The Pass-Through Income Deduction under Code Section 199A (199A Deduction) allows taxpayers to deduct up to 20% of their pass-through business income. However, the deduction is either eliminated or limited when a taxpayer’s taxable income exceeds certain thresholds. Despite this limitation, charitably inclined high earners can stack tax savings by strategically making charitable gifts to push their taxable income below the 199A Deduction thresholds. This mechanism allows the taxpayer to receive both a federal income tax charitable deduction (Charitable Deduction) and the full 199A Deduction. The taxpayer has two primary options for making strategic charitable gifts, which we'll address in an upcoming article. First, we'd like to give a quick overview of how these two deductions function.
The 199A Deduction was enacted on December 22, 2017, as part of the Tax Cuts and Jobs Act. It is scheduled to sunset in 2026 and is quite complex. A complete recitation of its many nuances is beyond the scope of this article; however, as a general matter, a taxpayer’s 199A Deduction is calculated based on the nature of her pass-through business income (so called “Qualified Business Income” or “QBI” from a sole proprietorship, S corporation or partnership) and her taxable income. The steps for determining a taxpayer’s 199A Deduction are briefly summarized below.
First, the QBI must arise from a trade or business but does not include capital gains, qualified REIT dividends or qualified publicly traded partnership income (PTP). Roughly speaking, a trade or business is something pursued with the intent to make a profit, as opposed to income earned from holding property or from hobbies. Within this broad category, a taxpayer must also determine if the trade or business is a “specified service trade or business” (SSTB). SSTBs include most professional services, including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture are explicitly excluded from the classification of an SSTB. A business need only receive 10% or more of its revenues from an SSTB activity for it to count as an SSTB entirely. Classification as an SSTB becomes particularly relevant at high income levels.
Second, the taxpayer must determine her taxable income in relation to certain thresholds. The 199A Deduction’s calculation is dependent upon the taxpayer’s taxable income. The first threshold is $157,500 (or $315,000 if married filing jointly) (Minimum Threshold). The second threshold is $207,500 (or $415,000 if married filing jointly) (Maximum Threshold).
Third, if a taxpayer has taxable income below the Minimum Threshold, the taxpayer can apply the full 20% deduction regardless of whether income comes from an SSTB or is ordinary QBI. The taxpayer’s deduction is equal to the lesser of (1) 20% of her QBI (including SSTB income) plus 20% of the qualified REIT dividends and PTP income, or (2) 20% of the excess of her taxable income over her net capital gain.
Fourth, if the taxpayer’s taxable income exceeds the Maximum Threshold, she cannot deduct any income arising from an SSTB. However, a taxpayer may deduct a portion of her income if that income includes non-SSTB QBI. For these taxpayers, the deduction (calculated at first in the same manner as above) is limited by the greater of (1) 50% of the W-2 wages the business paid out during the year, or (2) 25% of the W-2 wages plus 2.5% of the unadjusted basis of the business’s depreciable property.
Fifth, if a taxpayer’s taxable income falls between the Minimum Threshold and the Maximum Threshold, she is in a particularly complex tax situation. If some or all of the taxpayer’s QBI is from an SSTB, the deduction is phased out depending on where the taxable income falls between the two thresholds. Additionally, the W-2/depreciable property limit on the deduction outlined above is phased in between the Minimum and Maximum Thresholds, regardless of whether the income arises from an SSTB.
Especially for taxpayers who either have SSTB income, pay low W-2 wages or have limited depreciable property in their business, keeping taxable income below the Minimum Threshold can have dramatic tax results. If these taxpayers have high income levels, their 199A Deductions are limited or even eliminated entirely. Therefore, if the taxpayer can reduce taxable income below the Minimum Threshold and obtain the full 199A Deduction, the taxpayer’s tax burden may decrease significantly.
The Charitable Deduction is straightforward in comparison to the 199A Deduction. While limitations exist, the basic principle of the Charitable Deduction is that taxpayers receive a dollar-for-dollar deduction for contributions to qualified organizations.
Organizations that qualify to receive deductible contributions include schools, government entities, churches, veterans’ organizations and a multitude of others. Most organizations must have a determination letter from the IRS that concludes the organization is a 501(c)(3) organization. These organizations are then split into (1) public charities and (2) private foundations.
Caps on the Charitable Deduction exist depending on the nature of the gift and the type of charitable recipient. For example, taxpayers can deduct no more than 60% of the taxpayer’s adjusted gross income for cash gifts to public charities and certain private foundations that operate their own charitable programs, contribute to public charities or pool contributions in a common fund. For the same category of organizations, noncash contributions are usually limited to 50% of a taxpayer’s adjusted gross income. Appreciated capital gains property donated to these organizations may be limited to 30% of adjusted gross income. Contributions to other organizations are generally limited to 30% of adjusted gross income, or 20% for capital gains property donations.
Stay tuned for our next article, wherein we'll discuss the aforementioned methods for stacking the benefits of these two deductions.
Brent Nelson is a partner at Rimon PC, Rachel Sass is an associate at Snell & Wilmer, and Abby McCourt is summer associate at Snell & Wilmer.