The Tax Cuts and Jobs Act of 2017 legislation passed into law on 12-22-17 has a provision in it that allows for a reduction in taxable income for self-employed individuals who are sole proprietors or who have incorporated themselves as LLC’s, subchapter S-Corp’s or partnerships. It is contained in “Section 199A”.
This was included because during the legislative process there were complaints that the corporate tax rate cut from 35% to 21% would only benefit companies organized as “C” corporations and this was unfair to small business owners who make up a larger share of the economy.
The Section 199A deduction is designed to help businesses that provide a product through the use of labor as opposed to a company that provides a service through the use of capital, generally speaking. These types of companies are categorized as “qualified trade or business” (product/labor) or “specified service trade or business” (doctors, lawyers, accountants, consultants, financial services, brokerage to name a few).
A key definition in determining if a business is a “specified service trade” is whether or not “the principal asset of such trade or business is the representation or skill of 1 or more of its employees”.
The deduction is equal to 20% of the net income (qualified business income) from the business. W-2 wages paid to an S-Corp. shareholder as “reasonable compensation” don’t get this deduction.
This deduction does not reduce adjusted gross income (AGI).
That being said, a specified service trade, such as an accounting and tax practice may qualify for the deduction if the taxable income of the business owner/taxpayer does not exceed certain “thresholds”.
For a single taxpayer, that threshold is $157,500 with a “phase out” range up to $207,500.
For a married business owner filing jointly, the threshold is $315,000 with a “phase out” range up to $415,000.
So, a married filing jointly sole proprietor doctor, lawyer or CPA would get the 20% deduction (unless the business operated at a loss) as long as the taxable income is < $315,000 and would get a reduced deduction between $315,000 and $415,000. For a “qualified trade or business” not in the service area, the 20% deduction is available even if the taxable income exceeds $415,000 for a married couple filing jointly. The deduction may be reduced by a feature called the “W-2/QP limitation” which takes into account the wages paid to employees in the business and the cost basis of “qualified property”. I’ll write more about that as more details become available.