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.

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.

The post Section 199A(i) Fiscal Year Change Extends Deduction 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.

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.

This week, I talk about physician 199A deductions.

More specifically, I talk about how many physicians who own part or all of their medical services practices can take the Section 199A deduction.

Yes, I know. The law and the regulations lead you to conclude otherwise. But many physicians can use the 199A deduction.

And for one of three reasons: their taxable income falls or can be pushed below the thresholds… or they can use separate financial records to cull out qualified business income amounts … or in some special cases because what the physician does doesn’t count as specified service trade or business.

But let’s start with a quick review.

First The 199A Deduction in a Nutshell

The 199A deduction works like this. Someone who earns income from a sole proprietorship, partnership or S corporation gets a deduction equal to (potentially) 20 percent of the “qualified business income.”

Basically? The qualified business income equals the amount shown on the Schedule C or the K-1 from the partnership or S corporation.

For example, someone who earns $100,000 as a self-employed physician probably gets a $20,000 199A deduction. Someone who earns $200,000 maybe gets a $40,000 deduction. Someone who earns $1,000,000 might get a $200,000 deduction.

And then I should mention a couple of bookkeeping glitches. First, some business expenses (like for a pension or self-employed health insurance) don’t get counted on the Schedule C or on the partnership or S corporation tax return. So you have to adjust the Schedule C or K-1 number.

The other bookkeeping glitch. Not all of the income that shows up on a K-1 counts as qualified business income. Pretty much, only what shows in box 1.

Warning:  I’m cutting some corners here and skipping over some details. But if you need more precise information, don’t worry. We’ve got a bunch of 199A articles here at the blog.  And for people who just can’t get enough, you can even purchase and download a copy of our “Maximizing Section 199A Deductions” e-book.

The Rub for Physicians

The only problem with a physician taking the Section 199A deduction? The law and related regulations say you lose the deduction if you earn your business income providing medical services and taxable income rises too high.

The exact language comes from the final regulation and is worth quoting here with the critical phases italicized and boldfaced:

(ii) Meaning of services performed in the field of health. For purposes of section 199A(d)(2) and paragraph (b)(1)(i) of this section only, the performance of services in the field of health means the provision of medical services by individuals such as physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals performing services in their capacity as such. The performance of services in the field of health does not include the provision of services not directly related to a medical services field, even though the services provided may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or the research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.

And this other bit. The income level that causes a physician to lose the deduction? For 2020, the physician taxpayer loses her or his deduction as taxable income rises from $326,600 to $426,600 for joint filers, and from $163,300 to $213,300 for single filers.

Note that the law phases out the deduction as taxable income moves through the ranges just given. Accordingly, once a married taxpayer’s taxable income exceeds $426,600 or a single taxpayer’s taxable income exceeds $213,300, boom, no Section 199A deduction.

The Three Ways Physicians Salvage Section 199A Deduction

Now that you’ve got that background, let’s talk about how a physician can usually take the Section 199A deduction on at least some and maybe all of their business income.

As mentioned, a physician enjoys roughly three ways to salvage the Section 199A deduction.

Income Below or Pushed Below Thresholds

The first way? Which is obvious probably? When the physician’s taxable income falls below the thresholds.

For example, a single taxpayer making (say) $163,300 or less as a sole proprietor? She or he gets the Section 199A deduction. Even if the “business” provides “medical services.”

The same thing happens with a married taxpayer making $326,600. She or he gets the Section 199A even if the “business” provides “medical services.”

Remember too that the phaseout law looks at taxable income. Accordingly, if someone saves, say, $20,000 into a 401(k) and tallies up $30,000 of Schedule A “itemized deductions,” those deductions create space.

With $50,000 of tax deductions, a single taxpayer doesn’t start losing the 199A deduction at $163,300 of business income. And a married taxpayer doesn’t start losing the 199A deduction with $326,600 of business income. Rather, they can make $50,000 more than this amount and still take the full deduction.

The deduction, by the way, equals the lesser of 20% of the qualified business income or 20% of the taxable income taxed at ordinary tax rates. So, deductions that drive down the taxable income may effect the 199A deduction.

And while I’m on this subject, can I give you another example? Suppose some physician earns exactly $300,000 more than the threshold ($326,600 in 2020). So, $626,600.

If this taxpayer saves $50,000 into a pension, accumulates $50,000 in itemized deductions, and books $200,000 of losses from a spouse’s business or investments, the tax return shows $326,600 of taxable income and the return includes a generous 199A deduction. (The 199A deduction in this case probably equals 20% of the 326,600.)

