Note: More detailed instructions appear below the calculator but you can probably use numbers from your 2024 or 2025 tax returns to calculate the new formula’s effect on your Section 199A deduction.

Using the Big Beautiful Section 199A Calculator

To use the Section 199A calculator, follow these steps:

1. (Optional) Replace my very rough estimates of the thresholds for phasing in the Section 199A limitations–$200,000 for single filers and $400,000 for married filers–with better numbers if you have them. (The Treasury will provide better numbers for 2026 later in 2025 if the Big Beautiful Tax bill passes and thereby perpetuates the Section 199A deduction.)
2. Enter an M or an S into the Filing Status box to incidate your tax return filing status.
3. Enter or estimate your taxable income using the Taxable Income box.
4. Describe your non specified service trades or businesses qualified business income, W-2 wages and depreciable property boxes. Note that if you’ve aggregated your non-SSTB businesses, the calculator should work fine. If you have multiple, un-aggregated businesses, it may not work accurately. Sorry.
5. Provide your total specified service trade or business (SSTB) income. You should be able to aggregate all your SSTBs into a single number.
6. Click Calculate.

Tip: For more information about how the new Section 199A formula works, take a peek at this blog post: The New Big Beautiful Section 199A Deduction.

A final caution: Assuming the Big Beautiful Tax bill passes Congress, it’ll be months before the Treasury can issue updated regulations. Thus, consider the Big Beautiful Section 199A calculator’s numbers rough estimates.

The post Big Beautiful Section 199A Calculator appeared first on Evergreen Small Business.

But so you can plan how this new deduction will work in your situation? This short blog post explains the mechanics.

To give you a big picture overview here at the very start? The two main features of the new deduction formula are (1) the tax savings are a little bigger. And then (2) for business owners with limited deductions due to W-2 wages or status as a specified service trade or business, the limitations phase-out more slowly.

The actionable insight here: If the law passes, you want to verify your now larger and better Section 199A deductions are optimized.

New Formula Applies to Tax Years Starting in 2026

A first important note? The Big Beautiful Section 199A deduction applies for tax years beginning after December 31, 2025.

Also, the new Section 199A deduction is permanent. (The current version essentially expires at the end of 2025.)

Percentage Bumps Up from 20 Percent to 23 Percent

The deduction percentage rises from 20 percent to 23 percent.

Example 1: The original Section 199A deduction formula gave a taxpayer with $1,000,000 of qualified business income a $200,000 deduction (potentially.) The big beautiful Section 199A deduction gives that taxpayer a $230,000 deduction (again potentially.)

Note: A limitation exists for both the original and the new version of the Section 199A deduction. Taxpayers get that 20 percent or 23 percentage deduction on the lessor of their qualified business income or on their ordinary (so not long-term capital gains or qualified dividend) taxable income.

Limitations Phase-in Differently

Both the original and new version of the Section 199A deduction limit the deduction for taxpayers with taxable incomes above a threshold amount based on W-2 wages, the unadjusted (before depreciation) basis of depreciable property, and then based on the trade or business falling into a specified service trade or business category like healthcare, law, consulting, and so forth. (People call these SSTBs.)

But the new law changes the “speed” at which the limitations occur. This decreases the marginal tax rate these limited taxpayers pay. (Under the current formula, the marginal tax rate in worst case situations can approach 70 percent.) Mechanically, how this works is confusing. But essentially taxpayers calculate two Section 199A deduction amounts and then use the smaller amount as their tentative deduction.

Note: We’ve got a simple JavaScript calculator here, “The Big Beautiful Section 199A Calculator,” which you can use to make the calculations. But maybe finish reading this post so you understand what’s going on with the formulas.

Step 1 in New Section 199A Limitation Calculation

The first step in determining the Section 199A deduction? The formula calculates the Section 199A deduction looking just at the non-SSTB qualified business income.

It calculates this first potential Section 199A deduction as the lessor of 23 percent of either the qualified business income or as a “limited” amount based on the W-2 wages and original cost of depreciable property. (This is the same formula as in the original version of Section 199A. The formula limits the deduction to the greater of either 50 percent of the business’s W-2 wages or 25 percent of the W-2 wages plus 2.5 percent of business’s depreciable property using the unadjusted basis immediately after acquisition). But let’s work through an actual example.

Example 2: Thomas, a single taxpayer, owns two businesses which each make a $1,000,000 a year: a farm and a law firm. The farm pays $300,000 of wages and uses $400,000 of depreciable machinery. Thus, the first version of the formula ignores the law firm because it’s a specified service trade or business. It only calculates the Section 199A deduction on the farm. This non-SSTB deduction equals the lesser of either 23 percent of the $1,000,000 of qualified business income ($230,000)… or the greater of 50 percent of the wages ($150,000) or 25 percent of the wages ($75,000) plus 2.5 percent of the $400,000 of machinery ($10,000) so $85,000 in total. Thus, the non-SSTB Section 199A deduction equals $150,000.

Step 2 in New Section 199A Limitation Calculation

The second step in determining the new Section 199A deduction works like this. The formula tentatively calculates the Section 199A deduction as equal to 23 percent of all the qualified business income from both non-SSTBs and SSTBs. Then this version of the formula limits this deduction if a taxpayer’s taxable income rises above a threshold amount. Specifically, the formula subtracts an adjustment equal to 75 percent of the amount by which taxable income exceeds the Section 199A phase-out threshold.

In 2025—so the year before the Big Beautiful Section 199A deduction takes effect—the threshold amount equals $197,300 for single filers and $394,600 for married filers. Roughly then, in 2026, the threshold amounts should equal $200,000 for single filers and $400,000 for married filers. (If the Big Beautiful Tax Bill passes, Treasury will probably provide the actual 2026 threshold numbers in late 2025.) But let’s just work through an example using my guesses as to next year’s threshold amounts.

Example 3: Again, Thomas owns two businesses, a farm and a law firm. Both make $1,000,000 a year. Th second version of the Section 199A deduction therefore equals 23 percent of the $1,000,000 of farm income ($230,000) plus 23 percent of $1,000,000 of law firm income ($230,000)… so that’s $460,000… thenthe formula subtracts 75 percent of the taxable income Thomas earns in excess of the single filer’s threshold. If that threshold equals $200,000 and his taxable income equals $1,000,000 due to other deductions he claims? The excess equals $800,000, calculated as the $1,000,000 minus the $200,000. The adjustment amount then equals 75 percent of $800,000 excess, or $600,000. That $600,000 adjustment in effect zeros out the second version of Section 199A deduction which equaled $460,000.

In the end, the limited big beautiful Section 199A deduction then equals the greater of the two version’s calculation results: $150,000 or $0. And that means a Section 199A deduction equal to $150,000.

Business Development Company Dividends Now Qualified Business Income

A final tweak. The new big beautiful Section 199A deduction treats dividends from electing Section 851 qualified business development companies as qualified business income, so in the same way that REIT dividends get treated. Thus, this income produces a Section 199A deduction.

About the Inflation Adjustment

And a postscript: When I asked ChatGPT to review my draft for this post, it suggested I point out one other tweak: The new law resets the base year for inflation adjustments to 2025 so taxpayers don’t lose several years of CPI increases. Which is a good point.

The post The New Big Beautiful Section 199A Deduction appeared first on Evergreen Small Business.

Note: In the first part of this discussion, Using ChatGPT in a Small Business, I talked about how we’ve been using ChatGPT in our small CPA firm. That post amounted to a laundry list of tasks and projects we’ve used ChatGPT for.

ChatGPT Tip #1: Start Today

My first tip. Start today. In fact, before you read another paragraph, open your browser, enter chatgpt.com into the address box, click the Signup button, and then follow the on-screen instructions. Sign up for the $20 a month option to start.

Once you’ve done this, start using ChatGPT in place of the Google or Bing search engine. And start asking it the questions you might have in past asked a friend, a co-worker, or some online forum.

ChatGPT Tip #2: Use Detailed Prompts

You know how to use a search engine like Google. And ChatGPT sort of works the same way. You can type in a simple question.

But what you want to do with ChatGPT? Provide much more detail. My typical initial prompt probably runs 100 to 200 words. I provide background information. I explain my current understanding. If appropriate, I may cite or quote sources like a blurb from an Internal Revenue Code statute or from a Treasury Regulation. I also provide instructions for ChatGPT. I might ask for it to provide links to its source, for example. Or for a table that summarizes its analysis or its answers.

Think about the instructions you might provide to an entry-level employee. Or someone very smart but also very new to their job or role. That’s the level of detail or instruction you and I want to use.

ChatGPT Tip #3: Ask Follow-up Questions

You’re going to want to ask follow-up questions. Lots of them.

For example, maybe you realize with your first prompt and ChatGPT’s response, that you didn’t phrase things correctly. Or that you weren’t precise enough in your instructions. Ask ChatGPT for more information. Or to redo its work. Or ask for clarification about some bit of its response.

I’ve found ChatGPT so “human-like” in its response, that I’m inclined to treat it as I would treat a human. But what counts as good manners when interacting with a co-worker or professional? Like not re-asking nearly the same question ten times in a row? That’s not the right approach with something like ChatGPT. Rather with ChatGPT, you or I probably do want to ask numerous follow-up questions all based on slightly different wordings of the facts.

