IRS Issues Section 199A Guidance On The
New 20% Pass-Through Business Income Deduction:
Who Are The Winners and Losers?
Hello Everyone,
As you may recall from our previous Tax Alerts from Feb 3 and May 21, one of the key items passed in the recent tax reform, the Tax Cuts and Jobs Act (TCJA), was the 20% Pass Through Entity Business Income Deduction. It has also been called the “Qualified Business Income Deduction (QBI)”, and the tax nerds like me are calling it the “Section 199A Deduction”. I’ve been anxiously waiting official IRS guidance on this topic since it was passed by Congress, and the IRS released its initial guidance on August 7. At 184 pages, you can tell this new deduction is quite complex, and there are still unanswered questions, so we anticipate further guidance from the IRS in the coming weeks.
I’ll spare you all the gory details (but will send you a link to it if you’d like!). I’ll summarize it as best I can by listing out who the key winners and losers will be. Here goes nothing:
Winners!
- “Middle Class” Business Owners – Any business that is a sole proprietorship, single member LLC, partnership, or S corporation, whose owners will show less than $315,000 of taxable income (Married) or $157,500 of taxable income (Single), regardless of what business or profession you are in, you get the 20%-of-QBI deduction automatically.
- Service Providers Outside of the Narrow “Specified Service Business” Definition – The way the original rule was written, there was a “catch all” that said generic consultants or anyone whose “primary business asset was the reputation or skill of its owners”, would fall under the dreaded “specified service business” limitations. The recent IRS guidance very favorably gives a fairly narrow definition of “specified service business” and many people who were very concerned about being disqualified from getting the deduction have been spared. The lucky winners here are: real estate agents, insurance agents, gym or spa owners, broadcasters, salespeople, providers of education or training courses, bankers, and real estate managers, among others. The IRS clarified that the “reputation or skill” disqualification would apply only to those earning income from endorsements, compensation from the use of a person’s image/likeness/name/signature/voice/trademark or other symbols associated with a person’s identity, and appearance fees for radio, TV, or other media formats. So while the IRS will crack down on celebrities, they will leave the “average Joe’s” alone.
- Architects and Engineers – they were excluded from the “specified service business” definition in the original written rules issued by Congress, so they weren’t sweating the recent IRS guidance at all. Kudos to the lobbyists who represent architects and engineers.
- S Corporation Owners – The IRS guidance did not take away the ability for S Corporation owners to include their own Officer Compensation W-2 wages in the phase-out limitation calculation of overall W-2 wages paid. So, it still makes whole lot of sense to operate as an S Corporation, if you expect or could end up in the phase-out range of $315K-$415K (married) or $157.5K-$207.5K (single) taxable income range. Very careful planning is needed in order to implement that properly, and Reasonable Compensation Audits are expected to be a hot topic in the coming years.
- Proactive Planners and Typical Taxable Income Planning Strategies – If you have a solid accounting process, or have us handling it for you, and are willing and able to sit down and really take the time to map out your 2018 profit expectations, all of the typical taxable income planning techniques are still 100% viable and on the table, in order to maximize your S199A deduction. The IRS guidance didn’t put any special limitations on pre-tax retirement contributions, or Section 179 equipment expensing opportunities, and things of that nature that can legally limit the amount of taxable income the you report annually. So you can still work diligently to keep your income below the threshold amounts to maximize your 20% QBI income deduction. That is where we can help you the most. Our proactive planning services are still the best investment you can make in your business, so please reach out to book your Proactive Tax Planning Strategy project today!
- Those Who Fall Below the New De Minimus Rule – The IRS guidance did address business owners who have both revenues from non-specified service businesses and revenues from the dreaded list of specified service business activities. They say, as long as less than 10% of your overall business revenues come from specified service business activities, then you won’t need to worry, and you will still qualify for the full 20% deduction. (Note: the 10%-of-gross-income threshold falls to just 5% for businesses with gross revenues over $25M).
- Active Rental Property Owners – Under the original written rules, there were a lot of questions pertaining to whether profits from rental property activities would qualify for the 20% pass-through entity deduction. The recent IRS guidance seems to lean towards, as long as you can prove that you are actively engaged in operating and managing your rental property activities, you will qualify for the S199A deduction. So you’ll definitely want to document as best you can, the amount of hours and active activity you spend managing your property or properties. While truly passive owners who hire rental property managers, or only offer passive triple-net leases leases might suffer, everyone else seems to be safe here.
