Analyzing the service provider K-1 in light of section 199A
INSIGHT ARTICLE |
If you operate a service business and file your taxes as an individual, you may be able to take some additional deductions. New rules that took effect under section 199A of the tax code stipulate provisions for some specified service or trade businesses, known as SSTBs.
When analyzing the effect of the section 199A qualified business income deduction for an individual taxpayer, a key question is whether the entity reporting the pass-through income is conducting a SSTB.
An SSTB is generally defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services including any business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests or commodities.
Many taxpayers and tax professionals mistakenly believe that income from an SSTB is never eligible for the 20% deduction. While it is true that income from an SSTB is subject to less favorable treatment under section 199A, there may still be opportunities for some taxpayers to take advantage of the 20% pass-through deduction.
In many cases, the determination of whether a taxpayer with income from an SSTB is eligible for the deduction is relatively straightforward and is determined based on the individual’s total taxable income. See the various scenarios summarized below.
Taxable income is less than $321,400 married filing joint, or less than $160,700 filing single: Income from an SSTB is eligible for the 20% pass-through deduction. The tax preparer can simply multiply the qualified business income (QBI) reported on the K-1 by 20% in order to determine the tentative QBI deduction. While the regulations require that a K-1 disclose various pieces of information relevant to the section 199A deduction, there is no need for the Form 1040 preparer to analyze the amount of wages or fixed asset base when computing the deduction.
Taxable income falls between $321,400 and $421,400 MFJ, or between $160,700 and $210,700 filing single: Income from an SSTB is eligible for the 20% pass-through deduction; however, the deduction will be limited. In order to determine the proper deduction the tax preparer must do the following:
Step 1: Initial determination
- Determine 20% of QBI
- Determine your limitation factor, which is the greater of:
- The W-2 wage limitation (50% of W-2 wages)
- The combined asset base and wage base limitation (2.5% asset base + 25% W-2 wage base)
- Take the lessor of #1 and #2
Step 2: Specified service modification percentage
- If your taxable income exceeds the $160,700 ($321,400 MFJ) threshold, but does not exceed the threshold plus $50,000 ($100,000 MFJ), determine percentage by taking the difference of your taxable income and the threshold, and divide by $50,000 ($100,000 MFJ).
- Take the difference between 100% and the percentage derived in #1 above. This is your specified service modification percentage.
Step 3: Calculate QBI deduction
- Take the difference of #1 and #3 from your initial determination and multiply by your specified service modification percentage.
- Add #1 above to #3 from your initial determination.
- Multiply #2 above by your specified service modification percentage.
This is your tentative QBI deduction*
Taxable income exceeds $421,400 MFJ or $210,700 single: Income from an SSTB is not eligible for the 20% pass-through deduction. While the regulations require that a K-1 disclose the various pieces of information relevant to the section 199A deduction, there is no need for the Form 1040 preparer to analyze the amount of wages or fixed asset base allocated by the SSTB to the individual taxpayer.
Remember that guaranteed payments do not qualify for the section 199A deduction under any circumstance.
Also, remember that the same rules apply to SSTB income that is reported by a sole proprietor on a Form 1040 Schedule C.
As you can see from the scenarios above, there are opportunities for income from an SSTB to qualify for the 20% section 199A deduction. The availability and the amount of the section 199A deduction will be based on the individual’s overall taxable income. This creates potential tax planning opportunities for professionals that earn income from a trade or business that is classified as an SSTB.