Whether there may be unforeseen complexities or issues of interpretation under Section 199A with respect to passive activities remains to be seen. ((There is some discussion of the passive activity rules in the Sec. 199A legislative history in the House version. See Conf. Rep., e.g., p. 211 of the legislative history from the House. Conference followed the Senate version.))
The focus of the statute is on items that affect taxable income, so the authors consider it unlikely that the IRS will interpret Section 199A to remove from the computations passive losses that arise in pre-enactment years and enter into taxable income after 2017.
The potential effect of Section 199A in the various scenarios inclusive of Section 1231 gains and/or losses on the sale of business assets is important and discussed in more detail below in “A Closer Look at What Qualifies as Business Income.”
The topic of disallowed business expenses is beyond our scope, but as an example of such disallowance, we note the following in the legislative history of the 2017 Act. “Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel.)” ((Conf. Rep., p. 407.)) In the language of the new Section 199A, we note that in its definition of “qualified business income,” it basically refers to the net figure considering “income, gain, deduction and loss…” ((Sec. 199A(c)’ (1).)) But query whether the IRS will require disallowed business expenses to be subtracted in computing business income subject to the new 20% deduction?
Also included in “qualified business income” are REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. Note that a Subchapter S corporation is by definition one with a limited number of shareholders, so in this list we note only publicly traded partnership income.
Toward the goal of some simplification in our discussion of these very complex rules, we won’t include the particulars of REITs and cooperatives, which are basically flow-through entities.
The basic definition of a “trade or business” is “any trade or business” with two exceptions: wages of an employee and in certain cases “specified service trade or business.” ((Sec. 199A (d).))
An employee is considered to be in business, but wage income is expressly excluded from qualifying business income for this purpose. ((Sec. 199A (c’) (4).))
“Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer.” ((Conf. Rep., p. 215.))
Planning point: Earnings as an independent contractor may qualify, so this is one more area of the Code where employee vs. contractor distinctions are important, possibly even placing new strategic emphasis on minimizing employee characterization.
An independent contractor gets some deduction related to the self-employment tax but pays the entire tax versus paying half the payroll tax as an employee, and bearing the incremental self-employment tax in order to access the new credit is not a persuasive strategy, with the possible exception of high compensation levels that exceed the maximums subject to FICA/FUTA. So when the employee vs. contractor classification is debatable, borderline, we wouldn’t generally expect employees to be initiating requests to be reclassified as contractors.
Planning point: Subchapter S flow-through of business income generally qualifies as being eligible for the 20% of business income deduction but the new context suggests possible disputes with the IRS over whether payouts from the S corporation are nondeductible dividends or wages that should reduce the level of Subchapter S flow-through of business income. Wage classification is normally a negative because wages don’t qualify as business income, but wages can help in scenarios where a level of wages or wages and capital are necessary to avoid limitations on the 20% deduction. These limitation rules are discussed below. Whether payouts from S corporations are dividends or wages triggering payroll taxes and withholding is a traditional area of dispute between the IRS and owners of S corporations, and this issue is still with us. ((See Rev. Rul. 59-221, 1959-1 C.B. 225, Rev. Rul. 74-44, 1974-1 C.B. 287, Ding, 200 F. 3d 587 (1999), CA-9, http://caselaw.findlaw.com/us-9th-circuit/1435681.html, PLR 20030026, 3/31/03.))
Following is an excerpt from an IRS site discussing wages in an S corporation context:
“S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.” ((“S Corporation Compensation and Medical Insurance Issues,” “Reasonable Compensation,” https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues.))
As above, to the extent there is just flow-through income and no payouts to the shareholder-employee, the flow through is a dividend and not wages.
In an S corporation context, to summarize, here are the “wages” issues we see with respect to closely-held shareholders.
To the extent there are payouts in the context of shareholder services and such payments are characterized as dividends, the IRS has traditionally argued, and will continue to argue, that the “reasonable compensation” element of such payments are really wages subject to payroll tax.