Losers!
- Employee-to-Contractor Converts – Anyone who thought they would go ahead and quit their W-2 job, and then be hired back as a contractor. The IRS specifically has said they will go after those folks viciously. If you worked for an employer as a W-2 employee prior to tax reform, and then switch to a 1099 contractor, doing the same work for the same employer, your S199A deduction will be disallowed. And you’ll still be stuck with the additional self-employment tax and filing costs of running your own business. In short, you’d be screwed, so don’t quit your day job to try and take advantage of a 20% QBI deduction.
- “Crack and Pack” Strategies – At the onset of the rule passing, as written, it looked like businesses that fall under the “specified service business” definition would be able to split their revenue streams between 2 or more companies, and the companies that were not providing “specified services” could take advantage of the S199A deduction. Think of a law firm putting its billing department or admin staff into separate entities in order to get a 20% deduction for the profits earned by those activities. Well, the IRS sees right through that, and plans to audit the “you know what” out of businesses that attempt to do that. So those sorts of strategies are off the table. The IRS guidance around de minimus rules and anti-abuse rules can really work against certain businesses. Any businesses with 50% or more common ownership that provide 80% or more of its services to each other, or if the entities share wages and overhead and more than 5% of gross revenues full under the specified service business umbrella, both/all will be 100% treated as a specified service business.
- Specified Service Providers – Doctors, lawyers, accountants (yup, me), actuaries, actors, singers, musicians, entertainers, directors, business consultants and coaches, athletes, sports coaches and managers, financial advisors, M&A advisors, valuation consultants, investment bankers, wealth planners, retirement advisors, stock brokers, traders, and asset managers. If you over the $315K-$415k (married) and $157.5K-$207.5K (single) taxable income thresholds, you get no S199A deduction. So, in my opinion, you have 2 choices, 1) Stop working so hard, get some work/life balance, max out around $314K of income and take the S199A deduction, or 2) Work as much as you can, make as much money as you can, and don’t cry about losing some 20% deduction on the income, the government says you don’t need a deduction, you’re doing just fine. Note: Even if a small overall % of your annual revenues, anything over 10% of gross receipts, falls into the categories above, your entire business will be treated as a specified service business.
- Self Rentals – If you happen to own (or were planning to buy) the real estate that your business is located in, and rent the property to your business, the IRS guidance includes some “attribution” rules which will prevent you from shifting business profits from your specified service business to a non-specified service business entity. So you won’t qualify for any 20% deduction at all, as long as your property rental income is 80% or more from your also-owned specified service business. If you own a building, and less than 80% of the rental income is from your own co-owned businesses, you still have a shot at getting some pro-rated S199A deduction, but probably not the full deduction you were hoping for.
- Tax Accountants – The IRS guidance states that the time requirement for each and every business owner to research, assess, and properly report, their S199A deduction, will range between 30 minutes and 20 hours. They believe that the average business will require about 2.75 hours of analysis to get the S199A deduction correct and fully documented. Yikes! Tax accountants are already pushing the pedal to the metal in tax season, so we have no idea where these extra hours will come from! Our office will be working hard to streamline the implementation of this one deduction (among all of the other tax law changes), as best we can.
- Those Who Fall Above the New De Minimus Rule – As stated above, the IRS guidance did address business owners who have both revenues from non-specified service businesses and revenues from the dreaded list of specified service businesses. What if you do have “specified service business” revenue exceeding 10% of your overall business revenue? Well, then it “taints” your entire business and you won’t get any of the 20% deduction, if you are above the income thresholds. That can be crushing. If you find yourself in this position, you might re-think your entire business model. We are here to help you with planning, give us a call if you fall into this category.
The IRS still has a few holes to fill as far as S199A guidance goes, and the AICPA has already made a formal request for a few specific areas. We are all over this new rule, not sure how many other accountants can confidently say that. For those of you who really need to figure out how to maximize this deduction, we have several planning strategies tee’d up, and are ready to work with you on getting the tax planning needed to get the most out of the new rules.
Our tax planning session time slots are selling out quickly, please reach out if you are interested in knowing more, and we can reserve a spot for you.