Non-Medical-Services Income Separated and Tracked

The second way for a physician to get a 199A deduction? If the practice sells services or  products that don’t actually count as medical services, possibly (probably?) the physician can treat that activity as a separate trade or business. And then, as long as she or he separates the books and financial records, that should mean a 199A deduction.

This gambit amounts to a bookkeeping strategy. And the specifics depend on the non-medical-services a physician provides. But teaching, research, writing all count as “non-medical” and so if separated into different trades or businesses and then separately accounted for, the business owner probably gets a 199A deduction.

And then in some cases other services and products should produce 199A deductions too. Some eye doctors probably sell glasses. Some physicians sell health related products. A number of physicians “blog.”

You see the recipe. Reorganize your activities into two trades or businesses, one that lacks eligibility because it’s an SSTB and one that doesn’t. Then, take the 199A deduction on the non-SSTB income.

By the way, this a second trade or business with “separable financial records and books” approach isn’t specific to physicians. So the bookkeeping and related rules described in another blog post apply: Final Section 199A Regulation: Separate vs. Separable.

Recategorizing the Income as Qualified Rather than Disqualified

And then possibly a third way exists for placing a Section 199A deduction onto a self-employed physician’s tax return. And this third way? It requires looking at what a physician actually does to determine whether tax law considers that work “medical services.” But this gets complicated, so we need to go into the weeds here.

Peek back at the 199A regulation I quoted earlier… You can see that the final regulations disqualify income a physician earns from “the provision of medical services.” Unfortunately, the regulations don’t define the term “medical services.” And this bit of sobering reality. The Internal Revenue Code doesn’t define the term “medical services” either.

But it turns out that the IRS has developed a definition of medical services which they use for other sections of the Code. And you might want to use the same definition for 199A.

Medical Services Defined

That definition? A “medical service” is something defined as an allowable medical care “itemized” deduction under code section 213(d).

In a nutshell, Section 213(d) provides that medical care consists of services for the diagnosis, cure, mitigation, treatment, or prevention of disease, including services for the purpose of affecting any structure or function of the body.

Not surprising, not everything “medical-y” creates a Section 213(d) medical deduction. Which means not everything “medical-y” counts as a medical service—at least for purposes of some parts of the tax law.

A first example… In applying Section 448’s rules of when someone provides medical services, the IRS says “look at Section 213(d).” (See Technical Advice Memorandum 9222004.) Note that Section 448 carries more weight than you might at first think when looking at Section 199A. The key bit of phrasing about what is a specified service trade or business comes from Section 448. Further, Congress approvingly references Section 448’s regulations when talking about how Section 199A should work in its committee report.

A second example… In determining when a physician’s salary rises to a level that triggers a Section 4960 excise tax because she or he isn’t providing medical services, the IRS  again says, “look at Section 213(d).” (See IRS Notice 2019-09. ) Note that Section 4960 doesn’t connect closely to Section 199A. But it matters (maybe) that Congress added Section 4960 to the Internal Revenue Code at the same time as it added Section 199A. It would seem odd to use different definitions for a key term flowing out of the same legislation.

Cosmetic Surgery For Example…

Just to save casual readers from slogging through Section 213(d), here is the big example of this: Cosmetic surgery.

Specifically, here’s that blurb with the relevant bit of statute highlighted that says “hey cosmetic surgery and anything like cosmetic surgery? Yeah, they don’t count as medical deductions… sorry.”

(9)Cosmetic surgery.—

(A)In general.—

The term “medical care” does not include cosmetic surgery or other similar procedures, unless the surgery or procedure is necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease.

(B)Cosmetic surgery defined.—

For purposes of this paragraph, the term “cosmetic surgery” means any procedure which is directed at improving the patient’s appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.

Therefore, a physician who provides cosmetic surgery or cosmetic procedures isn’t necessarily providing what tax law considers a “medical service.” That means the physician arguably gets the Section 199A deduction.

And there are other examples where the failure to achieve a Section 213(d) deduction creates or arguably creates a Section 199A deduction, too. Fertility treatments for same sex parents, for example. Surrogacy costs for some women.

Closing Comments

Time to end this discussion. I’ve chattered on way too long.

But let me leave you with this thought. Most “business owning” physicians can get the Section 199A onto their tax returns. Many (most?) physicians report taxable incomes below the phase-out limits for example. And even those with higher incomes can push down their taxable incomes with deductions.

Surely a few physicians can do their bookkeeping in a way that creates books and financial records that separately report on qualified business income earned along side or inside a medical practice.