ChatGPT Tip #4: Watch for Errors

ChatGPT makes errors. And it’s hard to spot them because it does such an articulate job when it writes its answers. Also, most of the time? It gives you or me a good answer. I guessed in the earlier blog post ChatGPT gives the right answer maybe 80 percent of the time. And maybe that’s even too low.

But my point is, it makes mistakes. (People call these mistakes hallucinations, by the way. Because ChatGPT presents its answers or responses with seemingly unshakeable confidence.) Thus, you want to be aware of and watch for this.

By the way, often when you spot an error, you can explain to ChatGPT why you believe it made an error. And it will quickly agree. But not always.

This example from the world of tax accounting. So most small businesses can use a Section 199A deduction to avoid paying federal income taxes on the last 20 percent of their business income. However, tax law adjusts the deduction for high income small business owners if they don’t pay enough in wages or if they work in a professional service. ChatGPT probably can’t work with the adjustment formulas. (I’ve tried to get it to do this a bunch. And unless I explicitly provide the detailed steps and calculations, it stumbles again and again.)

This characteristic of ChatGPT to make errors (and of other large language model, or LLM, AIs to make errors) suggests a best practice: For really consequential chats? You and I probably want to stick to topics in which we have pretty deep knowledge.

ChatGPT Tip #5: Curate ChatGPT’s Memory

As you or I work with ChatGPT, it collects memories of business or personal facts that may matter for future discussions. Personal information such as your age, education, ethnicity, cultural background, marital status and net worth. Details about the type of business you operate including its revenues and profitability.

These memories help ChatGPT do a better job at providing you with answers and reports. But you probably want to manage and edit the information ChatGPT collects. Some information may inadvertently be incorrect. Other information may become out of date. And then some other information may be too personal to let ChatGPT use that information to infuse its answers to your questions.

You can do this curation in possibly two ways. First, you can tell ChatGPT to forget details you don’t want it to remember. (“Please ignore the information I provided about expected revenues for next year. That information was wrong.”)

Second, in the past though not currently, ChatGPT has alerted you when its memory is full. I mention this here because the feature might become available in the future. If it does, you can click a button, review its list of memories, and then remove some memories. Watch for this feature if it appears. I think it’s a good way to clean up memories that aren’t correct, up-to-date or accurate.

ChatGPT Tip #6: Use Attachments

ChatGPT lets you attach documents to your prompts. You click the plus button. It displays a dialog box that lets you point to the file. You select the Microsoft Office document, PDF or other file that should be part of the prompt.

Attachments let you provide lots of information to ChatGPT, thereby saving you from typing in a bunch of text. Also, you can include much more data when you use attachments. (ChatGPT does not at the time I’m writing this provide any firm recommendation about how much text you can enter into the text box. But it does suggest you work and it more easily works with attached, formatted documents and spreadsheets than with stuff copied or entered into the prompt box.)

And a tip here: Those JavaScript calculators I’ve been adding to our blog with ChatGPT’s help? Attachments make those possible. What I do is build a small Excel spreadsheet. Verify the spreadsheet formulas correctly make some set of calculations. Then attach the spreadsheet file to a prompt that asks ChatGPT to write JavaScript that collects the needed inputs, makes the same calculations and displays the outputs. I then copy and paste the JavaScript into a blog post.

ChatGPT Tip #7: Proceduralize Use of ChatGPT

I asked ChatGPT whether it had tips about how to begin employing an AI like ChatGPT in a small business.

Its response was lengthy, And I won’t copy and paste it here. But to generalize, it suggested creating standard procedures for using ChatGPT (for example, two-pass reviews and verification of key facts), adding explicit disclaimers to the deliverables when appropriate, recycling results when possible, and standardizing best practices.

All good ideas.

ChatGPT Tip #8: Consider p(doom)

I end with a brief discussion of p(doom), the probability that artificial intelligence creates an existential threat to humanity. I’m going to slightly redefine the term here though and focus on the possibility or probability that AI leads you or me to make some sort of catastrophic business decision or leads us down some absurdly dangerous path in our entrepreneurship or management.

Before I do that, however, let me first disclose my default bias about this sort of stuff. I’m almost always a skeptic. Seriously. To give an example that’s probably old enough to not be polarizing, I did not think there was any chance the Y2K bug would cause the power grid to fail and society to crumble. (I heard that concern from numerous, smart, well-intended friends and colleagues as the 1990s drew to a close.)

Yet I think we need to consider p(doom). Given the hallucinations an AI like ChatGPT regularly produces, given the incredibly polished, hypnotically good answers it provides, and given the supreme confidence it continually displays, we need to be careful it doesn’t send us off a cliff.

A personal example of this: Recently as part of a chat about staffing in the face of talent shortages, private equity firms muscling into the profession and then adjusting billing rates for inflation, ChatGPT recommended a tactical approach for our firm that appeared be a brilliant gamechanger.

Following its plan, we would apparently be able to massively improve our profitability. Two cups of coffee later, I was on-board.

Another cup of coffee, and I stumbled on the tactic’s terrible flaws. Boiled down to its essence, ChatGPT was suggesting we bump our prices by 50 percent more than the prices our able, smart, and highly skilled competitors charge. That tactic then would not have worked, I am pretty sure. Furthermore, the tactic irreversibly deployed very possibly would have caused our CPA firm to implode. Which counts, I think, as a p(doom) threat.

The takeaway then: Do consider p(doom) risk.

The post Small Business ChatGPT Tips and Tricks appeared first on Evergreen Small Business.

You will probably need your tax accountant’s help to do this. And you need to plan now for making this change. Or setting up the initial fiscal year correctly. But the extra year Section 199A deduction tax savings? Pretty substantial if you have a successful small business. And definitely worth considering…

Section 199A Deduction Ends for Most Taxpayers in 2025

Some quick background to start. Section 199A ends for most people at the end of 2025. But that’s because most small businesses and investors use a calendar year for their accounting.

Two things to know here. First, the actual law doesn’t say the deduction ends at the end of 2025. Rather, the law says the deduction ends for taxable years beginning after 2025. That’s why using the calendar year for your accounting—a calendar year starts on January 1—works.

Second thing to know: Most partnerships and S corporation can use or change to using another accounting, or fiscal, year. For example, most new partnerships and S corporations can use a fiscal year that starts on December 1 and ends on November 30. And many existing partnerships and S corporations can get the IRS’s permission to change to a fiscal year if the business shows seasonality in its gross receipts.

Extra Year Section 199A Deduction: Big Picture

Thus, the obvious tactic: You start a new partnership or S corporation and adopt a fiscal year. Or if possible, you change the fiscal year of an existing partnership or S corporation.

Say for purposes of illustration that a fiscal year starts on December 1 and ends on November 30. For the fiscal year that starts on December 1, 2025 and ends on November 30, 2026? Voila. You will get Section 199A deductions on essentially eleven months of business income earned in 2026.

Mechanically How This Works

You adopt an initial fiscal year or change your existing fiscal year by filing some paperwork with the IRS.

The paperwork you file depends on the method you use for establishing your fiscal year. But the simplest method, mechanically, requires you or your accountant to file a Form 8716 when you set up a new partnership or S corporation and as part of that process adopt an annual accounting period. A more complicated method works for some existing partnerships or S corporations and requires you or your accountant to file a Form 1128 and show your business’s gross receipts display seasonality.

You can and probably should file this paperwork soon. A Form 8716 that adopts a fiscal year needs to be filed for a new business before you establish another taxable year. A Form 1128 needs to be filed at the end of the first requested fiscal year.

Thus, talk to your accountant now. Adopting the initial fiscal year or making a change in a fiscal year of an existing partnership or S corporation will take time and require thinking. Given the shortages of accountants and the understaffing and processing delays at the Internal Revenue Service, you probably risk losing this opportunity if you wait.

Extra Year Section 199A Deduction Tax Savings

Roughly, you save from five to eight percent of the business income that appears on the K-1 you receive from a partnership or S corporation.

For example, a married partner or S corporation shareholder who receives $100,000 to $300,000 of business income from a partnership or S corporation probably saves between $5,000 and $15,000.

As another example, a married partner or S corporation shareholder who receives $300,000 to $600,000 of business income probably saves between $20,000 and $40,000.

Someone married with income above these amounts saves federal income taxes equal to roughly 8% of their income. At $1,000,000 of business income, the savings equal $80,000. At $10,000,000, the savings equal $800,000.

But note: The savings occur only for one year. And probably only on the income shown in box 1 of your K-1.

Thus, probably firms with business income falling under $100,000 shouldn’t do this. You and your accountant will go to extra work to “do” the fiscal year thing. The juice won’t be worth the squeeze if savings are modest.

Extra Year Section 199A Deduction Loophole Risks

The tactic described here really isn’t a loophole or “too clever by half” reading of the law.

The tactic described here relies on the last line of the Section 199A law. That chunk of the law says Section 199A “shall not apply to taxable years beginning after December 31, 2025.”

However, Congress could change that part of the law. For example, it could decide to terminate Section 199A earlier.

If Congress extends the termination date of Section 199A, you may not need to do the fiscal year thing to get a Section 199A deduction on 2026 business income. So that’s also a risk of pursuing this tactic.

Probably the biggest risks though: waiting so late that you lose the chance to adopt a fiscal year for a new partnership or S corporation. Or waiting so late that your tax accountant doesn’t have time to prepare your paperwork for changing your taxable year. Or finding you’ve waited so late that the IRS doesn’t have time to process your paperwork.