To the extent there are payouts in the context of shareholder services and such payments are characterized as dividends, the IRS will also argue that such payments reduce the business income otherwise eligible for the 20% of business income deduction because such payments are really wages. The IRS now has a second major incentive to classify S corporation payments to owners as wages.
When there are no payouts of wages and no payouts of dividends which could be challenged as disguised wages, will the IRS argue that for purposes of the new Section 199A, it is entitled to nevertheless characterize the flow-through income as wages to the degree of the value of the shareholder services? This concept is missing from the legislative history, is contrary to current IRS practice, and we would be very much surprised if the IRS takes such a position.
When there are payouts of wages to shareholder-employees, the taxpayer is conceding (a) payroll taxes; even above the annual FICA/FUTA limits, there is some incremental tax; (b) the wages are not subject to the 20% of business income tax; and (c) the wages reduce the S corporation’s business income flowing through to the shareholder-employee, as well as other shareholders if any. The taxpayer may gain wages classification when a level of wages or wages and capital is necessary to avoid limitations on the 20% business deduction. But it is difficult to envision it being a net advantage to the IRS to reclassify wages as a dividend. The more likely scenario is upon exam, the math indicates the wage limitation is already satisfied with other wages or not a factor because of the income level of the taxpayer, and the taxpayer’s representative uncovers arguments as to why wages were overstated; e.g., the taxpayer was ill, getting older and working fewer hours, etc.
Planning point: Keep in mind that reducing the historic level of wages to shareholder-employees of an S corporation may be justified in some circumstances (age, health, other responsibilities, etc.) and may be particularly advantageous under the new 20% of business income rules.
Guaranteed Payments to a Partner
A partner receiving guaranteed payments from the partnership is not receiving qualifying business income for this purpose. ((Sec. 199A (c’) (4).))
Planning point: Reviewing the level of guaranteed payments, which do affect the actual economics in a partnership context, is important because it reduces the flow-through partnership income that may otherwise qualify for the 20% of business income deduction.
The new environment of Section 199A may cause the IRS to argue that payments to partners characterized as distributions are really disguised guaranteed payments. Such an argument may be even more likely in a family partnership context.
“Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.” ((Conf. Rep., p. 215, footnotes omitted…))
There are higher-income areas of the 20% of business income rules that introduce limits that require wages or wages and capital, and we wouldn’t expect the IRS to interpret guaranteed payments of a partnership to qualify as wages for this purpose.
Qualifying business income must be effectively connected with the conduct of a trade or business within the United States. ((Sec. 199A (c’) (3) (A).)) Foreign earned income doesn’t qualify for the deduction. The long-standing but limited exclusion for foreign earned income was not repealed in the new law.
In general, such items as dividends and interest income don’t qualify, albeit it is possible in some circumstances to have interest income qualify if it relates to a business. ((Sec. 199A(c)’ (3) (B).)) Stock market gains, typical capital gains and losses in an investment rather than business context, do not qualify. ((Conf. Rep., p.215.))
REAL ESTATE INCOME
One doesn’t find “rent” or “rental” in the new Section 199A which is titled “Qualified Business Income.” It was the Senate version that prevailed, but we note the following comment from the legislative history of the House.
“Unlike a C corporation, partnership, or S corporation, a business conducted as a sole proprietorship is not treated as an entity distinct from its owner for Federal income tax purposes. Rather, the business owner is taxed directly on business income, and files Schedule C (sole proprietorships generally), Schedule E (rental real estate and royalties), or Schedule F (farms) with his or her individual tax return.” ((Conf. Rep. 208 of the House provisions, footnote omitted. There is also a reference to “rental activities” on p. 211 of the House provisions in the context of passive losses.)) It may be debatable whether these references to rentals were meant to include the activities in business income, although this does seem to say among the filings of the “business owner” is Schedule E with its rental real estate.