And then beyond that? Sure. A few physicians may be able to sidestep “specified service trade or business” status by using the IRS’s definitions of “medical services.”

The post Physician 199A Deductions Can Work (if You Know Rules) appeared first on Evergreen Small Business.

Which situations? Well, when some deduction you report on your individual tax return deduction in effect connects to a trade or business.

For the most part, this requirement makes sense. But in one case, the IRS got crazy. Specifically, the IRS says S corporation shareholders subtract self-employed health insurance premiums twice in order to determine qualified business income.

This particular adjustment makes no sense to the typical small business owner. Some folks even talk privately about ignoring the instruction.

Accordingly, in this blog post, I dig into the details of this goofy instruction for S corporation shareholders. And then I talk about the argument for ignorance.

But let’s start with the bookkeeping the IRS wants.

A Quick Example of the Nonsense

Say an S corporation earns $100,000 before paying any shareholder wages. Further, say after careful consideration and a bit of research, the S corporation decides to pay its shareholder-employee wages equal to $60,000.

In this case, that leftover $40,000 counts as Section 199A qualified business income. The shareholder-employee probably gets an $8,000 Section 199A.

Note: The Section 199A deduction typically equals 20 percent of the amount shown on the S corporation’s K-1.

But you may need to adjust the qualified business income, as noted. And here’s the rub with an S corporation.

If the S corporation buys health insurance for the shareholder-employee, the IRS says (in Notice 2008-1) that the health insurance gets added to the wages.

If this same corporation pays $20,000 in health insurance for the shareholder-employee, the IRS’s bookkeeping pushes up the wages from $60,000 to $80,000. And it pushes down the qualified business income from $40,000 to $20,000.

And then the other shoe drops.

The 8995 form instructions say the shareholder-employee also needs to subtract the $20,000 of health insurance. Again.

In a case like the one described here? That second reduction shrinks the qualified business income from $20,000 to $0. That shrinkage zeroes out the Section 199A deduction.

Note: As discussed in another blog post,  How the IRS Destroyed the Section 199A Deduction for Small Business Corporations and Partnerships, this same bookkeeping nonsense reduces qualified business income and the Section 199A deduction for partners in partnerships, too.

What Our CPA Firm Will Do

Just for the record, our firm will follow the 8995 instructions.

Partly, this policy stems from the modest impact of the nonsense prescribed by the IRS.

I used $20,000 in the example just described as the total health insurance amount.

But with a more typical $10,000 self-employed health insurance deduction, for example, the IRS bookkeeping method costs taxpayers $400 to $700 of lost tax savings.

That amount crosses the “okay this is irritating” threshold.

But not the “I don’t care about getting into an argument with the IRS” threshold.

However, I think some business owners and tax accountants probably will ignore the IRS’s 8995 instructions. And in my opinion, their position isn’t frivolous.

But to understand why, it helps to look first at when the IRS approach makes total sense.

Why the IRS Wants this Bookkeeping Approach

As noted earlier, the 199A regulations require adjustments to the qualified business income number that flows out of a business (like a sole proprietorship) when some deduction you report on your individual tax return deduction effectively connects to a trade or business

The final regulations detail the actual rules for determining when some item is effectively connected. And those rules say this:

Thus, for purposes of section 199A, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.

By the way, you may want to read the paragraph twice. Once in its entirety. Once reading just the boldfaced language.

But the gist of this?  To get a business’s qualified business income, we adjust the business’s income for “business-y” expenses that don’t appear on the actual business tax return.

A sole proprietor, for example, pays self-employment taxes if her or his business makes a profit. She or he gets to deduct a pension contribution, such as for something like a simplified employee pension plan (a SEP-IRA) if her or his business makes a profit. And she or he gets a self-employed health insurance deduction if the business makes a profit.

Logically, these expenses are “effectively connected” to the business. And so the taxpayer should tweak their qualified business income for these deductions.

A relevant sidebar? These sorts of expenses, in comparison, do appear on a corporation’s tax return.

But it’s hard to see why this bookkeeping makes sense for S corporations. And for two reasons which form the basis for ignoring the IRS 8995 instructions.

The First Reason You Might Argue the 8995 Instructions Don’t Apply to S Corporations

A first, common-sense reason to ignore.

The bookkeeping approach the IRS requires for self-employed health insurance in S corporation situations already indirectly reduces the qualified business income.