You should also know that if the IRS audits the partnership, the S corporation, or an owner? Or if the entity or an owner is involved in a appeals hearing or a tax court case—or anything like this—that may sabotage or blow up an entity’s ability to change the fiscal year in time to get an extra year of deductions.

Next Steps and Tips If You Need Help

If you’re a tax accountant exploring this tactic, you probably want to brush up on the ways Sections 199A, 442 and 444 work. Another blog post here, Section 199A(i) fiscal year change, and here, Section 199A(i) Fiscal Year Charge FAQ, may be useful as you start your refresh.

If you’re a taxpayer, again, you want to talk to your accountant ASAP. Get on her or his schedule to explore and possibly handle the paperwork.

If you’re a taxpayer but don’t have an accountant to do this work, you can reach out to our firm. We can do a consultation in many situations. And we also have time to do a limited number of fiscal year change engagements. And we might be able to do yours.

Note to people who may want our help: Please do not telephone. Please use the contact form. Also in your query indicate whether you’ve filed your first partnership or S corporation tax return or not, what accounting software you use (for example, QuickBooks, Xero, etc.), and whether your business generates most of its revenue during a two or three month “high season.” We should respond quickly with an indication of whether we can help.

The post How to Get Extra Year Section 199A Deductions appeared first on Evergreen Small Business.

For example, if you’re anticipating a big Section 199A deduction on your return? Like a $1,000,000 deduction say? Or even bigger? You can maybe save any extra $400,000, $500,000 or more in federal taxes by starting a new business using a fiscal year or by changing the fiscal year of your existing business.

Let me quickly go into the details. You can see if you agree. One comment to make up front. I didn’t always think this. When I wrote my book “Maximizing Section 199A Deductions” in 2017, I thought what I’m about to describe did not work. Now? Yeah, I do. But let’s step into the weeds.

The Statutory Language of Section 199A(i)

The first thing to look at is what the Section 199A(i) applicability “end” date language says in the actual statute. That language appears below:

(i)Termination

This section shall not apply to taxable years beginning after December 31, 2025.

You and I want to pay attention to the precise language. Section 199A doesn’t apply to taxable years that begin after December 31, 2025. So, obviously, a calendar taxable year that begins on January 1, 2025 works. We  all agree on that.

And it’s no big jump to realize, “Okay. Yeah. Starting on February 1, 2025? Or March 1, 2025? Or any other date within 2025? That works too. None of those dates begin after December 31, 2025.”

One other comment: If Congress, the writer of the law, wanted to prevent someone taking a Section 199A deduction on a fiscal year tax return that starts in 2025 but ends in 2026? It seems like it could and should have written Section 199A(i) differently. Something like this, to my mind, does the trick:

(i)Termination

This section shall not apply to taxable years beginning ending after December 31, 2025.

If you agree with what I’ve said or maybe always thought what I describe in the earlier paragraphs? You can stop reading. You know what you need to know. And you don’t need to spend any more time on this.

For people who vaguely remember reading something different? For accountants who maybe recall a training session where the presenter described things differently? Let me keep going. Because I maybe know where things went off the rails.

The Applicability Date Language of Regulation 1.199A-1(f)

The source of my initial confusion? And possibly your confusion too if you’re part of the brotherhood or sisterhood who fell down this rabbit hole? The applicability “starting” date language from the regulations works differently. And that language really triggered the fog here. That language says this:

(f) Applicability date—(1) General rule. Except as provided in paragraph (f)(2) of this section, the provisions of this section apply to taxable years ending after February 8, 2019.

(2) Exception for non-calendar year RPE. For purposes of determining QBI, W-2 wages, UBIA of qualified property, and the aggregate amount of qualified REIT dividends and qualified PTP income, if an individual receives any of these items from an RPE with a taxable year that begins before January 1, 2018, and ends after December 31, 2017, such items are treated as having been incurred by the individual during the individual’s taxable year in which or with which such RPE taxable year ends.

To summarize the general rule? The regulations apply to taxable years ending after February 8, 2019. (Not very relevant here. We’re only talking years ending after February 8, 2019 anyway.) But then the tweak that benefits taxpayers. For a non-calendar year RPE, or “relevant pass-through entity,” so a partnership or S corporation? If the fiscal year started in 2017 and ended in 2018? The Treasury gave the taxpayer a Section 199A deduction on his or her 2018 tax return.

In effect, even though the Section 199A only became effective for tax years beginning after December 31, 2017? Yeah. Christmas came early for fiscal year pass-through entities. They enjoyed the Section 199A deduction on qualified business income earned in calendar year 2017 but reported by the pass-through entity on the tax return that ended its fiscal year in 2018.

What a number of people did—me included—is apply this special rule about how Section 199A started in 2018 to how things work when it ends after 2025. Awkwardly, that reading is wrong.

A tangential note: Section 11011(e) of the Tax Cuts and Jobs Act set the applicable date of Section 199A as “taxable years beginning after December 31, 2017.”

The Obvious First Section 199A(i) Question

Let’s jump to the obvious first question: Can a relevant pass-through entity use a fiscal year or change its fiscal year and enjoy an extra year of Section 199A deduction? Answer: Maybe.

You just read what Section 199A(i) says. The section shall not apply to taxable years beginning after December 31, 2025. So that’s not a problem. But you need a way to wriggle into using a fiscal year. And two possible wriggles exist.

Wriggle #1: Section 442 says a partnership or S corporation—the two relevant pass-through entities that Section 199A applies to—can change from a calendar year to a natural year. (A natural year exists when a business generates at least 25 percent of its gross receipts in a two-month interval.)

Wriggle #2: Section 444 says a new partnership or S corporation can adopt a fiscal year that ends September 30, October 31, or November 30. (An existing calendar year partnership or S corporation probably cannot use Section 444 to change its fiscal year.)

Thus, theoretically any partnership or S corporation might be able to change its taxable year from a calendar year to a fiscal year that begins before December 31, 2025 using Section 442. New partnerships or S corporations can make a Section 444 election that begins their fiscal year on October 1, November 1, or December 1 of 2024 or 2025.

To adopt a fiscal year or make a fiscal year change, predictably, the entity must comply with requirements of Section 442 or 444. Some entities will surely fail to qualify for technical reasons. (Again, for example, note that it is not possible to move from an established calendar year S corporation to fiscal year using a Section 444 election.)

But assuming an entity does get a fiscal year to work, if an entity calculates and reports a Section 199A deduction to its owners on its fiscal year tax return that starts in 2025 but ends in 2026? Owners include a Section 199A deduction on their 2026 1040 tax return.

The Obvious Second Section 199A(i) Question

Next question: Should new pass-through entities adopt a fiscal year and should existing entities change their fiscal year (when possible) to get an extra year of Section 199A deduction?

This question seems trickier. Sure, you probably can do this in many situations. But should you? My sense is the cost of adopting a fiscal year (for a new business) or of making a fiscal year change (for an existing business) exceeds the benefit for most pass-through entities.

I think our CPA firm’s rule of thumb might be something like “you need to anticipate getting a Section 199A deduction well into six figures to adopt a fiscal year or to make changing to a fiscal year worth considering.”

Someone who enjoys a $100,000 Section 199A deduction in 2025 might possibly save $30,000 to $40,000 in federal income taxes by getting one more year. Someone who enjoys a $200,000 Section 199A deduction in 2025 might save $80,000 with one more year. Grabbing that additional savings probably makes sense.

Furthermore, someone who makes ten times that much and enjoys a $1,000,000 or larger Section 199A deduction?  They maybe save $400,000 or more in federal income taxes by getting one more year of Section 199A treatment. Grabbing that additional savings absolutely makes sense.

But the typical successful small business owner who makes, say, $100,00o? So, that guy who currently gets a $20,000 Section 199A deduction? That size deduction may save $4000 or $5000. Which sounds good and is good. But that amount may not be enough to justify the fiddling. Or the costs of the accountants.

The Timeclock is Running Out

One other factor to consider here is timing. CPA firms and pass-through entities do not have much time to prepare and file the paperwork that effects a change in the accounting year assuming they even want to do so.

To change to a Section 442 natural year that ends on, for example, April 30, 2025 (if that’s possible), one files a Form 1128. That form’s due date would typically be July 15, 2025. But you probably want to file sooner. You can and probably should file the Form 1128 on January 1, 2025

To make a Section 444 election that adopts a taxable year ending on November 30, 2025 (if that’s possible), one files a Form 8716. That form’s due date would typically be February 15, 2025. But again, you can and probably should file the Form 8716 earlier on in that first fiscal year.

All in all, then, not much time considering that most of the time between now and then is tax season.

Not Everyone Agrees Yet

A final point. Some tax practitioners probably still think you in effect look at the Section 199A regulations’ instructions about how one handles fiscal year entities that start their taxable year in 2017 to determine how you should handle fiscal year entitites that start their taxable year in 2025. (This is the stuff I talked about in the preceding discussion of Regulation Section 1.199A-1(f).)

For example, here’s the relevant blurb from the Bloomberg BNA Tax Management Portfolio, “Portfolio 537-1st: Qualified Business Income Deduction,” that talks about how the fiscal year thing affects the Section 199A deduction:

However, the regulations do not provide a similarly favorable “mirror image” rule in the case of an RPE with a taxable year beginning on or before December 31, 2025, and ending after such date. As a result, a taxpayer that is a partner or shareholder in such an RPE would not be able to take a §199A deduction with respect to amounts allocable to such taxpayer even if realized by the RPE during 2025.

