Can Charitable Contributions Increase Your 199A Deduction?

Section 199A, also called the qualified business income (QBI) deduction, gives owners of pass-through entities a deduction on their personal income tax returns for up to 20% of business income. This deduction can significantly reduce income tax burdens for those who qualify. Unfortunately, taxpayers’ deductions will be reduced if their taxable incomes are too high, and those who work in certain service industries may lose their deductions altogether. There is no perfect technique for avoiding this taxable income limitation but making additional charitable contributions may help.

Quick Overview of QBI Deduction

Section 199A was created as part of the Tax Cuts and Jobs Act and went into effect in 2018. It provides small business owners with deductions of 20% of qualified business income. In part, the QBI deduction was created to level the playing field between C corporations and pass-through entities like S corporations and partnerships. When Congress dropped the corporate tax rate to 21%, they didn’t want owners of pass-through entities to be left in a lurch. Their solution was to lower business owners’ effective tax rates using a deduction. While the low corporate tax rate was a permanent addition to the tax code, the QBI deduction will expire in 2026, so it’s important for taxpayers to take advantage of the deduction while they can.

Taxable Income Limitation

Almost all business owners, no matter their industry, will lose some of their Section 199A deduction if their incomes get too high. In 2019, these limitations begin to kick in when taxable incomes exceed $160,700 for single filers or $321,400 for joint filers and will apply fully once taxable incomes reach $210,700 and $421,400, respectively. Their deductions will be limited to the greater of:

1. Their reportable share of 50% of business W-2 wages, or
2. The sum of their share of 25% of business W-2 wages plus their share of 2.5% of the unadjusted basis of qualified business property, which is typically the asset’s original cost.

Business owners who operate specified service trades or businesses (SSTBs) face even harsher limitations. At the lower-income thresholds, they will begin to apply the wage and property limitations like any other taxpayer, but as taxable incomes increase, they lose their deductions entirely. The deductions will be reduced to zero when their taxable incomes reach the upper taxable income thresholds. To learn more about these limitations, you can read more here.

How Charitable Contributions Come into Play

The QBI deduction’s taxable income limitations can be restrictive. It’s smart for taxpayers to look for ways to lower their taxable income so they can retain the full deduction. Charitable contributions have historically been the perfect tax planning solution. Individuals could reduce their taxable income to just the right amount by donating a bit more to charity at the end of the year. But when Congress raised the standard deduction as part of the Tax Cuts and Jobs Act, millions of taxpayers lost their tax incentives for donating to charity. Instead of itemizing their deductions, taking the standard deduction was the better option. Fortunately, some taxpayers can reduce their taxable incomes even without having to itemize: by directing IRA distributions to charity.

Qualified charitable distributions are distributions from a retirement account that go directly to a charity. These distributions would typically be taxable, but because they are directed to charity, taxpayers can exclude them from their income. This will lower their Adjusted Gross Income (AGI) and therefore their taxable income.

When taxpayers are close to being able to itemize, they can reduce their taxable income by bunching charitable donations. By donating two- or three-years’ worth of contributions into one tax year, they can (1) exceed the standard deduction that year, (2) receive a tax benefit for their donation, and (3) reduce their taxable income to qualify for the full QBI deduction. Taxpayers just need to remember that charitable donations are only deductible up to 50% or 60% of AGI, and some property (like appreciated stock shares) are only deductible up to 20% of AGI.

Another technique is to utilize a donor-advised fund (DAF). A DAF is a charitable trust established and run by a public charity. Taxpayers donate to their DAF, take the deduction immediately, and dole out charitable donations from their trust in future years. They can itemize their deductions the year they fund the DAF and take the standard deduction in subsequent years.

Questions?

Contributing to charity as a way to qualify for the full QBI deduction may not work for everybody, but it will work for some and can be an easy way to qualify for that full 20% deduction. If you have any questions about Section 199A or need assistance with tax planning, contact us today. For additional information call us at 770-476-1004 or click here to contact us. We look forward to speaking with you soon.