By now you must have heard about the 20% deductions for businesses, right? However, you must hold your horses – you cannot get too excited about it yet because, on August 8, 2018, the IRS issued new rulings for the 20% deduction provision that will impact small businesses as well as sole proprietorships, partnerships, trusts, and S corporations.
What Is Section 199A Deduction?
The Section 199A deduction was created under the Tax Cuts and Jobs Act and is applicable for the tax years commencing after Dec. 31, 2017. All the taxpayers who are eligible for this deduction can claim the Section 199A deduction while filing the 2018 income tax return in 2019.
Who Is Eligible For The Section 199A Deduction?
The Section 199A deduction is available to taxpayers whose taxable incomes are below $315,000 for joint returns (married couples filing jointly) and $157,500 for single individuals. If the taxable income exceeds this limit, the deductions will be subject to limitations.
Business incomes that qualify for the deduction include domestic income generated through business/trade. One cannot include capital gain, employee wages, and interest and dividend income here.
Exception: Section 199A deduction is not applicable for specified services or businesses such as lawyers, doctors, and other such specialist professions if their taxable income exceeds $207,000 (for single filers) and $415,000 (for married couples filing jointly).
“Crack and Pack” No Longer Stands
Before the IRS passed the new ruling, businesses that usually didn’t qualify for the Section 199A deduction owing to the fact that they hold the “specified services” tag and exceeded the specified taxable income threshold, would split themselves into two companies. In this way, the new entity created by a firm would be eligible for the Section 199A deduction since it is no longer a part of the “specified service.” This technique is known as “Crack and Pack.”
However, the new ruling of the IRS has eliminated the ‘crack and pack’ strategy. If two organizations (a foundation entity and a newly created entity) have a common relationship, then both the entities will be considered as a “specified service trade or business” and hence, neither would be eligible for the tax deduction.
Furthermore, now enterprise employees cannot leave their job roles at a said enterprise/firm to become an independent contractor and be rehired by the same enterprise to qualify for the Section 199A deduction. According to the new provision of the IRS, if an individual has worked under an employer and later assumed the role of an independent contractor for the same employer with his/her job description remaining the same, then it is assumed that he/she still retains their status of an employee. In fact, by doing so one will only manage to complicate your tax situation because when you break off from a firm to become an independent contractor, you become liable for bearing all the tax responsibilities associated with running a personal business. Tim Steffen, CPA and Director of Advanced Planning at Robert W. Baird & Co., explains this:
“The self-employment tax, the need to file a separate tax return for the entity, depending on how you set it up? All of that still applies…You might’ve unnecessarily complicated your life without the upside of the exclusion.”
How To Reduce Your Taxable Income?
There are still many ways to reduce your taxable income to become eligible for the Section 199A deduction. For instance, you can legally reduce both your taxable income and AGI by investing/contributing to retirement funds such as IRAs. Also, you can make charitable contributions either directly to any charitable institution or through a donor-advised fund.
So, whatever step you choose to take to claim the 20% deduction, you have to measure your steps carefully while adhering to the new norms set by the IRS.