The authors then provide this example:

Example 9: Assume the same facts as Example 8, except that the S corporation’s taxable year begins on November 1, 2025, and ends on October 31, 2026. A is not entitled to a §199A deduction with respect to any portion of A’s share of QBI, W-2 wages, UBIA of qualified property, and the aggregate amount of qualified REIT dividends and qualified PTP income from the S corporation for the months of November and December 2025.

But I think that’s wrong.

Again, for the record, I was originally saying the same thing (and long before the BNA tax management portfolio said it.) But now? Now I think you don’t expand the regulation’s language that tweaks the applicability start date and then apply that language to the applicability end date. Rather you look at the statute’s termination date language. The rule Congress wrote.

Other Resources about Section 199A(i) Fiscal Year Charges

For an overview of changing an accounting year of a partnership or S corporation, you may want to refer to Revenue Procedure 2006-46. (It describes the mechanics of using Form 1128 to request an accounting year change based on a natural business year.)

For instructions for making a Section 444 election, you want to refer to the Form 8716 and its instructions as well as the Form 8752 and its instructions.

We also have a Section 199A(i) Fiscal Year Change FAQ available at our CPA firm website. That appears here: Section 199A(i) Fiscal Year Change FAQ.

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Five million small businesses operate as S corporations. And surely most of those folks know the simple trick for saving money with an S corporation. You pay a low salary and avoid payroll taxes.

Too many S corporation owners, unfortunately, do not know about all the other more advanced S corporation tax planning tricks and tactics. Thus, this month’s blog post.

Basic S Corporation Trick: Avoid Payroll Taxes

To start, however, I want to review the standard, simple S corporation trick for saving taxes. Just to make sure we’re all on the same page.

And to do this, let me give a quick example where a business owner earns $100,000. I’m going to slightly round the numbers, by the way. That’ll keep this blog post more readable.

Tip: Use our free calculator to estimate S corporation tax savings for your situation: S Corporation Tax Savings Calculator

If the business operates as a sole proprietorship or a partnership and the owner realizes $100,000 of profit. He or she pays Social Security and Medicare payroll taxes on most of the $100,000. Those taxes run roughly 14%, which means about a $14,000 payroll tax. (The actual formula might work like this: a 15.3% tax on 92.35% of the $100,000. And now you see why I’m rounding numbers. And simplifying.)

If the business instead operates as an S corporation, however, tax law allows the business owner to split the $100,000 into regular employee wages and then a shareholder distributive share. The split, by the way, needs to be fair. The resulting shareholder-employee wages amount needs to be reasonable.

But if a business owner can reasonably split the $100,000 of profit into $50,000 of wages and $50,000 of distributive share, he or she halves the payroll taxes. The savings in this case run slightly more than $7,000 a year, which is great.

Too many S corporation shareholders stop there, however. Because a bunch of other powerful, more advanced S corporation tax planning tactics exist.

Trick #1: Optimize for Section 199A Deduction with Higher Wages

A first powerful technique: some business owners pay too little in W-2 wages by focusing just on the payroll tax savings. But if a business generates Section 199A qualified business income and earns its owners a high income, the owners need wages to support a full Section 199A deduction.

The Section 199A deduction, something we’ve talked about a lot through the years (see list here), allows a taxpayer to avoid paying income taxes on the last twenty percent of her or his taxable income. If a taxpayer’s income rises above a threshold amount—roughly $200,000 for a single filer and roughly $400,000 for a married filer in 2024—the Section 199A deduction can’t exceed more than 50 percent of the W-2 wages paid by the business.

Now to be clear, you can’t arbitrarily set your wages to some amount simply to optimize your 199A deduction. You need to pay yourself a reasonable salary. But in general, if you’re losing 199A deductions because you don’t have enough wages, you want to look at bumping your wages so you’re paying out 2/7ths of your profits as wages and 5/7ths as shareholder distributions.

Example: An S corporation makes $7,000,000 in profit for its owner. The owner pays herself $500,000 in W-2 wages, and those are the only wages. This approach limits her Section 199A to just $250,000. If she can reasonably bump her wages to $2,000,000, she increases her Section 199A deduction from $250,000 to $1,000,000. That bump should save her about $280,000 in income taxes.

Trick #2: Split a Specified Service Trade or Business to Requalify for Section 199A

Another 199A gambit: many high-income S corporations lose the Section 199A deduction because some part of the operation is a specified service trade or business (SSTB). These SSTBs include most of the traditional professions (but not all), performing artists, athletes, and celebrities.

But a tip? Many entrepreneurs operate multiple trades or businesses, some of which are SSTBs, and some of which are not. Often, the entrepreneurs hold these businesses in a single S corporation entity. The problem here: combining an SSTB and a non-SSTB disqualifies the entire business for purposes of Section 199A. This leads to an obvious idea: if the business owner can split one S corporation into two S corporations, that’ll often re-qualify some of the income for the Section 199A deduction.

Example: A physician owns a clinic and earns $400,000 practicing medicine. He also provides continuing medical education services in his specialty and earns $400,000 from that. If he combines those two activities in a single S corporation, he loses the 199A deduction on 100% of the $800,000 of income in all likelihood. Practicing medicine counts as an SSTB. And if half the taxpayer’s activity is SSTB-related, that taints everything. If, however, he separates the two activities into separate trades or businesses, probably using a couple of S corporations, he can get a big $80,000 199A deduction on the second non-SSTB business of providing continuing medical education. The savings here: close to $30,000 annually.

Trick #3: Elect to Pay Pass-through-entity Tax

A quick option for shareholders living in states with income taxes.

You can probably pay the state income taxes you individually owe on your S corporation profits directly from the S corporation. To do this, you make an election to pay a pass-through entity tax. And you want to do this.

Here’s why: if you personally pay the $30,000 in state income taxes on your S corporation profits, you almost surely don’t get a federal tax deduction for the payment. (Federal tax law limits the Schedule A tax deductions for state and local taxes to $10,000.) However, if your S corporation pays the $30,000 as a pass-through-entity tax, you almost surely will get a $30,000 federal tax deduction. If your federal tax rate is, say, 24%, that tweak to your tax accounting should save you about $7,200.

Trick #4: Use Tax-free Fringe Benefits

A simple gambit: you want to load as many tax-free fringe benefits onto your S corporation tax return as you can. These fringe benefits bump your shareholder-employee compensation without bumping your payroll taxes.

Example: Suppose an entrepreneur owns an S corporation that generates $100,000 of profit but wants to pay herself $50,000. That amount might be unreasonably low. But if she provides herself with $30,000 of health insurance (which counts as wages but isn’t subject to income or payroll taxes), that $80,000 of W-2 wages and fringe benefits might rise to the level of reasonable.

Trick #5: Set up a Generous Pension for Shareholder-employees

We think most small businesses want to set up good employee pension plans for rank-and-file employees. That step, especially when small firms compete for talent, makes good sense as a business practice in many situations.

But entrepreneurs also want to think about pensions as tax planning gambits they can use to not only save taxes but build wealth outside of their equity in the business.

Example: A Simplified Employee Pension (SEP) plan lets a business owner contribute up to 25 percent of their W-2 wages. Someone who pays herself $50,000 in base wages and then $30,000 in health insurance might be able to pay a $20,000 SEP contribution. This pension plan contribution in this situation probably saves payroll taxes. (With an S corporation, the SEP contribution saves both income taxes and payroll taxes.) And it also probably increases the reasonable compensation. Someone who receives $50,000 in base W-2 wages, $30,000 in health insurance benefits, and $20,000 of pension contributions arguably enjoys a $100,000 compensation package.

But higher-contribution options exist too. Inexpensive 401(k) plans in many cases not only allow for 25 percent employer contributions but let the shareholder-employee also add elective deferrals (from their W-2 wages) that in 2024 equal $23,000 for most individuals and $30,000 for folks aged 50 or older.

In special cases, an S corporation allows a shareholder-employee to set up a defined benefit plan that might allow an even larger employer contribution. Perhaps a low to mid six-figures deduction in some situations? Again, in this case, that pension benefit should count toward the reasonable compensation requirement. And as with SEP contributions and employer matching for 401(k) plans, a large defined benefit plan contribution saves not only income taxes but payroll taxes.

Trick #6: Own Partnership Interests Through an S Corporation

A partnership cannot own an interest in an S corporation. In essence, only U.S. citizens and permanent residents, and other taxpayers very similar to U.S. citizens and permanent residents can own interests in an S corporation. But this rule gets twisted and scrambled sometimes.

For example, the rule about eligible shareholders sometimes gets rephrased (incorrectly) as saying that an S corporation cannot own an interest in a partnership. But it can. Thus, if you own partnership interests in working trades or businesses and those partnerships generate self-employment income for you, you should explore with your tax advisor the possibility of setting up an S corporation and then having your S corporation own your partnership interests. That tiered structure—owning an S corporation that owns a partnership interest—will let you harvest many of the benefits of owning an S corporation already discussed on your partnership income.

A sidebar: Partnerships provide their own tax planning benefits including the ability flexibly allocate income and deductions. Thus, combining partnerships and S corporations in a tiered structure often lets you enjoy the best of both worlds.

Trick #7: Group Compatible Activities with an S Corporation

If you own an S corporation that operates an active trade or business generating strong profits and you start a new business, you need to consider making grouping elections that combine a loss-generating activity with the profitable S corporation’s activity.