There are endless fact patterns but the authors suggest that most tax practitioners wouldn’t consider, say, a “rental house” to be a business activity. The self-employment tax applies generally to a trade or business but real estate rentals are generally excluded. They are excluded if the realty is held for investment. ((Sec. 1402 (a) (1); Regs. 1.1402(a)-4. See also, Regs. 1.1411-1, 1.1411-5.))
Almost certainly, one would expect, e.g., a housing contractor or hotel/motel operator to be in a trade or business. ((The following says Section 199A was “clearly intended to apply to commercial real estate,” opines that the rule about 2.5% of basis for qualified property was intended to allow the deduction for rental entities without employees, and queries whether the definition of a trade or business will emphasize Section 162 or Section 1411. See “New Code Section 199A, Pass-through Qualified Business Income Deduction,” Leon C. LaBrecque, Michigan Association of Certified Public Accountants, MICPA.org, p. 1; http://micpa.org/docs/site/e-news/is-section-199a-of-the-code-a-windfall-for-cpa-firms.pdf?sfvrsn=6. See also “Planning for UBTI Changes,” Dennis Walsh, Planned Giving Design Center, 1/16/18; http://www.pgdc.com/pgdc/planning-ubti-changes.))
Note these comments from an IRS site discussing post-construction realty rentals in a self-employment tax context:
“Rents received from the use of or occupancy of hotels, boarding houses, or apartment houses are included in self-employment income IF you provide services to the occupants. Services considered provided to the occupants are services primarily provided for the convenience of the occupants and not normally provided with the rental of rooms or space for occupancy only. Maid service, for example, is a service provided for the convenience of occupants, while heat and light, cleaning of stairways, and the collection of trash are not.. ((“Rents,” https://www.irs.gov/individuals/tax-trails-self-employment-income-6.))
Let’s initially consider a real estate rental fact pattern where it at least may have the appearance of a trade or business.
One might find an office with employees and an integrated operation of real estate operations focused on real estate rentals, occasional projects that involve major improvements or even new construction, owned by two associates or a married couple. The details of rent collections, calling the plumber, etc., may be with this company, or related company possibly owned by a family member, or such company may be unrelated. One may argue the real estate rental income is still not subject to self-employment tax, which normally applies to a “trade or business.” One might argue the realty is held for investment despite a certain recurring level of activities inherent in owning multiple properties. But does such a position necessarily remove it from being a trade or business for purposes of the 20% of business income deduction? It is quite possible that the IRS will not consider real estate rentals as subject to Section 199A unless the activities are also subject to self-employment tax.
At the other end of the spectrum is the busy employee or business owner with one real estate rental property, perhaps a former residence, and whether this rises to the level of a trade or business for purposes of the 20% of business income deduction is another question.
It was the Senate version that prevailed albeit with significant modifications in conference. The legislative history of the Senate and conference discusses qualified business income without mentioning real estate rentals, and investment income without mentioning real estate rentals. ((Conf. Rep., p. 214, 215.))
Had it been the intent to include real estate rentals carte blanche in the definition of a trade or business for purposes of the new Section 199A, one would expect that such intent would have been made patently clear in the statute, or at least the legislative history.
At the other end of the spectrum are real estate “dealers” who are typically considered as being in a trade or business. ((Regs. 1.1402(a)-4.)) There are many cases focusing on whether the facts indicate realty sales produce ordinary income because the taxpayer was acting as a “dealer,” and the sale of realty, which often involves some level of construction or improvement, was akin to the grocer selling canned goods. ((Taxpayers sometimes unsuccessfully argue dealer status on a realty sale to avoid the annual limit on capital losses arising from the sale of investment realty. Conner, T. C. Memo 2018-6.))
Another question in this context is whether or when real estate activities, including rentals, constitute a single trade or business. Some of the details in the computations look to the income and expense of “each” trade or business. See the discussion of “Multiple Businesses.”
