business, which section 199A calls a “qualified trade or business” (a QTOB). SSTBs consist of all of the classic professions except architecture and engineering. Thus, if, for example, if you are married, if you own a single-member LLC classified for federal tax purposes as a disregarded entity, if you are taxable on your single-member LLCs income as a sole proprietorship, if your business is manufacturing and selling widgets (i.e., it is a QTOB) and if your net 2020 business income is $300,000, your section 199A deduction will be $60,000 and your taxable income will be $240,000. And this will also be true if your business is an SSTB — e.g., accounting or law.
■But if your taxable income is at or above your section 199A threshold amount, computing your section 199A deduction can suddenly become extremely difficult. For example, in order to obtain the deduction in this situation, you will probably have to conduct your business as an S corporation.
■However, if your business is an S corporation and if, as is often the case, you yourself are one of its employees, you will have to determine the maximum salary that you can pay yourself under Subchapter S “minimum compensation” rules in order to maximize your company’s W-2 wages and thus your section 199A deduction. But you must balance this determination with Social Security Tax considerations, New Hampshire Business Profits Tax considerations, and factors concerning any contributions you may want to make to a federally tax-favored qualified retirement plan.
■Furthermore, if your business is an SSTB and if your taxable income is within your phase-in range, your section 199A deduction may be subject to a significant reduction, and if your taxable income exceeds your phase-in range, you’ll receive no section 199A deduction at all.
■Indeed, whether your income is below, at or above your section 199A threshold amount, you may have to undertake significant restructuring of your business to maximize your section 199A deduction, such as, in the case of taxpayers whose threshold amount is less than their threshold amount, transforming their business from an entity taxable as an S corporation to one taxable as a partnership. And in some cases, in order to maximize it you and your partner will have to get married! (Seriously.)
■Finally, it is important for you to be aware that the tax preparation software that every accountant uses to prepare client tax returns and that you yourself undoubtedly use if you prepare your own returns may not compute your section 199A deduction accurately. And no tax prepare software will deal with your possible need to restructure your business or personal arrangements to maximize your section 199A deduction.
If you’re still not convinced that section 199A is a complex as I’m suggesting, may I suggest that you take a look at section 199A(b)(3)(B)(i). But first take an aspirin or two. (Just kidding.)
Or, to be more practical, may I suggest that before your file your 2020 federal tax return, you consult about your Line 13 claim with an accountant who has a comprehensive knowledge of section 199A.