How is the new tax law impacting your passthrough business? Many taxpayers do not know for sure at this point. While most provisions went into effect January 1, 2018, the possible tax savings will not become clear until early 2019 when 2018 tax year filings are prepared. One thing is for sure, Code Section 199A has become the tax of the tax world.
The IRS has prioritized guidance on the passthrough deduction to help taxpayers comply with the complex new rules. Proposed regulations were released in August 2018, and the IRS held a hearing on the rules on October 16, 2018, with over 20 trade groups, tax professionals, and other stakeholders testifying. Some of the concerns presented by taxpayers are summarized below, but first, let’s review the basics.
Section 199A Basics
The 20% passthrough deduction is allowed for “qualified business income” received by owners from a passthrough entity, including partnerships, S Corporations, and LLCs.
Qualified business income includes domestic income from a trade or business, but not all income. Employee wages, other compensation, a partner’s guaranteed payments, capital gain, interest and dividend income are not eligible for the deduction.
Many other restrictions apply as well, including the disqualification of “specified service trade or businesses”, such as lawyers and accountants, from eligibility for the deduction unless their income is under these thresholds: taxable income of less than $157k for singles and $315k for joint filers. The deduction phases out completely at the taxable income of $207k for singles and $415k for joint filers.
Salaries: An Important Equation
One of the more difficult analyses taxpayers are now going through in an attempt to maximize their passthrough deduction is determining the allocation of owner payments between salaries and profits, particularly for S Corporations. In the past owner-employees of S Corporations have sought to minimize salaries to avoid Social Security and Medicare taxes. Under the Section 199A rules, however, non-service businesses get an increased deduction if the entity’s W-2 wages are higher, so this now S Corporation shareholders have to weigh how much income they should take as a W-2 salary versus how much should be treated as an income allocation. (Note that owner-employees are required to pay themselves a “reasonable salary” under existing tax rules.) The answer may depend on which formula the taxpayer uses to compute the deduction. Two of the calculation methods use a percentage of the entity’s total W-2 wages to determine the deduction limitation. These computations are complex, so taxpayers should consult with their tax advisors now to review their numbers and determine the best path forward.
Selling Expertise Narrowly Defined
Passthrough owners received good news when the proposed IRS regulations clarified which types of passthrough businesses were allowed the deduction. Initially, there was concern that the language of the TCJA would disqualify any type of business that provided services based on skill or reputation if the income thresholds were exceeded.
However, the regulations took a more narrow view. The following professions were determined to fall under the definition of disqualified services:
- brokerage services
- insurance services
- financial services
- trading or dealing in securities, partnership interests or commodities
- law, accounting, actuarial science
- athletics and performing arts.
The regulations also included a de minimis rule, under which a business will not be a disqualified service business if it only provides a small amount of disqualified services. Finally, the proposed rules allow separate trades or businesses to be grouped together when applying the deduction based on common ownership, shared services, and other related activities.
Entertainment Expenses & Deduction for Meals
Passthrough owners will also be interested in the changes to meals and entertainment. The new law eliminated the deduction for business entertainment expenses, but taxpayers can continue to deduct 50 percent of the cost of business meals if the taxpayer or an employee of the taxpayer is present, and the food or beverages are not considered lavish or extravagant.
The meals may be provided to a current or potential business customer, client, consultant or similar business contact. Food and beverages that are purchased or consumed during entertainment events will not be considered entertainment if either of these applies:
- they are purchased separately from the entertainment
- the cost is stated separately from the entertainment on one or more bills, invoices or receipts
This clarification by the IRS was one of the most welcome IRS Notices this year. (Notice 2018-76). Businesses of all sizes are affected by the new restrictions, so the IRS’s reading of the law preserves the write-off of an important business practice.
Reg Comments Identify Possible Changes
Several themes emerge in a review of the comments the IRS has received on the proposed regulations, with most of them related to which activities and businesses represent disqualified service businesses. Here’s a sampling:
Service Businesses: Many comments asked the IRS for even more clarity on what it considers a disqualified specified service trade or business (SSTB).Taxpayers that are not in the listed professions are having difficulty determining whether their activities come under the statute’s catch-all language that disqualifies a business if the “principal asset of the business” is the “reputation or skill” of its employees or owners. Taxpayers want the IRS to identify exactly which other types of businesses meet this definition.
Major League Baseball (MLB) entered the fray, arguing in a letter to IRS that professional sports clubs are not “personal services corporations” and do not provide “services.” Thus, Commissioner Robert D. Manfred, Jr., said, baseball owners should be allowed the full deduction and should not be subject to the phase-out based on an income of specified service firms.
Rental Real Estate: The proper treatment of rental real estate activities also has caused confusion among taxpayers. Troy Lewis of the American Institute of CPAs (AICPA) asked the IRS for assurances that rental real estate activities are generally considered a trade or business eligible for the passthrough deduction. He also said that taxpayers need to know the specific circumstances under which income from rental real estate would not be considered qualified business income.
Aggregation Test: While taxpayers welcomed the ability to aggregate businesses for purposes of the deduction, some commentators, such as the Real Estate Roundtable, believe that the 50 percent ownership test is too high. That test requires that the taxpayer own 50 percent or more of each trade or business to be aggregated. (The aggregation is only for purposes of computing qualified income and cannot be used to increase the wage or depreciable property limits.)
The IRS will likely adopt some of the suggestions when it finalizes the regulations sometime in early 2019, so the regulations comments can give insight into the changes that may be coming.
The IRS has estimated that it will take 25 million hours for passthrough taxpayers to meet the compliance burdens created by the new deduction. The IRS expects that 8.8 million passthrough owners will need more detailed information from their entities to properly calculate their deduction. Taxpayers then will be required to make more disclosures of administrative and financial information to the IRS with regard to their operations, compensation policies, and income allocations.
House Votes for Permanent Deduction
The passthrough deduction is set to expire after 2025, but the House of Representatives has indicated that it has no intention of letting that happen. In September 2018, the House voted to make the Section 199A deduction permanent, as part of its Tax Reform 2.0 bill. (H.R. 6760, the Protecting Family and Small Business Tax Cuts Act of 2018.) Although the Senate is not expected to take up the bill before the mid-term elections, the permanent extension of the passthrough deduction will remain a key goal of House leaders.
The formulas for qualified business income reward entities with more W-2 income, with presumably a job creation goal by Congress, and also benefit businesses with a large amount of capital investment. The trade-off for these incentives is the complexity created by the new concepts of “specified service trade or businesses” and “qualified business income.” With welcome guidance from the IRS and the hard work of professional tax advisors, the learning curve is beginning to shorten.