Example: If you own two activities, materially participate in the one making $500,000 a year but don’t materially participate in the one losing $300,000 a year, you can’t use the $300,000 in losses to shelter any of the $500,000 of income. However, chances are good that you can find a way to group the two activities into a single activity. And that grouping will let you use your material participation in the one business for both businesses.

Predictably, the IRS requires your grouping to follow common-sense rules. We discuss those in another blog post here: Grouping Activities to Achieve Material Participation. But the general concept? The grouping needs to be timely and reflect common sense.

Trick #8: Use the Self-rental Rules to Harvest Big Real Estate Deductions

A related trick: in theory, real estate investments should allow entrepreneurs to shelter other income. Say someone owns a business that generates $200,000 of taxable income and owns a real estate property that loses $100,000 on paper due to depreciation.

A taxpayer might think he or she can use the $100,000 loss to shelter half of the $200,000 in income. However, in many cases, tax law prevents you from doing this. A specific chunk of the law, Section 469, prevents you from taking the easy obvious deduction in most cases.

A handful of ways exist to dodge the Section 469 limitations on real estate-related losses, however. And one of the most powerful ways works for profitable S corporations. If you elect to group a self-rental property with the other active trade or business using the property, the Section 469 loss limitation rules don’t apply if you set things up right.

This gambit is a little tricky. The ownership percentages of the rental property and the S corporation need to match. Also, you need to make the grouping election when you acquire the property. But done right, you can use depreciation deductions from real estate you own and use in your business to shelter that business’s income.

One other note: normally nonresidential property results in a tiny trickle of real estate depreciation deductions over basically four decades. That doesn’t do much to help with a profitable business you’re running today. You can, however, frontload your depreciation deductions using accelerated depreciation. In some cases, you might be able to immediately deduct ten, twenty, or even thirty percent of the purchase price in the year you invest.

Trick #9: Put a “Hobby” Inside Your S Corporation

Okay, I want to be very careful here. I am not saying you can operate a hobby inside your S corporation and thereby deduct hobby losses or hobby expenses. Again, not saying that…

Furthermore, for you to deduct expenses on a business tax return, you must be engaged in the activity in pursuit of profit. That’s a requirement of a little chunk of tax law called Section 183 and popularly referred to as the “hobby losses rule.”

However, some activities you engage in for profit may look like a “hobby” or an “activity not engaged in for profit” if you operate the activity outside of an S corporation. In a worst-case scenario, you lose the deductions these activities generate. Putting the income and expenses inside your S corporation may work, however.

Example: Say you do barn design and home interiors design that reflect an owner’s interest in and love of horses and all things equine. Maybe you sell your work to horse folk who can’t normally be approached or marketed to using telephone calls, email blasts, or direct mail. But you can effectively market through personal one-on-one selling if you’re riding your own horse at dressage competitions, cross country events, or hunter jumper shows.

In this case, you very likely might lose your deductions if you conduct your horsemanship activities outside your business. But if you do all this stuff “inside” an S corporation that does barn and home design work, the deduction will probably work. (For an example of how this might work, take a peek at this Tax Advisor article: Aggregating Activities to Avoid the Hobby Loss Rules.)

Trick #10: Section 1202 Qualified Small Business Stock Inside an S Corporation

A final trick to mention: some stock in C corporations qualifies as Section 1202 Qualified Small Business Stock. The attraction of this qualification? When the stock is sold, capital gain is either partially or wholly avoided as long as the requirements are met. For stock acquired after Sept 28, 2010, the exclusion equals 100% of the gain if held more than five years. (A handful of other requirements exist too.)

Stock in an S corporation can’t “be” Section 1202 stock. But some taxpayers who own S corporations have a workaround on this. A taxpayer who owns an S corporation with a valuable activity that can be spun off into a separate C corporation can often get Section 1202 for that corporation.

We’ve got a longer discussion of how Section 1202 works here: Section 1202 Qualified Small Business Stock Exclusion. But know for now that you might be able to use the Section 1202 tax planning strategy even for some activity you start up inside an S corporation.

Example: A taxpayer does contract programming as an S corporation. A few years after starting this venture, the S corporation owner working weekends also develops a software program. The S corporation then “incorporates” a new C corporation owned by the S corporation and contributes the software program to that new C corporation. Thus, the S corporation owns a C corporation that owns and sells the software program. Assume at the point the software program is contributed to that new C corporation the software program and therefore the C corporation is worth $1,000,000. Further assume the S corporation sells the C corporation for $11,000,000 five years later. In this situation, the S corporation will treat $10,000,000 of the $11,000,000 of gain as Section 1202 qualified small business stock gain and pay zero income taxes.

A Final Comment about Advanced S Corporation Tax Planning

Your existing tax advisor probably knows about all this stuff. So, if you’ve got questions or ideas you want to run by an expert, talk to her or him. (I mention this because I see too many advertisements on social media sites where someone advertising “tax strategy consulting” suggests they know something your regular tax advisor doesn’t.)

But if you don’t have access to someone expert you can easily ask about these sorts of ideas? Sure. Go ahead and reach out to our CPA firm. Here’s how to contact us: Click here. We’d be happy to discuss working with you.

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Tax increases in the bill

Here’s some good news: if you’re a small business owner or real estate investor, the Inflation Reduction Act probably doesn’t raise your taxes.

The major revenue raisers in this bill are:

• A new book minimum tax for large ($1 billion+ average book income) C corporations
• A new excise tax on stock buybacks (only applies to publicly-traded corporations)
• Extension of excess business loss limitation rules from 2026 to 2028
• Increased money for IRS enforcement

The extension of the excess business loss limitation rules will hit some real estate investors. But for most folks in this category, we think the increased money for the IRS will be the most visible and meaningful change to our tax system due to this law. As we’ve frequently noted on this blog, keeping good records and staying on top of your bookkeeping are the two most important ways to protect yourself in an audit.

Tax increases not in the bill

Back in the autumn of 2021, Democrats had proposed significant changes to the federal income tax code. In response to these proposals we wrote a blog post last September on the slow death of the S corporation, had the ideas become law.

Well, it turns out reports of the S corporation’s death were greatly exaggerated; the Inflation Reduction Act contains no changes to the net investment income tax, or NIIT. It also contains no changes to the basis step-up rules for inherited assets, no change to the unified gift/estate tax credit, and no changes to IRA contribution or distribution rules. In fact, we could write a whole laundry list of proposed changes that never found their way into the Inflation Reduction Act—and we have:

• No change to top marginal rate for individuals
• No changes to capital gains tax rates
• No “billionaire tax”
• No changes to SALT
• No changes to 199A
• No change to carried interest loophole
• No change to 21% C corporation rate
• No new limits on deductibility of interest expense for C corporations
• No changes to limit 1202 exclusions
• No changes to expand wash sale rules
• No changes to foreign tax credit
• No changes to GILTI, FDII, or BEAT

So, what else is in this bill? Well, a lot of climate change-related stuff.

Green tax incentives for real estate investors

Real estate investors may be interested in the bill’s tax incentives for green retrofits—especially if your building is in Washington State and subject to the Clean Buildings law.

For multifamily and commercial buildings: a 179D revamp

Section 13303 of the Inflation Reduction Act dusts the cobwebs off Section 179D of the tax code. The 179D deduction is, in essence, a depreciation acceleration trick similar to the Section 179 deduction small business owners are familiar with. The basic idea is if a real estate investor either (1) purchases a new energy efficient building or (2) makes a deep energy retrofit to an existing building, the investor can deduct a large chunk of the cost of that asset in the first year instead of waiting several years to deduct the cost as “depreciation expense.”

The amount a taxpayer can deduct up front is the lesser of either (1) the cost of the retrofit or (2) the result of a complex formula built around an efficiency engineering standard, ASHRAE Standard 90.1. Predictably, then, one of the rules for claiming a 179D deduction is that an independent licensed engineer (or in some cases, an architect) must certify the energy savings targets before the taxpayer can claim the deduction.

We’re not going to go into the nuts and bolts of the formula here, because really the way to claim this deduction is to hire a consulting firm staffed with tax professionals and engineers to design the retrofit to maximize the deduction for you. They’ll calculate your deduction and prepare a report for your regular tax accountant as part of that process. But here are a few key things to understand about Section 179D if you’re interested in this tax savings opportunity.

First, know that this deduction is for larger buildings: think commercial buildings, 4+ story apartment buildings, schools, hospitals, etc.

Second, know that a 179D deduction isn’t something to start thinking about when it’s time to prepare your tax return for the year. You need to decide whether you’ll claim this deduction before you begin the project. That’s because you’ll want to choose a design firm that really knows Section 179D and the ASHRAE standard it rests on, to make sure their design meets the tax law’s requirements. And if you want to claim the full deduction, not just part of it, you’ll need to be sure the building contractor you select for the construction work understands and complies with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules.

Third, for the sake of my own conscience, I feel I ought to point out that the consulting fees for calculating 179D deductions can be very expensive. And some big players have gotten into hot water after being fairly aggressive with this stuff.

Finally, this may be an odd thing for a tax accountant to admit, but there are options for funding deep energy retrofits that go beyond tax deductions and credits. For example, some sophisticated real estate investors in Seattle are experimenting with a novel transaction structure called the “metered energy efficiency transaction structure,” or “MEETS” for short. And King County recently launched a PACE loan program. Of course, we can’t endorse any particular financing idea for you if we don’t know your situation. But we want to acknowledge that there are many options to consider.

