The Tax Cuts and Jobs Act of 2017 created Internal Revenue Code Section 199A, which allows for an income tax deduction generally equal to twenty percent (20%) of a taxpayer’s share of income from a pass-through entity (a sole proprietorship, an S corporation or an LLC taxed as a partnership).
Special rules apply, however, for taxpayers receiving pass-through income from certain Specified Service Businesses, which include the performance of services in the field of health, such as physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists and other similar health care professionals.
There are three possible 199A scenarios for owners of a Specified Service Business, all of which are based upon the amount of taxable income of the owner.
First, for an owner of a Specified Service Business who has taxable income greater than $207,500 (for single filers) or $415,000 (for joint filers), the 199A deduction is simply not available for pass-through income from a Specified Service Business.
Second, for an owner with taxable income below $157,500 (single) or $315,000 (joint), there is no special restriction. Thus, the 199A deduction is equal to 20% of the pass-through income from the Specified Service Business.
Assume, for example, that a doctor (a single taxpayer) receives a Schedule K-1 from his medical practice which shows his share of income as $100,000 and he has no other income. Because his taxable income (before taking into account any 199A deduction) is below $157,500, he would be entitled to a 199A deduction equal to $20,000 (20% x $100,000), or stated differently, he would pay tax on only $80,000 of the $100,000 shown on his Schedule K-1.
Third, for an owner with taxable income between $157,500 and $207,500 (single) or between $315,000 and $415,000 (joint), the 199A deduction is limited based on the following two-step process, the second step of which is very complicated.
The first step in the process is to reduce the amount of the Specified Service Business’ pass-through income, for purposes of calculating the 199A deduction, based upon how far along the owner’s taxable income is on the “path” from the bottom end of the applicable phase-out threshold ($157,500 for single taxpayers or $315,000 for joint filers) to the top end of the applicable phase-out threshold ($207,500 for single taxpayers or $415,000 for joint filers).
Thus, for single filers, the path consists of $50,000 from bottom to top, and for joint filers, the path consists of $100,000 from bottom to top.
For example, if an owner of a medical practice has pass-through income of $100,000 from the practice, and the owner’s taxable income, on a joint return before taking into account any 199A deduction, is $385,000, the owner would be seventy percent (70%) along the path ($385,000 - $315,000 = $70,000, which is 70% along the $100,000 path).
Thus, the amount of the owner’s pass-through income for purposes of calculating the 199A deduction would be reduced by seventy percent (70%) from $100,000 to $30,000. Accordingly, the maximum amount of the owner’s 199A deduction would be $6,000 ($30,000 x 20%), instead of $20,000 ($100,000 x 20%).
The second step in the process is to limit the 199A deduction based upon the amount of W-2 wages paid, and the amount of depreciable property owned, by the pass-through business.
Specifically, the 199A deduction is limited to the lesser of (i) 20% of the taxpayer’s pass-through income, or (ii) the greater of (a) 50% of the taxpayer’s share of W-2 wages with respect to the pass-through business, or (b) the sum of 25% of the taxpayer’s share of W-2 wages with respect to the pass-through business, plus 2.5% of the taxpayer’s share of the unadjusted basis of the business’ depreciable property.
The amount of W-2 wages and depreciable property, however, is reduced based upon how far the owner’s taxable income is through the relevant phase-out thresholds, and the overall second step limitation is phased-in based upon how far the owner’s taxable income is through the relevant phase-out thresholds.
Returning to the example above, the second step could cause the owner’s 199A deduction to be less than the $6,000 deduction determined under the first step. Fortunately, however, the W-2 wages paid by many physician practices may often allow the owners of those practices to ignore the second step entirely.
Below is a chart that illustrates the maximum amount of the 199A deduction for income reported on a Schedule K-1 of a Specified Service Business for an owner of that business whose taxable income (before taking into account the 199A deduction) is within the relevant phase-out thresholds.
|20%||$157,500 and under||$315,000 and under|
|None||$207,500 and over||$415,0000 and over|
Douglas T. Coats
410-576-4002 • firstname.lastname@example.org