199A Deduction Errors Cost Small Businesses Big Refunds
The Section 199A deduction lets business owners avoid federal income taxes on that last twenty percent of their business income. Which sounds great.
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.
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.
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.
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.
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.)
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).