For buildings with a sunny roof: the commercial solar panel credit

Section 13102 of the Inflation Reduction Act extends the commercial tax credit for solar panels (in Section 48 of the IRC) to 2034, with a phase-out beginning in 2032. Starting January 1, 2022, your maximum tax savings will be 30% of whatever the panels cost your business or real estate activity.

Example: You install a $20,000 solar panel system on a duplex you own and lease to tenants. If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the system—so, $6,000.

That probably already sounds pretty good. But here’s where the numbers get silly. In addition to getting a (usually 30%) tax credit, Section 48 “energy property” also gets a 5-year asset life under MACRS. What’s more, the section 48 credit reduces the basis for depreciation by only half the credit amount. And while you can’t use the Section 179 deduction on any property you’ve claimed the Section 48 energy credit on, for the next few years you can likely use bonus depreciation to achieve a similar result.

So, just to put this all together: if a landlord installs a solar energy system on a building it owns and rents to tenants, or a small business installs a solar energy system on a building it owns and uses for business, not only will the IRS pay for up to 30% of the cost of the solar panels, but the panels get depreciated over just 5 years (even though in reality the panels will likely last for 25-30 years). What’s more, even though you might think the depreciable basis would be the 70% of the cost of the panel the landlord or business owner paid themselves, really the basis for depreciation is 85% of the total cost of the panels (because only ½ of the credit is subtracted from the depreciable basis). And remember, just like any other 5-year property, the depreciable basis can be (at least partially) expensed using the bonus depreciation rules, depending on what year you install and start using the property.

Now, of course Congress has attached some strings to all of this free money. The panel system must be new, not used, and it needs to be located in the United States. You’ll also need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules, or the credit is only 6%. And you must hold the property at least 5 years or the IRS will recapture the credit.

One final comment: the Inflation Reduction Act adds 10% to your solar panel credit if you install the panels in a low-income community, and 20% if you install the panels on a qualified low-income residential building project. There are also bonus credits for using domestic content and for installing panels in an “energy community” (think West Virginia coal country).

For parking lots in low income or rural areas: the EV charger credit

Section 13404 of the Inflation Reduction Act extends and modifies the Alternative Fuel Refueling Property Credit. “Alternative refueling property” includes electric vehicle charging stations, so this credit is relevant for any building owner who would like to install EV chargers in their parking garage or parking lot.

The new EV charger credit rules apply to property placed in service after December 31, 2022, and the credit expires December 31, 2032. One notable difference between the Senate Finance Committee proposal and what passed the Senate last Sunday: this credit is now only available to EV chargers installed in low income communities and rural areas. It’s also worth noting that the Inflation Reduction Act modifies section 30C to make bidirectional charging equipment and charging equipment for 2- and 3-wheelers eligible for the credit.

Example: You own a small office building in a low-income community and install 10 level 2 EV chargers in the building’s parking lot for $3,500 each (including parts and labor). If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the chargers—so, $10,500.

Predictably, there are some strings attached. The charger must be new, not used, and it needs to be located in the United States. To get the full 30% credit, you’ll need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules; otherwise, the credit is only 6%. And the credit is limited to $100,000 per item of property (that limit used to be $30,000 and it used to apply per location, not per item).

The Inflation Reduction Act keeps language in the old statute which says recapture rules “similar to” the rules of 179A apply to the credit. Section 179A has since been repealed, and the IRS never actually put out formal guidance on how the recapture rules work. All we have is an 11-page notice, IRS Notice 2007-43.

For housing developers: the Energy Efficient Home Credit

If you’re a housing developer who specializes in building energy efficient homes, you’ve probably been watching this provision in Build Ba—er, the Inflation Reduction Act—for months. But for the sake of thoroughness, we’ll note that section 13304 extended the Energy Efficient Home Credit (in section 45L of the Internal Revenue Code) to 2032, increased the credit’s size, and modified the eligibility requirements.

The old version of the credit provided $2,000 to eligible contractors for each newly constructed or “substantially reconstructed” home if the home consumed 50% less energy than a comparable dwelling unit and had a building envelope that accounted for at least 1/5 of the energy reductions. The Inflation Reduction Act increases this amount to $2,500 for homes meeting Energy Star requirements and $5,000 for zero energy ready homes, assuming the project meets new prevailing wage and apprenticeship requirements.

The new credit rules apply to dwelling units acquired after December 31, 2022.

How the credits interact with utility rebates

One final thing I’ll mention is how the tax code treats utility rebates, and how those rebates interact with the tax credits I’ve described in this blog post.

In general, utility rebates are taxable income. But section 136 of the Internal Revenue Code says a taxpayer’s gross income doesn’t include “any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure.” This section also says taxpayers can’t claim a tax credit or deduction for any amount paid for with this sort of utility rebate.

So, if you claim a rebate from your local utility for a purchase that meets the statute’s definition of an “energy conservation measure,” you won’t need to pay income tax on the amount, which is good. But you’ll also need to subtract that amount from the purchase price first before calculating any tax deductions or credits. For example, if you install solar panels on an apartment building you own and claim a utility rebate for the panels, and the rebate counts as an “energy conservation measure” under Section 136, you’ll need to subtract the rebate from the cost of the panels before calculating the credit.

The post Inflation Reduction Act: What Every Real Estate Investor Should Know appeared first on Evergreen Small Business.

Except for one thing. The deduction formula has proved way too complicated for many people to calculate.

Accordingly, this blog post. I’m going to describe how you spot a return that bungles the 199A deduction and costs the taxpayer a big refund. Then I’ll quickly identify and explain the three most common 199A errors we see on returns. Finally, I’ll explain how you can fix the errors and hopefully get the refund you or a client is entitled to.

But let’s start by pointing out how you spot the 199A deduction errors.

Spotting 199A Deduction Errors

The 199A deduction typically equals the lesser of either twenty percent of your business income. Or twenty percent of your taxable income. If your business income equals $100,000 and your taxable income (say because your spouse worked) equals $120,000, your Section 199A deduction equals $20,000.

The way to spot a 199A deduction error then? Your 1040 return should include a big qualified business income deduction amount if you have business income.

On your 2018 individual tax return—your 1040 return—the deduction appears on line 9. On the 2019 return, on line 10. And on the 2020 and 2021 tax returns, on line 13.

So, your first step? Confirm you see an appropriately sized deduction on the right line.

Why Fixing 199A Deduction Errors Matters

And then to make this point: You really want to fix 199A deduction errors on your return. The dollars add up. Quickly.

To calculate the tax savings lost from omitting the 199A deduction, you multiply your top tax rate by the deduction amount.

Someone who pays a 22% tax rate on that last chunk of their income, for example, saves $4,400 in income taxes from a $20,000 199A deduction.

And then two things to note: First, these savings occur annually. If you missed the 199A deduction on your 2018 tax return and lost a $4,000 or $5,000 refund? You probably also missed the deduction and lost the refund on your 2019, 2020 and 2021 returns. And just as bad, going forward you may be setting yourself up to miss the deduction and lose the refund in future years too.

Second, the more your business earns, the bigger the deduction and the savings. If your business earns $1,000,000 annually, for example, your top tax rate probably equals 37%, the deduction maybe equals $200,000 and the saving roughly equal $74,000. Annually. If your business earns $10,000,000 a year, the deduction maybe equals $2,000,000 and the savings roughly $740,000.

Three 199A Deduction Errors Common

The 199A formulas get complicated once you try to calculate them. Especially in high income situations.

In high income situations, the formula limits or eliminates the deduction based on the W-2 wages the business pays, the depreciable property the business owns and based on the type of business.

But ironically, the errors one usually sees? Simple stuff that’s pretty basic.

The Specified Service Trade or Business Error

The most common error we see? When either the taxpayer or the tax accountant mislabels some business as a “specified service trade or business.”

Here’s why this matters: For high income business owners and investors (basically top one percent earners), the taxpayer doesn’t get to use the deduction if the business is a specified service trade or business (or SSTB).

A long list of white-collar professions get labeled as SSTBs: Doctors, lawyers, accountants, investment advisors, consultants, and so on.

Performing artists and athletes also get labeled as SSTBs.

Further, the law says any business that relies on the skill or reputation of one or more owners? Also an SSTB.

And so what happens, really commonly, is taxpayers and their accountants play it safe and assume incorrectly that their business must be on the SSTB list. And that’s the error.

Example: Someone who does contract programming or engineering calls themselves a consultant. Consulting is by definition an SSTB. So the tax return omits the 199A deduction. And that’s an error. Why? Because tax law considers neither contract programming nor engineering to be consulting. Which the tax preparer should have spotted. But they play it safe. And the client loses a big deduction. And a big refund.

Example: Someone runs a one-person high-income business doing something really niche-y. And you’d think that has to count as an SSTB, right? How can that not be a business that’s relying on the “skill or reputation” of the one owner. But again, that treatment erroneously applies the 199A law. The “skill or reputation” label applies only to celebrities, basically, for endorsements, appearance fees, and image licensing.

By the way? The largest 199A deduction errors our office has seen? High income business owners who may be a doctor or a lawyer or may run a one-person business. So the return omits the 199A deduction. But then it turns out the business is absolutely not an SSTB.

The Qualified Business Income Error

Probably the second most common error? Miscalculating the business income, or what the tax law calls “qualified business income,” that plugs into the formula.

