This will be long, so apologies.
Lots of you prepare your own returns. I think that is great--seriously. I pored through the Section 199A regs last night to get a good handle on how this deduction is calculated. It is not easy. It is incredibly complex. So without further adieu, here is as concise a summary as I am mortally capable of:
First item is the taxable income limitation. Taxable income is defined as Line 7 minus Line 8 of the 1040, less any capital gains and qualified dividends included in Line 7. So, if a TP's (taxpayer) Line 7 minus Line 8 is $235,000, but included in that total is $5,000 of long term capital gain and $3,000 of qualified dividends, the maximum deduction would be 20%(235,000-5,000-3,000) or 20%(227,000) or $45,400. (Assuming MFJ)
Second item is the business income limitation. Again, 20% is the multiplier. In the above example, assume the husband is self-employed and netted $175,000 in his business. However, all deductions that are associated with this business must be deducted as well. Even though his Schedule C shows a $175,000 profit, the taxpayer also has business deductions taken elsewhere. These include the deduction for 50% of SE tax, the deduction for health insurance, and the deduction for a pension plan associated with the business owner. So, it might appear that this limitation would be .2(175,000) or $35,000. Nope. The business profit must be reduced by the SE tax deduction ($10,304), self-employed health insurance premiums (assume $12,000) and his contribution (if any) to a SIMPLE IRA or equivalent (the max SIMPLE IRA contribution in this example would be $20,348.) Accordingly, the business income limitation is (175,000-10,304-12,000-20,348)(.2) = $132,348, or $26,470.
Third item is the phase-out income limitations. For MFJ, this begins at $315,000 of taxable income and phases out at $415,000. For all others, it begins at $157,500 and phases out at $207,500. There are other strings attached to this deduction when incomes are exceed these thresholds. (1) Specified Service Trade or Business [SSTB]: These are defined essentially as professions like law, accounting, medicine, performing arts; there are others on this list. These professions do not receive this deduction if income is above these thresholds, and the deduction is limited within the phase-out brackets. (2) W-2 wages and Unadjusted Basis in Assets: If a TP has income above these thresholds, then further limitations come into play: The greater of 50% of W-2 wages paid to employees or 25% of W-2 wages plus 2.5% of the unadjusted basis in business assets. You can see that a self-employed person with a $250,000 profit and no employees and $30,000 in business assets would be limited to a $750 deduction.
Fourth item is flow-through investments like partnerships and S-Corporations. Your K-1s will reflect the salient features of this deduction to be used in calculating your deduction. These amounts are determined at the entity level, not at the taxpayer level. Be very sure that the K-1s are accurate. There are a lot of preparers out there who might make some mistakes on the K-1s. For taxpayers with multiple K-1s and a Schedule C there could be a very detailed calculation to determine the correct amount of the deduction.
Fifth item is business losses. If a TP has a profit from an S Corporation but a Schedule C loss, there are rules where these are offset to determine the deduction. An excess loss in Year 1 must be carried forward to offset any profit in the future. For those who bought a Model X this year and wrote that sucker off entirely to reflect a business loss, be aware that this loss will be carried forward to 2019 to offset your profit in your business for the purposes of determining this 20% deduction.
Sixth item is rental real estate. This one is tricky. The 469 rules do not apply. The real estate professional rules do not apply. However, in a supplement to the regs, the Service issued a "safe harbor" for rentals to be considered a 162 trade or business. The safe harbor requirements include maintaining a separate bank account for the rentals and an annual 250-hour work requirement on the rentals. The work can be done by anyone like agents, contractors, or employees as well as the taxpayer. However, accurate and contemporaneous time records must be maintained under these safe harbor regs. Investment activities like financing do not count. Tenant screening, banking, and accounting would apply. It appears to me that a person who rents a duplex would not qualify. A person who rents 3-4 rental houses equally would not apply. But if you have a commercial piece of real estate with several tenants and ongoing services like security and landscaping, you likely would reach this 250-hour threshold. It should be noted that net leases are specifically excluded from this deduction.
The final item is the accuracy-related penalty for understatement of income under 6662. Generally, this penalty applies when the understatement of tax is 10% or $5,000, whichever is greater. However, code section 199A tweaked this penalty just for this deduction by replacing 10% with 5%. The penalty is 20% of the tax understatement. I read this section as applying to any tax return that claims the 199A deduction. In other words, you may have correctly figured the 199A deduction, but you messed up elsewhere on your return. Bam! the threshold for the 20% accuracy penalty is reduced to 5% instead of 10%.
I am not shilling here, nor am I trying to frighten anyone. But I have seen enough bad returns over the years by do-it-yourselfers that were just wrong. But many of us like to get our returns done promptly and move on with our lives. There is no guarantee that TurboTax or any of the other programs out there will prepare an accurate return for you if you are unclear on how to answer their questions. I suggest that if your returns appear to be complicated, go on extension. Pay any estimated amount due with the extension, plus a cushion (you can always have any overpayment refunded or applied to 2019). Then engage a local professional after filing season to review your return. It might be worth it to have someone else's eyes spend an hour going over your work and giving it his or her blessing.