How? As already explained, the IRS requires self-employed health insurance to be counted as W-2 wages. W-2 wages reduce an S corporation’s qualified business income. That reduction means S corporation qualified business income is already and automatically adjusted for the self-employed health insurance.

That sounds pretty good, right? Yeah, I agree.

Unfortunately, while this reason maybe makes perfect sense to you and me, it makes no sense to the IRS’s tax attorneys. Apparently.

Note: The above reasoning might, I will guess, resonant with an IRS auditor, her or his manager or an IRS Appeals officer. But that’s not really relevant…

The Second Reason You Might Argue the IRS Instructions Don’t Apply to S corporations

But a second reason also maybe lets S corporations ignore the IRS 8995 instructions about self-employed health insurance.

Remember from the earlier paragraphs that the regulations require adjustments to qualified business income when a deduction is effectively connected to a trade or business. And the “effective” connection per the regulations occurs when

for purposes of section 199A, deductions such as the self-employed health insurance deduction under section 162(l) are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction

You probably see I’m just copying the boldfaced language from the regulations I showed earlier.

Now clearly, the above language applies for sole proprietors and partnerships.

But look at the rule for the self-employed health insurance deduction for S corporations which I copied from IRS Notice 2008-1. For an S corporation shareholder-employee, the rule says

The deduction is not allowed to the extent that the amount of the deduction exceeds the earned income (within the meaning of section 401(c)(2)) derived by the taxpayer from the trade or business….

Slightly restated, for S corporations, the self-employed health insurance deduction doesn’t look at the extent that an individual’s gross income from the trade or business is taken into account.

Rather, the deduction limits the deduction to the taxpayer’s earned income from the business. (Most specifically, what shows up in Box 5 of the shareholder-employee’s W-2 as “Wages subject to Medicare taxes.”)

Mash up the instructions from IRS Notice 2008-1 with the regulations’ language—all the while paying attention to the adjectives “gross” and “earned,” and voila, the language seems to say sole proprietorships and partnerships adjust. But that S corporations don’t.

Connecting the Dots

So, to wrap this up? If you’re going to argue the IRS instructions make no sense, you essentially make two arguments.

First, you argue the S corporation already has subtracted health insurance from the qualified business income by using the bookkeeping method prescribed in IRS Notice 2008-1.

Second, you argue the only detailed guidance says you adjust for self-employed health insurance in situations like those a sole proprietorship or partnership faces where the deduction depends on the gross income of the business.

And my final remark about all this? I understand the arguments for ignoring the IRS 8995 instructions.  I really do.

But in our practice? For a few hundred dollars of lost savings? Yeah, we’re just going to follow the IRS form instructions.

The post Ignoring IRS 8995 Instructions to Double-deduct Self-employed Health Insurance appeared first on Evergreen Small Business.

But some good news here: If you know what mistakes people usually make? You can pretty easily identify and fix them.

Note: This blog post uses the 2025 Section 199A phase-out thresholds.

A Quick Review of the Section 199A Deduction

If you already understand how the Section 199A deduction works, skip to the next section. If you’re still unclear, though, let’s review the basics.

The Section 199A deduction gives sole proprietors, partners in partnerships, shareholders in S corporations and then some real estate investors an extra deduction.

That deduction equals 20 percent of the income earned in a trade or business. If a business earns $100,000 in profits, for example, the owner probably gets a $20,000 tax deduction.

But the deduction comes with complications.

First, the ultimate deduction equals the lesser of 20 percent of the “qualified” business income or 20 percent of the taxable income reduced for any capital gains.

Second, for high income taxpayers, the formula adds other requirements for taking the deduction.

For example, above taxable income thresholds (in 2025 $247,300 for single taxpayers and $494,600 for married taxpayers), the deduction can’t exceed 50 percent of the wages paid or the sum of 25 percent of the wages paid plus 2.5 percent of the depreciable property’s original cost.

And then even more significant, for people over those thresholds, the Section 199A deduction doesn’t shelter income earned from a “specified service trade or business.” The “specified service trade or business” category includes doctors, lawyers, investment bankers, consultants, athletes, actors and a bunch of other high-income often white-collar-y professionals.

And a further complication: A phase-out range exists (in 2025 from $197,300 to $247,300 for single individuals and from $394,600 to $494,600 for married folks.) In that range, stuff like W-2 wages, depreciable property and “specified service trade or business” status only partially affects the Section 199A deduction.

And now let’s talk about the common Section 199A rookie mistakes…

Section 199A Rookie-year Mistake #1: Mislabeled “Specified Service Trade or Business”

A first painful mistake we see several times most years: Someone mistakenly assumes some business falls into the “specified service trade or business” category. Then, based on that mistake, the business owner doesn’t take the 20 percent Section 199A deduction.

