Qualified Trade or Business Under Section 199A: Definition and Tax Benefits

Introduction

Section 199A of the Internal Revenue Code was introduced in 2018 as part of the Tax Cuts and Jobs Act (TCJA). It provides a deduction for qualified trades or businesses and is one of the most significant tax reforms of recent years. The deduction can be taken on up to 20 percent of a taxpayer’s qualified income from a qualified trade or business. This article will explore the definition of a qualified trade or business under Section 199A, eligibility requirements, tax benefits, and examples of businesses that may qualify.

Definition of a Qualified Trade or Business Under Section 199A

The Internal Revenue Service (IRS) defines a qualified trade or business as “any trade or business other than a specified service trade or business.” A specified service trade or business is defined as any activity involving the performance of services in the fields of 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 or owners.

In order to qualify as a trade or business under Section 199A, the activity must meet certain requirements. The activity must be conducted with the intent to make a profit, and the taxpayer must have regular, continuous, and substantial involvement in the activity. Additionally, the activity must not be considered a hobby or a passive activity. If a taxpayer meets these requirements, the activity qualifies as a trade or business under Section 199A.

There are several types of businesses that may qualify as a qualified trade or business under Section 199A. These include sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, and C corporations. In addition, rental real estate activities may also qualify, provided they meet the requirements outlined by the IRS.

Tax Benefits of Qualified Trade or Businesses Under Section 199A

Section 199A provides a deduction of up to 20 percent of a taxpayer’s qualified income from a qualified trade or business. This deduction is available to both individuals and businesses, and it applies to income earned from a qualified trade or business in the United States. The deduction is limited to 50 percent of the wages paid by the qualified trade or business, or 25 percent of the wages plus 2.5 percent of the unadjusted basis of tangible property used in the qualified trade or business.

The deduction is also subject to various phase-outs and limitations based on taxable income levels. For instance, taxpayers with taxable income above $415,000 ($207,500 for single filers) are ineligible for the deduction. Additionally, the deduction is limited to 20 percent of the excess of the taxpayer’s taxable income over net capital gain.

In 2019, the IRS issued new guidance that expanded the definition of a qualified trade or business for purposes of the Section 199A deduction. Specifically, the IRS clarified that certain real estate activities, such as developing, redeveloping, construction, reconstruction, acquiring, converting, renting, operating, managing, leasing, or brokering real estate, can qualify as a qualified trade or business. This expansion of the definition of a qualified trade or business has made it easier for real estate professionals to take advantage of the Section 199A deduction.

Comparison of Qualified Trade or Businesses with Other Types of Businesses for Tax Purposes

While the Section 199A deduction is only available to qualified trades or businesses, there are other types of businesses that may provide tax benefits. For instance, businesses organized as C corporations are subject to double taxation, meaning that corporate income is taxed at the corporate level and then again at the shareholder level when profits are distributed. By contrast, businesses organized as S corporations, partnerships, and LLCs are generally only taxed once at the individual shareholder level.

Additionally, some businesses may be eligible for special tax incentives such as the research and development tax credit or the Work Opportunity Tax Credit. These credits can reduce a business’s taxable income and potentially save them money on their taxes. Ultimately, the type of business entity chosen should depend on the specific needs of the business, as each type of entity may offer different tax benefits.

Examples of Qualified Trade or Businesses Under Section 199A

Common examples of qualified trade or businesses under Section 199A include doctors, lawyers, accountants, real estate agents, web designers, photographers, consultants, and freelancers. Additionally, businesses such as restaurants, retail stores, manufacturing businesses, and construction businesses may also qualify as qualified trades or businesses.

It is important to note that not all businesses will qualify as a qualified trade or business under Section 199A. For instance, businesses that are primarily engaged in providing services such as investment advice, financial planning, or insurance services do not qualify. Additionally, businesses that generate most of their income from passive investments, such as rental properties, do not qualify.

Conclusion

Section 199A of the Internal Revenue Code provides a deduction for qualified trades or businesses. To qualify, the activity must be conducted with the intent to make a profit, and the taxpayer must have regular, continuous, and substantial involvement in the activity. Additionally, the activity must not be considered a hobby or a passive activity. The deduction is available to both individuals and businesses, and it applies to income earned from a qualified trade or business in the United States. Common examples of qualified trades or businesses include doctors, lawyers, accountants, real estate agents, web designers, photographers, consultants, and freelancers.

The Section 199A deduction can provide significant tax savings for businesses, especially those in the real estate industry. However, it is important to understand the definition of a qualified trade or business and the eligibility requirements, as well as the potential tax benefits and limitations of the deduction. By understanding these factors, businesses can ensure they are taking full advantage of the tax savings available under Section 199A.