Taxpayers and their paid preparers, unfortunately, regularly fail to correctly identify the income that qualifies for the deduction. Because not all income counts. Playing it safe, the taxpayer or the preparer understates the qualified business income.

Two quick examples illustrate this costly error.

Example: Partnership income allocated to partners qualifies for 199A deduction treatment. But guaranteed payments? So those amounts paid to partners regardless of the partnership income? They don’t count. And neither do payments made to partners for their non-partner services. The error that bookkeepers across the country make? And that too many tax accountants make? They mis-categorize amounts paid out to partners as guaranteed payments or payments for services. Even when the amounts are not guaranteed payments and not payments for services. And that erroneous treatment zeros out the deduction and refund.

Example: Operating profits from real estate don’t count as qualified business income unless either the real estate investor qualifies as a Section 162 trade or business (a somewhat complicated analysis) or the investor uses an impractical 250-hour safe harbor formula. As a result of that complexity or impracticality, real estate investor taxpayers or their paid preparers then play it safe, skip the deduction (unnecessarily) and lose the refund.

The No Optimization 199A Deduction Error

One final error to mention: High income taxpayers can optimize their 199A deduction by making different accounting choices. Why this works? For high income taxpayers, the 199A formula looks at the W-2 wages the firm pays domestic employees. The formula also looks at the depreciable property the firm owns.

When the 199A deduction formula does consider other factors like domestic W-2 wages and depreciable property? A business owner can often legitimately boost the 199A deduction by restructuring parts of the business.

Example: If the W-2 wages paid by a high income taxpayer’s business limits the 199A deduction, the firm may be able to bump its 199A deduction and get a refund by hiring someone who previously has worked as an independent contractor. Or by moving an employee working outside the country to the US.

Steps for Fixing 199A Deduction Errors

So the good news? You can often fix the 199A deduction errors your return includes. Which means you can probably go back and claim refunds. In many cases, big refunds.

For errors like a mislabeled SSTB and understated qualified business income, for example, you can amend the erroneous returns. Every business should be able to amend their 2019, 2020 and 2021 tax returns if already filed.

Some businesses—those who filed their 2018 return on an extension—can probably amend their 2018 return too to fix 199A deduction errors. And then get a big refund.

The no optimization error? That’s something you can’t go back in time for. But the good news is, the 199A deduction will be available for your 2022, 2023, 2024 and 2025 returns. So even if you’ve missed an opportunity to optimize during the last four years? You can at least bump your tax savings for the next four years.

If you do think you need to amend or optimize, I’d say contact your current tax advisor.

If she or he or they don’t have the expertise to fix the problems they’ve possibly had a hand in creating? Talk to a firm that can help you with this.

And by the way? We are accepting clients again now that it’s May. So, sure, we’d love to hear from you. (How to start working with us.)

Other Section 199A Resources

We’ve got a blog post that explains and discusses all the common mistakes people make here: Rookie 199A Mistakes.

For partnership situations, if that’s what you need to fix or address, this blog post might help: Salvaging Partnership 199A Deductions.

For an example of how tax accountants can mislabel a business as a specified service trade or business, see this blog post: Physician 199A Deductions Can Work (If you know the rules).

The post 199A Deduction Errors Cost Small Businesses Big Refunds appeared first on Evergreen Small Business.

That misconception? That distributions from partnerships, S corporations and other pass-through entities get taxed. (They usually don’t, by the way.)

The misconception regularly leads to a minor financial tragedy. Because often times a business owner sits on a huge cash balance in their business checking account. That money, they actually need to use on, you know, life things like rent or mortgage payments, insurance, taxes, day care, food, clothing, vacations and so forth.

But the business owner doesn’t want to distribute the profits. Because she or he fears paying tax on the money. Which is ironic. And wrong.

So this article explains what’s going on here. I’ll discuss what you get taxed on. When you get taxed. I’ll explain how the mysterious thing the accountants call “basis”works. And then I’ll end with a warning about a common error you want to avoid because it unnecessarily triggers additional taxes.

To start, a quick discussion about taxable income and basis…

Taxable Income from Your Business

Each business entity type calculates taxable income in basically the same way. Taxable income equals taxable revenues minus deductible expenses. This number gets reported in box 1 of the K-1 form you receive from the business, which in turn gets plugged into and taxed on your individual 1040.

For example, you start a business at the beginning of the year and collect $100,000 of revenues and pay $50,000 of deductible expenses.  Your business’s taxable net income at the end of the year equals $50,000. Suppose you only used the revenue you collected to pay the business expenses and now have $50,000 in your business checking account.

Money left over in the bank is the confusing part. Because you might think you avoid taxes on this money if you leave it in the business. And that you only pay taxes on the money when you take it out of the partnership or S corporation or sole proprietorship.

But that’s not the way the accounting works. You pay taxes on the business profit. Not, usually, on the distributions of profit paid to an owner.

Now let’s have a quick chat about basis.

Basis and Why It Matters

I want this discussion to remain as simple as possible. (If you would like to dive deeper, you can read the statute for S Corporations here and the statute for Partnerships here.) But to generalize, a business owner’s basis consists of the cash and adjusted-for-depreciation cost of property contributed to a business, adjusted for certain items that increase and decrease said basis.

Let’s look at the common increases and decreases…

Increases to Basis:

• Contributions of cash and property into the business
• Taxable income from the business
• Sale of appreciated property the business owns
• Non-taxable income (think PPP and EIDL grants)
• Recourse and qualified non-recourse debt for partnerships
• Partner loans to the business
• Credit cards used for business issued personally to the shareholder for S Corporations

Decreases to Basis:

• Distribution of cash and property from the business
• Loss from the sale of property the business owns
• Non-deductible expenses (meals, entertainment, etc.)
• Decreases in partner loans and decreases in recourse and qualified recourse debt
• Payments made by the business to pay off S Corporation owner owned credit cards

The general rule: As long as you have basis, you pay no taxes on distributions. Which is why basis matters.

Examples Show How Mechanics Work

But the problem here? Basis constantly fluctuates from year to year. That reality means you or your accountant need to carefully track the basis each tax year in order to know whether distributions trigger tax.

Let me show you some examples so you see how this works.

Example 1

Let’s circle back to our example where you earned $50,000. Pretend you spent no money funding the startup for this business because there is little to no overhead.

Your basis at the beginning of the year is $0.00. The $50,000 of net income increases your basis by $50,000. Now what?

You can take the total $50,000 as a distribution and pay $0.00 in taxes. In this case, your basis at the beginning of year 2 is $0.00. Remember, your basis increased by the net income of $50,000 (what you paid tax on), and decreased by the distribution of $50,000.

Alternatively, you decide to leave the whole $50,000 in the business in year 1.  Maybe you are living off of savings.

But remember, you are still taxed on $50,000 of income, regardless of where the money goes.

By the way? If in year 2 the business loses $25,000 and you never extracted any profits from year 1? You can still distribute $25,000 to yourself tax free at the end of the year, so year two, ending year 2 with $0.00 basis.

Example 2

Another example. You start your business with a personal contribution of $100,000.  You use the money to buy some equipment, lease an office space, and hire an employee.  Year 1 net income equals $200,000, and you distribute $100,000 to yourself to pay your personal expenses.  Your basis looks like this:

Year 1

You pay tax on $200,000 of income, the distribution is tax free, and you end the year with $200,000 of basis.

Year 2 profits are down a bit, and net income equals $50,000 for the year. You took the same distribution of $100,000, and your basis at the end of the year is $150,000.

Year 2

Year 3 you try to aggressively expand and require more capital to do so. Your business secures a $500,000 loan to pay for more equipment, employees, advertising and general overhead. This year you are also purchasing an investment property to take advantage of the deductions offered by a short term rental.

The aggressive expansion is a success, and you end the year with $200,000 of net income. But you had to distribute $400,000 to yourself to put a down payment on your rental property and pay the same living expenses. Whoops, now part of your distribution is taxable. Lets break it down:

Year 3

You probably noticed that doesn’t foot out. And it’s because basis can’t dip below $0.00.

In this third year, you are taxed on $200,000 of net income (taxed at ordinary income tax rates) and are left with $350,000 that can be distributed tax free.

But the additional $50,000 of distribution?  This is called “a distribution in excess of basis.” The $50,000 of distribution which you do not have basis for becomes a capital gain and gets taxed at capital gains rates.

Guaranteed Payments or Distributions?

One final important point. I want to discuss a mistake we often see on partnership returns.

Distributions to partners are commonly but incorrectly coded as guaranteed payments.  And this can have negative income tax consequences.

But first, a little background on guaranteed payments. A company uses guaranteed payments to incentivize a potential partner to join a partnership, most often in professional service firms. The partnership pays a specified amount to the partner each year, regardless of how the company performs. Their payment is “guaranteed,” kind of like a salary.

However, a majority of partnership agreements I read have no clause for guaranteed payments. And still, tax preparers frequently incorrectly code distributions as guaranteed payments.  Why does this matter?

Reason #1

Guaranteed payment income is not eligible income for the Section 199A, Qualified Business Income Deduction (QBID).  The partner forfeits a 20% deduction because their distribution is coded incorrectly.

Reason #2

Limited partners are not subject to self-employment taxes.  But guaranteed payments are subject to self-employment taxes.  A limited partner unnecessarily pays an additional 15.3% in taxes when their distribution is incorrectly coded as a guaranteed payment.