A common example of this misfortune? Situations where some entrepreneur describes his or her business as “consulting.”

In the past, this imprecision didn’t matter. All that really happened? The CPAs within the tax return classified the firm as a”consulting” business.

Note: Some of these firms may also use the word “consultants” or “consulting” in their business name.

Here’s the problem, though. Very possibly, these firms don’t count as consulting firms. Which means they shouldn’t lose their Section 199A deduction due to classification as a specified service trade or business.

The programmer who calls herself a consultant, for example? She’s not a consultant according to the law. She’s a programmer.

The engineer? Yeah, not a consultant. He’s an engineer.

The trainer? Again, not a consultant. But a trainer.

A consultant, per the Section 199A regulations, provides advice and counsel. Or does political lobbying

If you’re a tax accountant, you want to understand, precisely, the trades and businesses falling into each specified service trade or business category.

And then, this unfortunate reality if you’re a taxpayer: You want to verify you’ve been correctly classified. (The tax return will disclose this status.)

You don’t want to lose the deduction because your tax accountant doesn’t know the law. Or because you’ve been sloppy describing to your accountant what your firm does.

And this tip: Talk with your accountant about amending your past returns if you made this error.

Section 199A Rookie-year Mistake #2: Not Recognizing “Specified Service Trade or Business” Taint

A related mistake we see even some large CPA firms making? A “specified service trade or business” (aka “SSTB”) tainting other affiliated businesses that share 50 percent or more common ownership.

Here’s the rule, by the way. If two businesses share 50 percent or more common ownership and the “non-SSTB” business provides services or goods to the “SSTB” business, a percentage of the “non-SSTB” business’s income doesn’t count as “qualified” business income that plugs into the Section 199A formula.

Example: A group of surgeons operate as a C corporation. The same group of doctors owns a partnership that owns the building the surgical center operates in. Because the partnership rents its building to the C corporation providing surgical services, the real estate office building partnership gets tainted as an SSTB. That SSTB taint means its income doesn’t plug into the Section 199A formula.

Make this error and a taxpayer overstates his or her Section 199A deduction.

Section 199A Rookie-year Mistake #3: Not Creating Separable Businesses When One is SSTB

Let me mention one other rookie mistake related to specified service trades and businesses, or SSTBs.

If a business combines both non-SSTB and SSTB business income, Section 199A probably treats the entire business as a specified service trade or business.

Example: A group of attorneys both practice law and provide continuing legal education seminars. If the attorneys treat all of this activity as a single business, probably the entire business gets treated as an SSTB due to the law firm activity tainting the continuing legal education activity.

What business owners can do, however, is separate the two businesses into the potentially disqualified SSTB (the law firm) and then the probably qualified non-SSTB (the continuing legal education business). This saves the Section 199A deduction on at least the eligible part of the business.

How to separate the two businesses? The treasury regulations provide good examples of how this works. But as I remarked in another blog post, if you want to separate out activities into their own trades or businesses, you want things like “separate employees” and for the activities to be treated in the real world as  “separate trades or businesses.” You also need separable financial records and books.

Section 199A Rookie-year Mistake #4: Labeling Partnership Distributions as Guaranteed Payments

One of the worst mistakes we see most years? The partnership returns that mistakenly label distributions to partnership partners as guaranteed payments.

The problem here? Section 199A says guaranteed payments don’t count as qualified business income. As a result, guaranteed payments don’t get partially sheltered by the Section 199A deduction.

Example: A partnership generates $200,000 in profits for each of its three partners. The partnership pays out $180,000 of this profit to each partner. If the partnership categorizes the $180,000 of money paid to each partner as a guaranteed payment, individual partners get the 20 percent Section 199A deduction only on the leftover $20,000 of business income.

Note: The stories we hear about distributions to partners being mis-classified as guaranteed payments often include a modestly skilled bookkeeper unfamiliar with partnership tax accounting.

Section 199A Rookie-year Mistake #5: Not Rewriting the Partnership Agreement to Remove Guaranteed Payments

Another guaranteed payment mistake impacts the current and future years…

As just noted, Section 199A says guaranteed payments don’t count as qualified business income and so don’t get partially sheltered by the Section 199A deduction.

A partnership that generates $200,000 of profit for a partner but pays out $10,000 a month as a guaranteed payment—so $120,000 in guaranteed payments over the course of the year—produces $80,000 of “qualified” business income and a $16,000 Section 199A deduction.

