2022 Last-Minute Section 199A Tax Reduction StrategiesTax Planning
With all that happened in 2022, it’s easy to forget 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. You didn’t have to do anything to get this deduction.
One thing to be aware of: tax planning that reduces your business income can also reduce your Section 199A deduction. For example, let’s say 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 2022 QBI exceeds the threshold —$170,050 (or $340,100 on a joint return).
In this article, we bring you three Section 199A strategies you can implement before December 31, 2022, to help you obtain your optimal deduction.
First Things First
If your Form 1040 taxable income is above $170,050 (or $340,100 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, but you can lessen the confusion by using a Section 199A calculator.
Planning point. In general, when planning for your Section 199A deduction, you need to look at:
- Your 1040 taxable income. This determines your eligibility for the 199A deduction.
- Your QBI, wages paid, and type of business (in-favor or out-of-favor). This determines the deduction, which is limited to no more than 20 percent of your taxable income less capital gains.
If your Section 199A deduction is less than 20 percent of your QBI, 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.
- Taxable income determines your eligibility for the Section 199A tax deduction.
- Taxable income less capital gains sets the upper limit (ceiling) on the amount of your Section 199A tax deduction.
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 $190,000, 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 $12,020 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 ($190,000 - $20,000 = $170,000), and her Section 199A deduction increases to $20,000, as the calculation shows.
By using the capital gains offset strategy, Susan has obtained a total federal tax cash benefit of $4,915 from the capital loss, as follows:
$3,000 in cash from the reduced capital gain taxes (15 percent of $20,000)
$1,915 from the additional Section 199A deduction (24 percent of $7,980 [$20,000 - $12,020])
Doing the Section 199A deduction in your head or by hand is time-consuming and difficult—and it often comes out incorrect. The calculator is a big help. When drawing up strategies as we did above, use a calculator.
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 2022 Last-Minute Year-End Tax Strategies for Your Stock Portfolio.
- Prepay (before December 31,2022) your planned 2023 charitable contributions so you can claim them as deductions this year.
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 a built-in long-term capital gain of $8,000 to her favorite charity.
If the donation increases her itemized deductions by $20,000, her taxable income drops by $20,000.
With this strategy, Susan saves $8,023 in 2022 federal income taxes from the stock donation:
- $6,108 from the $20,000 charitable contribution, which comes from two tax brackets (32 percent of $19,050 + 24 percent of $50), and
- $1,915 from the additional Section 199A deduction (24 percent of $7,980 [$20,000 - $12,020]).
Susan also eliminated $1,200 in future capital gain taxes (15 percent of $8,000) because the stock donation 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, 2022.
The big asset purchase can help your Section 199A deduction in two ways:
- It can reduce your taxable income and increase your Section 199A deduction when the write-off can get your taxable income under the threshold.
- It 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 Form 1040 taxable income of $220,050, 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 $220,050 and his business is an out-of-favor specified service business.
Let’s say that before December 31, 2022, 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 $12,411 in federal income taxes:
- $9,723 from the $30,000 equipment write-off, which comes from two tax brackets (35 percent of $4,100 + 32 percent of $25,900), 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.)
If your 2022 taxable income is over $170,050 (or $340,100 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:
- Harvest capital losses if you have capital gain income that’s causing the trouble.
- Make charitable contributions to increase your itemized deductions and reduce your taxable income— and to come out even better, consider donating appreciated long-term-gain stock.
- Buy and place in service before midnight on December 31, 2022, business assets you can expense 100 percent to lower your taxable income. (This also reduces your QBI, but if you need lower income to gain the Section 199 deduction, the asset purchase is a good strategy.)
Final points. The Section 199A deduction can get confusing. Be sure to use a 2022 Section 199A calculator to run the numbers so you can identify your correct Section 199A deduction.