Pretend a tax preparer codes a $50,000 distribution as a guaranteed payment.  The partner pays income tax on $50,000 instead of $40,000 by missing out on QBID.  Assume a 25% tax rate and that’s an additional $2,500 they pay in income taxes.

Additionally, the partner pays $7,065 ((92.35% x 50,000) x 15.3%) of self employment tax on the $50,000!

The point I’m trying to make is you want to get this right for partners.

Final Thoughts

I hope this clears up some confusion on what actually gets taxed when a flow-through business generates profits.  And also that the discussion not only eases your anxiety about taking distributions–but allows you to avoid the one or two bookkeeping blunders that trigger tax.

The post Why Profit Distributions Usually Don’t Get Taxed appeared first on Evergreen Small Business.

The strategy? Convert guaranteed payments to qualified business income, or QBI. Which should cut someone’s income taxes by about a quarter.

Accordingly, this week, the Tax Strategy Tuesday blog post discusses this gambit. And its mechanics. And note that at the end of this post, additional information resources appear.

Tip: If you’re interested in other tax strategies, click here: Tax Strategy Tuesday.

But let’s start by giving a nutshell description of the strategy…

Convert Guaranteed Payments into QBI Tax Strategy in Nutshell

You perhaps know this, but if a partnership pays a partner some amount and calls that disbursement a guaranteed payment, the partner pays income taxes on the full amount.

Example: Dolly works as a physician in a group medical practice operating as a partnership. As a partner, she receives a $300,000 guaranteed payment for her work. Dolly pays income taxes on the $300,000.

The tax accounting works differently, however, if the partnership allocates and then pays out profit shares to partners.

Why? Because tax law (through 2025) gives partners in partnerships a special “qualified business income” deduction equal to twenty percent of the qualified business income, or QBI. And a profit allocation counts as qualified business income. Guaranteed payments don’t count.

Example: James, a physician in a different group medical practice, also earns $300,000. But his partnership doesn’t use guaranteed payments in its accounting. Rather, the partnership allocates profits to James and then pays out profits as distributions. James therefore pays income taxes on only eighty percent of the $300,000, or $240,000. His taxable income drops from $300,000 to $240,000 due to the $60,000 QBI deduction.

A final quick point about this tax strategy. Partly the problem this blog post describes reflects a legacy of accountants taking shortcuts. Before 2018? It didn’t matter that bookkeepers and accountants incorrectly labeled payments to partners as guaranteed payments. That made the accounting easy. But often the partnership didn’t really have guaranteed payments.

Tricks that Convert Guaranteed Payments into Qualified Business Income Tax Strategy Work

Okay, the obvious basic trick for making the convert-guaranteed-payments-to-QBI strategy work? Not using guaranteed payments.

That means, per tax law, saying partners get paid out of profits. And not saying some amount gets paid to a partner regardless of profits.

Also, all the internal documentation that describes and controls and documents how partner profits get allocated? And then paid out to partners? That stuff all needs to tell the same story. (A partnership’s attorney quarterbacks this process, including the key step of updating the partnership agreement.)

But get the mechanics right, and the results work wonderfully. And get sloppy and cut corners? Ouch.

Referencing the earlier examples, if Dolly’s partnership says she gets that $300,000 no matter what happens, no matter the firm’s profitability, that $300,000 is a guaranteed payment.

But if the partnership updates its partner compensation agreements to say that partners can plan on a $25,000 month distribution (so $300,000 for the year but subject to partnership cash flows and profits) and then people get allocated profits based on the management committee’s allocation of profits at year-end, that subtle difference converts the guaranteed payments into profit allocations.

Voila. The partner gets a twenty percent qualified business income deduction, or QBI deduction.

Possible Tax Savings from Convert Guaranteed Payments Tax Strategy

The savings a taxpayer enjoys from this strategy? Equal to the new QBI deduction times the taxpayer marginal federal tax rate.

For example, if a taxpayer earns about $330,000 in qualified business income and gets a $65,000 QBI deduction—that’s about as large as someone in a specified service trade or business can get—that saves the taxpayer about $16,000 in federal taxes each year.

Note: A specified service trade or business is basically a white collar or white coat professional. The QBI deduction for these taxpayers phases out once the taxpayers income reaches a threshold amount. For married taxpayers in 2021, the phase-out threshold begins at roughly $330,000 of taxable income.

Partners in non-specified-service-trades-or-businesses may get a larger deduction. For example, a partner in a non-specified-service-trade-or-business with $2 million of qualified business income may get a $400,000 QBI deduction. That $400,000 QBI deduction probably saves the partner around $150,000 in taxes.

Most partners earn five figure or low six figure incomes, however. In these more typical cases, the savings generated by the QBI deduction drop. For example, on $50,000 of QBI, the deduction equals $10,000. And if the marginal tax return equals 12 percent, the tax savings run $1,200 annually.

Turbocharging the Convert Guaranteed Payments into QBI Strategy

Most often, a taxpayer really shouldn’t have to “do” anything to get this strategy to work. Or to work better. Though in a few cases, and as noted earlier, working the strategy sometimes requires the partnership agreement to be updated.

Example: A twenty-partner law firm pays equal shares of the profit to partners. Usually, that share runs roughly $450,000 a year. The partnership K-1 that goes to partners shows about $80,000 of deductions for pension, self-employed health insurance and self-employment taxes. Partners all average another $40,000 in itemized deductions. Which means even though the law firm surely is a specified service trade or business, each partner (at least in this example) should annually get roughly a $65,000 tax deduction and save roughly $16,000 in taxes.

By the way, if a partnership has bungled the accounting for profit allocations, a solution exists. The partnership just amends its 2018, 2019 and 2020 1065 tax returns. And then the partners amend their 1040 tax returns for the same years. (This error, sadly, happens more often that you would guess.)

Limits to Strategy

Typically, high income partners working in a specified service trade or business (basically a white-collar or white-coat profession) lose their ability to easily use the qualified business income once their adjusted gross income rises above, say, $225,000 if single and above $450,000 if married.

Note: The specified service trade or business label only matters as married taxpayers’ taxable income rises above $329,000 and as a single taxpayer’s taxable income rises above $164,900. These taxable income thresholds probably roughly equate to adjusted gross incomes that are at least $50,000 to $100,000 higher due to common tax deductions.

These specified-service-trade-or-business partners can still get the deduction onto their returns. But the deduction requires more work either in the partnership’s accounting. Or on the partners’ individual tax returns.

Example: Dolly the physician mentioned earlier sees her partnership profit triple to $900,000. Her spouse, however, manages the family’s rental property portfolio and creates roughly a $400,000 annual business loss using depreciation. When the couple adds their other adjustments and deductions to their federal return, the taxable income drops below the threshold where specified service trade or business status matters.

How This Tax Strategy Can Blow Up

Bad bookkeeping and internal documentation that mislabels distributions as guaranteed payments surely undermines the strategy.

And then if a partnership agreement historically made use of guaranteed payments? Obviously, the partnership and its partners need to update that agreement.

One other practical matter may torpedo this tax strategy. Partners may find it unacceptable to explicitly bear the risk of fluctuating incomes. Or their families may find it unacceptable.

Example: Three engineers named Hillary, Laura, Michelle consistently generate $1,500,000 in profits from their engineering services partnership. And the agreement between these three women? They evenly share the profits as they evenly share the work. Thus each partner earns $500,000 annually. On its face, this arrangement does not use guaranteed payments and so generates potentially as much as $500,000 a year of qualified business income and possibly a $100,000 QBI deduction. However, it may be that one of the partners or one of the partner’s spouses wants to call the distributions “guaranteed.” Even though of course, they probably aren’t really guaranteed. But that label just, well, “feels” safer.

The Convert Guaranteed Payments into Qualified Business Strategy Works Best for These Taxpayers

The convert guaranteed payments into QBI tax strategy works well for high-income partners. Especially when the partnership doesn’t operate a specified service trade or business.

As noted, partners in specified service trades or businesses face some challenges if their tax returns show high incomes. But regularly, even these folks benefit from treating partnership profits as allocations of profit rather than guaranteed payments paid regardless of profits.

Other Information Sources

The Internal Revenue Code section that describes how guaranteed payments work appears here: Section 707. The related regulations start here: Reg. Sec. 1.707. Someone working with this tax strategy needs to know well what these bits of tax law say.

We’ve also got some blog posts that discuss in more detail how partnerships make the convert-guaranteed-payments-into-QBI tax strategy work: This blog post for example provides a backgrounder on the Section 199A deduction as well as discussion of common ways the Section 199A deduction gets bungled: Section 199A Rookie Mistakes.

This blog post explains the detailed mechanics: Salvaging Partnership Section 199A Deductions.

Finally, this blog post shows how the specified-service-trade-or-business rules sometimes work differently than one might guess: Physician Section 199A Deductions Can Work (If You Know The Rules). Note that this same sort of workaround commonly exists for firms in other categories that initially seem to be disqualified from Section 199A.

Finally, and as always, taxpayers want to discuss a strategy like this with their tax advisor. He or she knows the details of your specific situation. And this plug for our CPA firm: If you don’t have a tax advisor who can help, onboarding info appears here and you can contact us here: Nelson CPA.

The post Tax Strategy Tuesday:  Convert Guaranteed Payments to Qualified Business Income appeared first on Evergreen Small Business.