But some partnerships may have only used guaranteed payments to simplify the allocation of partnership profits. In those sorts of situations, the partnership may want to rewrite the partnership agreement to use special allocations and distributions in place of guaranteed payments.

For example, say a partnership generates $200,000 in profit for a partner and has been paying $10,000 a month guaranteed payments. Rather than paying out that $10,000 a month as a guaranteed payment, the partnership could make a $10,000 monthly distribution from the profits. This change means the entire $200,000 counts as “qualified” business income and means the partner gets a $40,000 Section 199A deduction.

Section 199A Rookie-year Mistake #6: Not Operating as an S Corporation

High income taxpayers need a business to report either W-2 wages or hold significant depreciable property to get the 20 percent deduction.

Example: Some taxpayer with a business earning $1,000,000 in profit doesn’t necessarily receive a $200,000 deduction. The actual deduction can’t exceed the greater of 50 percent of the W-2 wages or 25 percent of the W-2 wages plus 2.5 percent of the depreciable property. If the firm doesn’t own any depreciable property, the firm would need to pay at least $400,000 in W-2 wages to get a $200,000 Section 199A deduction. Why? Because the Section 199A deduction equals the lesser 20 percent of the $1,000,000 of “qualified” business income or 50 percent of the W-2 wages, whichever is less.

For sole proprietorships and partnerships without employees, this W-2 wages requirement can zero out the Section 199A deduction. No wages? No Section 199A deduction.

Fortunately, a workaround exists to fix this problem. The sole proprietorship or partnership can incorporate and elect Subchapter S status. This tax accounting treatment causes the sole proprietor and partners to be treated as employees and creates owner W-2 wages the taxpayer needs to get the Section 199A deduction.

Note: A sole proprietorship or partnership operating as an LLC can make an election to have the LLC treated for tax purposes as an S corporation. Note that a partnership, however, may not be able to make its partnership profit sharing formula work using an LLC taxed as an S corporation. Therefore, a partnership may need to set up a partnership of S corporations.

Section 199A Rookie-year Mistake #7: Late W-2s or “No W-2” Wage Amounts

Another problem related to W-2s?

Section 199A requires W-2 wages to appear on timely filed W-2s for their amounts to be counted in the deduction formula.

This requirement means that if a taxpayer needs W-2 wages to make the Section 199A deduction work, the business not only needs employee wages. It needs to file W-2s on time.

Further, this requirement means that if a business simply doesn’t file W-2s, the business owners miss out on their Section 199A deduction.

Note: A small but still significant number of small business corporations skip filing W-2s for their shareholder-employees. Instead, these firms use some slapdash approach which means the payroll taxes get paid (or most of them anyway). But then no quarterly 941s or year-end W-2s get filed.

Section 199A Rookie-year Mistake #8: Lost Fixed Assets Detail

A mistake related to a bookkeeping misdemeanor: Not maintaining good fixed assets records. The problem here? Folks sloppy with their fixed assets record-keeping often aren’t able to pass through richly detailed information about depreciable assets necessary for the Section 199A deduction.

As noted, for high income taxpayers, the Section 199A deduction also considers the un-adjusted basis of depreciable property at the time the property was acquired.

Example: A high income taxpayer earning $100,000 in “qualified” business income from a real estate property doesn’t necessarily receive a $20,000 deduction. The actual deduction can’t exceed the greater of 50 percent of the W-2 wages or 25 percent of the W-2 wages plus 2.5 percent of the depreciable property. If the firm doesn’t pay any W-2 wages, the firm would need to hold at least $800,000 of depreciable property to get a $20,000 Section 199A deduction. Why? Because the Section 199A deduction equals the lesser 20 percent of the $100,000 of “qualified” business income or 25 percent of the W-2 wages (so $0) plus 2.5 percent of the $800,000 (which equals $20,000)

Note: We see the “incomplete” fixed assets problem pop up with old partnerships holding fully depreciated property. Prior to 2018, that property sort of didn’t matter for the current year’s tax return. (It mattered only if the property was disposed of during the year in many cases.) But now that detail does matter. A lot.

Section 199A Rookie-year Mistake #9: Failing the Real Estate Safe Harbor Requirement

A final mistake to mention: Real estate investors skipping the Section 199A deduction because they think the IRS’s real estate safe harbor provides the only way to get a Section 199A deduction on their tax return.

