2021 Last-Minute Section 199A Tax Reduction Strategies

With all that’s happened in 2021, it’s easy to forget about your Section 199A deduction.

You may remember that the Tax Cuts and Jobs Act (TCJA) gave many pass-through businesses the Section 199A deduction as a no-effort, do-nothing 20 percent tax deduction based on defined business income.

For example, with defined qualified business income (QBI) of $100,000 and defined taxable income of $100,000, you qualify for a $20,000 Section 199A deduction that you claim on your Form 1040.

One thing to be aware of is that tax planning that reduces your business income can also reduce your Section 199A deduction. For example, you buy $40,000 of equipment and expense it. Now, your QBI is $60,000 ($100,000 - $40,000) and your 199A deduction is $12,000 ($60,000 x 20 percent).

Your planning for the Section 199A deduction requires more attention if your 2021 QBI is more than $164,900 (or $329,800 on a joint return).

In this article, we bring you three Section 199A strategies you can implement before December 31, 2021, that can help you obtain your best deduction.

First Things First

If your taxable income is above $164,900 (or $329,800 on a joint return), then your type of business, wages paid, and property can reduce and/or eliminate your Section 199A tax deduction.

The combinations can create confusion. 

Planning point. In general, you need to look at two numbers:

• Your 1040 taxable income determines your eligibility for the 199A deduction.
• Your deduction is equal to 20 percent of the lesser of your QBI or your 1040 taxable income.

If your Section 199A deduction is less than 20 percent of your QBI, then consider using one or more of the strategies discussed below to increase your deduction.

Strategy 1: Harvest Capital Losses to Reduce Taxable Income

Capital gains add to your taxable income, which is the income that

determines your eligibility for the Section 199A tax deduction,

sets the upper limit (ceiling) on the amount of your Section 199A tax deduction, and

establishes when you need wages and/or property to obtain your maximum deductions.

If the capital gains are hurting your Section 199A deduction, you have time before the end of the year to harvest capital losses to offset those harmful gains.

Example. Susan is single. She has QBI of $100,000 and taxable income of $180,000, of which $50,000 is net capital gain. Her business is an out-of-favor specified service business with $50,000 in wages and no qualified property.

If Susan takes no action, her Section 199A deduction is $13,960 because she is above the threshold and in the phaseout range.

If Susan harvests $20,000 in capital losses—say, from her stock portfolio—she is now below the threshold ($180,000 - $20,000 = $160,000), and her Section 199A deduction increases to $20,000

By using the capital gains offset strategy, Susan has obtained a total federal tax cash benefit of $4,450 from the capital loss, as follows:

• $3,000 in cash from the reduced capital gain taxes (15 percent of $20,000)
• $1,450 from the additional Section 199A deduction (24 percent of $6,040 [$20,000 - $13,960])

Calculating the Section 199A deduction by hand is not for the faint of heart—in fact, it’s pretty much not for anyone. 

When drawing up strategies as we did above, make sure to use the calculator. Doing the Section 199A deduction in your head or by hand is not only difficult but time-consuming and often confusing—and it often comes out incorrect.

Strategy 2: Make Charitable Contributions to Reduce Taxable Income

Since the Section 199A deduction uses taxable income for its thresholds, you can use itemized deductions to reduce and/or eliminate threshold problems and increase your Section 199A deduction.

Charitable contribution deductions are the easiest way to increase your itemized deductions before the end of the year. Consider doing one or both of the following:

• Donate appreciated stock, as we discuss in 2021 Last-Minute Year-End Tax Strategies for Your Stock Portfolio.
• Prepay (before December 31) your planned 2022 charitable contributions so you can claim them as deductions this year.

If you need a really large charitable contribution deduction to make this work, you should look into Conservation Easement Donations. 

Example. Let’s assume Susan (from our example above) decides to donate appreciated stock to her favorite charity instead of harvesting losses in her stock portfolio.

She donates appreciated stock with a value of $20,000 and built-in long-term capital gain of $8,000 to her favorite charity.

If the donation increases her itemized deductions by $20,000, then her taxable income drops by $20,000.

With this strategy, Susan saves $7,456 in 2021 federal income taxes from the stock donation:

• $6,006 from the $20,000 charitable contribution, which comes from two tax brackets (32 percent of $15,075 + 24 percent of $4,925); and
• $1,450 from the additional Section 199A deduction (24 percent of $6,040 [$20,000 - $13,960])

Susan also eliminated $1,200 in future capital gain taxes (15 percent of $8,000) because with the stock donation, she removed the capital gain from her portfolio.

Strategy 3: Buy Business Assets

Thanks to 100 percent bonus depreciation and Section 179 expensing, you can write off the entire cost of most assets you buy and place in service before December 31, 2021.

This can help your Section 199A deduction in two ways:

The big asset purchase and write-off can reduce your taxable income and increase your Section 199A deduction when the write-off can get your taxable income under the threshold.

The big asset purchase and write-off can contribute to an increased Section 199A deduction if your deduction currently uses the calculation that includes the 2.5 percent of unadjusted basis in qualified property immediately after acquisition (UBIA). In this scenario, your asset purchases increase your UBIA, which in turn increases the deduction you already depend on.

Example. Jim, who is single, runs his medical practice as an S corporation. He has taxable income of $214,900, and the S corporation has QBI of $100,000, wages of $120,000, and UBIA of $20,000.

If Jim takes no action, his Section 199A deduction is $0, because his taxable income is at the 199A upper threshold of $214,900 and his business is an out-of-favor specified service business.

Let’s say that before December 31, 2021, Jim buys and places in service medical equipment costing $30,000 that he had previously planned to buy over the next one to two years.

Assuming Jim fully expenses the property, he saves $12,452 in federal income taxes:

• $9,764 from the $30,000 equipment write-off, which comes from two tax brackets (35 percent of $5,475 + 32 percent of $24,525), and
• $2,688 from the Section 199A deduction. (Note that the $30,000 of expensing reduces both Jim’s taxable income and his QBI. We use the calculator to see that Jim now has an $8,400 Section 199A deduction. His tax benefit is 32 percent of that, or $2,688.)

Takeaways

If your 2021 taxable income is over $164,900 (or $329,800 on a joint return), you could face a reduced or eliminated Section 199A deduction.

In such cases, consider using one or more of the three strategies described in this article to reduce your taxable income and increase your Section 199A deduction. The three strategies are as follows:

1. Harvest capital losses if you have capital gain income that’s causing the trouble.
2. Make charitable contributions to increase your itemized deductions and reduce your taxable income— and consider donating appreciated long-term-gain stock to come out even better.
3. Buy and place in service before midnight on December 31, 2021, business assets that you can expense 100 percent to lower your taxable income. (This also lowers your QBI, but if you need it to gain the Section 199 deduction, it’s a good strategy.)

Final points. The Section 199A deduction can get confusing. Be sure you can identify your correct Section 199A deduction. If you have more than one business, make sure to review Caution.