Lots of you prepare your own returns. I think that is great--seriously. I pored through the Section 199A regs last night to get a good handle on how this deduction is calculated. It is not easy. It is incredibly complex. So without further adieu, here is as concise a summary as I am mortally capable of:
First item is the taxable income limitation. Taxable income is defined as Line 7 minus Line 8 of the 1040, less any capital gains and qualified dividends included in Line 7. So, if a TP's (taxpayer) Line 7 minus Line 8 is $235,000, but included in that total is $5,000 of long term capital gain and $3,000 of qualified dividends, the maximum deduction would be 20%(235,000-5,000-3,000) or 20%(227,000) or $45,400. (Assuming MFJ)
Second item is the business income limitation. Again, 20% is the multiplier. In the above example, assume the husband is self-employed and netted $175,000 in his business. However, all deductions that are associated with this business must be deducted as well. Even though his Schedule C shows a $175,000 profit, the taxpayer also has business deductions taken elsewhere. These include the deduction for 50% of SE tax, the deduction for health insurance, and the deduction for a pension plan associated with the business owner. So, it might appear that this limitation would be .2(175,000) or $35,000. Nope. The business profit must be reduced by the SE tax deduction ($10,304), self-employed health insurance premiums (assume $12,000) and his contribution (if any) to a SIMPLE IRA or equivalent (the max SIMPLE IRA contribution in this example would be $20,348.) Accordingly, the business income limitation is (175,000-10,304-12,000-20,348)(.2) = $132,348, or $26,470.
Third item is the phase-out income limitations. For MFJ, this begins at $315,000 of taxable income and phases out at $415,000. For all others, it begins at $157,500 and phases out at $207,500. There are other strings attached to this deduction when incomes are exceed these thresholds. (1) Specified Service Trade or Business [SSTB]: These are defined essentially as professions like law, accounting, medicine, performing arts; there are others on this list. These professions do not receive this deduction if income is above these thresholds, and the deduction is limited within the phase-out brackets. (2) W-2 wages and Unadjusted Basis in Assets: If a TP has income above these thresholds, then further limitations come into play: The greater of 50% of W-2 wages paid to employees or 25% of W-2 wages plus 2.5% of the unadjusted basis in business assets. You can see that a self-employed person with a $250,000 profit and no employees and $30,000 in business assets would be limited to a $750 deduction.
Fourth item is flow-through investments like partnerships and S-Corporations. Your K-1s will reflect the salient features of this deduction to be used in calculating your deduction. These amounts are determined at the entity level, not at the taxpayer level. Be very sure that the K-1s are accurate. There are a lot of preparers out there who might make some mistakes on the K-1s. For taxpayers with multiple K-1s and a Schedule C there could be a very detailed calculation to determine the correct amount of the deduction.
Fifth item is business losses. If a TP has a profit from an S Corporation but a Schedule C loss, there are rules where these are offset to determine the deduction. An excess loss in Year 1 must be carried forward to offset any profit in the future. For those who bought a Model X this year and wrote that sucker off entirely to reflect a business loss, be aware that this loss will be carried forward to 2019 to offset your profit in your business for the purposes of determining this 20% deduction.
Sixth item is rental real estate. This one is tricky. The 469 rules do not apply. The real estate professional rules do not apply. However, in a supplement to the regs, the Service issued a "safe harbor" for rentals to be considered a 162 trade or business. The safe harbor requirements include maintaining a separate bank account for the rentals and an annual 250-hour work requirement on the rentals. The work can be done by anyone like agents, contractors, or employees as well as the taxpayer. However, accurate and contemporaneous time records must be maintained under these safe harbor regs. Investment activities like financing do not count. Tenant screening, banking, and accounting would apply. It appears to me that a person who rents a duplex would not qualify. A person who rents 3-4 rental houses equally would not apply. But if you have a commercial piece of real estate with several tenants and ongoing services like security and landscaping, you likely would reach this 250-hour threshold. It should be noted that net leases are specifically excluded from this deduction.
The final item is the accuracy-related penalty for understatement of income under 6662. Generally, this penalty applies when the understatement of tax is 10% or $5,000, whichever is greater. However, code section 199A tweaked this penalty just for this deduction by replacing 10% with 5%. The penalty is 20% of the tax understatement. I read this section as applying to any tax return that claims the 199A deduction. In other words, you may have correctly figured the 199A deduction, but you messed up elsewhere on your return. Bam! the threshold for the 20% accuracy penalty is reduced to 5% instead of 10%.
I am not shilling here, nor am I trying to frighten anyone. But I have seen enough bad returns over the years by do-it-yourselfers that were just wrong. But many of us like to get our returns done promptly and move on with our lives. There is no guarantee that TurboTax or any of the other programs out there will prepare an accurate return for you if you are unclear on how to answer their questions. I suggest that if your returns appear to be complicated, go on extension. Pay any estimated amount due with the extension, plus a cushion (you can always have any overpayment refunded or applied to 2019). Then engage a local professional after filing season to review your return. It might be worth it to have someone else's eyes spend an hour going over your work and giving it his or her blessing.