Here is reality: The real estate safe harbor for Section 199A makes it really hard to qualify for Section 199A. Not easy. Therefore, most investors don’t want or won’t be able to take that route to a Section 199A deduction. But these taxpayers have an alternative…

Real estate investors can instead learn and then use the Section 162 “trade or business” standard to get the Section 199A deduction onto their tax returns.

Tip: We have a longer discussion of the Section 162 rule and the safe harbor here: Section 199A Rental Property Trade or Business.

One Final Comment

The current version of the Section 199A deduction expires at the end of 2025. But the proposed Big Beautiful Tax Bill creates a new version of the Section 199A deduction starting in 2026. If you’re interested in how the new proposed deduction works, peek at this blog post, The New Big Beautiful Section 199A Deduction. Or experiment with our Big Beautiful Section 199A Deduction Calculator.

The post Section 199A Deduction Rookie Mistakes appeared first on Evergreen Small Business.

But let’s review the Section 199A deduction’s calculations. And then I can walk you through the nonsensical logic the IRS used to eliminate or dramatically reduce the Section 199A deduction for many small business owners.

I can also point out the two or three possible gambits you may be able to use to sidestep or minimize the IRS’s new rules.

A Quick Review of Section 199A Deduction

The Section 199A deduction gives small business owners a deduction equal to 20 percent of a sole proprietorship’s profits, the profit an S corporation shareholder earns, or the profit a partner earns from a partnership interest.

Let me provide some slightly simplified examples to show how this works…

Example: A sole proprietor who earns $100,000 in self-employment earnings gets a Section 199A deduction equal to 20 percent of the $100,000, or $20,000.

But then this wrinkle: Deductions associated with those self-employment earnings—even if they don’t count as business deductions—reduce the business income that plugs into the Section 199A formula.

Example: A sole proprietor who earns $100,000 in self-employment earnings but deducts $20,000 for self-employed health insurance sees her Section 199A deduction reduced for the health insurance deduction. Why? The $100,000 of business income shrinks to $80,000 after subtracting the $20,000 of health insurance. She therefore gets a Section 199A deduction equal to 20 percent of $80,000, or $16,000.

Example: A partner who earns $100,000 from a partnership but per the partnership agreement pays another $10,000 of business expenses that go un-reimbursed by the partnership sees his Section 199A deduction reduced for those expenses. The $100,000 of business income shrinks to $90,000 after subtracting the $10,000 of unreimbursed expenses. He then gets a Section 199A deduction equal to 20 percent of $90,000, or $18,000.

Note: The deductible part of the self-employment taxes a sole proprietor or partner pays also reduce the “qualified” business income that plugs into the Section 199A calculations. I’m not providing examples of that adjustment. The arithmetic gets too gritty for a blog post.

The above accounting all makes sense. You and I should have no problem with these sorts of bookkeeping tweaks. Some small business expenses don’t appear on the actual form or page that calculates the business’s profit or loss. Yet the expenses still tightly connect to the business.

But S corporations and partnerships? These small businesses get beat up bad by what I can only describe as bookkeeping nonsense.

Partnership and S Corporation Section 199A Deduction Complications

The problem for S corporations and partnerships? Business owners deduct the self-employed health insurance deduction a second time. The accounting gets complicated. But you want to understand it.

How Partners and Partnerships Double-Deduct Health Insurance

Let’s return to the simplified example where a partner earns $100,000 of self-employment earnings from a partnership.

Further assume the partnership pays $20,000 for the partner’s health insurance out of this $100,000.

At first glance, you might suppose the partner’s “net” business income equals $80,000: the $100,000 of business profit minus the $20,000 of health insurance.

But if the partnership provides a $20,000 health insurance benefit, the benefit probably shows up as a guaranteed payment paid by the partnership.

And what’s significant with that accounting treatment? Guaranteed payments don’t count as business income that’s qualified for the Section 199A deduction. In other words, if you start with $100,000 of self-employment earnings and then provide a $20,000 self-employed health insurance “guaranteed payment,” the “qualified” business income drops from $100,000 to $80,000.

But then this wrinkle. When the partner prepares his individual tax return, the $20,000 of health insurance gets deducted a second time from the $80,000, leaving $60,000 of adjusted “qualified” business income:

The Section 199A deduction then equals, probably, 20 percent of the $60,000, or $12,000.

You see what’s happened, right? The IRS says you deduct that same $20,000 self-employed health insurance amount twice.

How S Corporations and their Shareholders Double-Deduct Health Insurance

The IRS’s Section 199A accounting for S corporations works the same black magic. But with more twists. So let me walk you through the accounting using an admittedly worst-case scenario.

Assume for sake of illustration that an S corporation generates $100,000 of profit for some shareholder-employee.

The S corporation needs to break this amount into a chunk it calls wages and another chunk it calls distributive share. For example, perhaps the corporation breaks the $100,000 into $60,000 of wages and $40,000 of distributive share.

Note: The attraction of an S corporation is shareholders pay employment taxes only on the part of the profits broken out as wages.

The Section 199A deduction doesn’t apply to the wages an S corporation pays its shareholders. You may already know that. It applies to the leftover “distributive share, “ or $40,000 in this example.

But here’s what happens if this business provides a shareholder with $20,000 of health insurance.

First, the IRS says the S corporation needs to count the $20,000 of health insurance as shareholder wages. That artificially pushes the shareholder wages from $60,000 to $80,000. And it reduces the “qualified” business income from $40,000 to $20,000.

But then the other shoe drops. That $20,000 of self-employed health insurance becomes not just a tax deduction on the shareholder-employee’s individual 1040 tax return. It also reduces the “qualified” business income.

In this example, the remaining $20,000 of “qualified” business income goes to zero.

And that’s how the IRS can eliminate the Section 199A deduction for an S corporation.

Let Me Point You to Source

Just so you have it, here’s the actual language from page 2 of the draft Form 8995 instructions,

To figure the total amount of QBI, the taxpayer must consider all items that are related to the trade or business. This includes, but not limited to, charitable contributions, unreimbursed partnership expenses, business interest expense, deductible part of self-employment tax, self-employment health insurance deduction, and contributions to qualified retirement plans.

Note: The IRS also prescribes the accounting I describe in the preceding paragraphs in Question 33 at the FAQ shown here. Also note that draft version of the Form 8995 instructions appear here.

Is there Anything You Can Do About This?

Sorry, I don’t think you can do much to finesse the accounting on this one. In fact, I have only two or three ideas. And then one crazy suggestion.

The first small idea: If you happen to own both an S corporation and a sole proprietorship, you should take the self-employed health insurance deduction on the Schedule C “sole proprietorship” income. Not on the S corporation income. This tweak will mean you only reduce your Section 199A once for your self-employed health insurance.

A second small, related idea: Take a close look at how you handle any employer-provided Health Savings Account, too. For business owners, an HSA may shrink the Section 199A, too, if the business treats HSA contributions like health insurance. What may work better is for shareholder-employees and partners to contribute to HSAs personally.

The third small tangential idea from the draft instructions language quoted earlier: If your partnership or S corporation makes charitable contributions, you want to stop that practice. Those charitable contributions reduce “qualified” business income, too. You can still make those contributions personally. I think…

But other than those two or three small ideas, I think you or your accountant needs to follow the IRS’s form instructions. Presumably when finalized they will instruct you to deduct the self-employed health insurance deduction twice. And then also deduct anything else tangentially connected to the business.

Form instructions aren’t official IRS guidance. But heaven help you if you ignore them and then get audited. The IRS agent will expect you to comply fully with the form instructions. Even if they appear to conflict with the law.

One Final Crazy Suggestion

So here’s my crazy suggestion: I think you write your senators and house representative a letter that complains about needing to double-deduct the self-employed health insurance when calculating the qualified business income that plugs into your Section 199A calculations. Maybe mention the charitable contribution thing too.

You want to respectfully point out the IRS approach really beats up on small businesses.

A short letter like the one below should convey the insanity with clarity:

Dear Senator/Representative,

As someone who voted for you in your last election, I respectfully request you or your staff review the way the IRS has severely reduced the benefit of the new small business Section 199A deduction.

For many small businesses, the IRS 8995 form instructions either eliminate or severely reduce the Section 199A deduction available if a partnership or S corporation provides health insurance to business owners. Or makes charitable contributions.

This surely cannot be what Congress intended.

Respectfully,

Stephen L. Nelson, CPA

By the way, you can look up representative’s contact information here and your senator’s contact information here.

Your objective in writing such a letter? Get some elected official to add her or his criticism to that from tax accountants about this reduction in the value of the Section 199A deduction.

Additional Information about Section 199A

Need to get a basic overview of how the Section 199A deduction works? Check out this blog post: Pass-through Income Deductions: Top 12 Things Every Business Owner Must Know.

Need more information about how to adjust “qualified” business income for things like self-employed health insurance on your tax return? Section 199A Qualified Business Income Adjustments.

If you’re trying to optimize Section 199A deductions for a partnership, peek at this blog post: Salvaging Partnership Section 199A Deductions.

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