The real estate industry generally will have considerable focus on the development of the regulations concerning the scope of Section 199A. ((Section 199, the domestic production activities deduction, was repealed with the enactment of Sec. 199A, and there were aspects of the real estate industry that benefitted in the past from the repealed provision. Section 199 was generally repealed for taxable years beginning after 2017. For corporate taxpayers, it was repealed for taxable years beginning after 2018. Conf. Rep., p. 400. See “Domestic Production Activities Deduction – Planning and Practicality,” J. Michael Pusey, Main Street Practitioner, https://mainstreetpractitioner.org/feature/domestic-production-activities-deduction-planning-and-practicality/.))
In general, we are beginning to hear some suggestions that real estate rentals are per se subject to the new 20% of business income deduction, and we have reservations. For example, if you’re a busy executive planning to buy a rent house and include this 20% of business income in the projections, we would suggest caution.
Hopefully, the IRS will prioritize real estate industry issues in their analysis of this important new legislation.
Basically, a sole proprietorship, partnership or Subchapter S corporation can generate income that qualifies for the 20% of business income deduction.
An LLC with a single owner may be a disregarded entity, or it may elect to be taxed as a corporation in which case the income would not qualify unless electing S corporation status. ((See, e.g., Conf. Rep. P.206.))
A publicly traded partnership is generally treated as a corporation for tax purposes but there are exceptions. ((See Conf. Rep. p. 206; Sec. 7704 (a) (2).))
A sole proprietorship is generally not considered an entity apart from the owner, except for employment tax purposes. A sole proprietorship, whether just the individual or an LLC not considered an entity apart from its owner, qualifies under the 20% of business income rules if the income is of a nature to qualify. ((Conf. Rep. 208 reporting the House Report, see Regs. 301.7701-2(c) (2) (IV).))
“While sole proprietorships generally may have no more than one owner, a married couple that files a joint return and jointly owns and operates a business may elect to have that business treated as a sole proprietorship under section 761(f).” ((Conf. Rep., 208 reporting the House Report.))
In general, a husband and wife in a community property state may disregard their LLC for tax purposes and report results directly on the joint return. ((See Rev. Proc. 2002-69, 2002 CB 831.))
Whether a partnership or S corporation, the computations focus on the individual taxpayer; i.e., there aren’t computations that begin and end at the partnership or S corporation level for purposes of this new concept.
SOME GENERAL RULES AND ISSUES
This deduction is available in arriving at taxable income but not adjusted gross income. This deduction, for example, won’t affect such areas as medical expense deductions which arise above a percentage of adjusted gross income. This new deduction is available whether or not the taxpayer itemizes. ((Conf. Report, p. 224.))
The deduction is available to trusts and estates with provision for apportioning of the deduction between the entity and beneficiaries. ((Conf. Rep. p.224.))
This particular deduction doesn’t increase the taxpayer’s net operating loss, so if there is an incremental deduction under the rules of the new Section 199A, the rules seemingly restrict its use to current year’s tax return. There is no provision to carry over the Section 199A deduction itself.
There is some possibility of carryover within the Section 199A rules for unused business losses. ((Conf. Rep. p.214. “If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business in the next year.”)) This carryover is only a negative; i.e., can only lessen future deductions measured by a percentage of future business income. Presumably this carryover goes away at the death of the taxpayer.
This deduction isn’t available in computing the self-employment tax. ((Conf. Rep. p. 220 reporting the Senate Report.))
While the corporate alternative minimum tax was repealed, the individual alternative minimum tax is still with us. The beginning point in computing such tax is taxable income, and apparently the new 20% of business income deduction is a deduction for AMT purposes. Seemingly this would be the deduction after applying the 20% and considering the “if less” computation which looks to 20% of taxable income as reduced by the sum of net long-term capital gain in excess of short-term capital loss and qualified dividends, as well as the myriad detailed rules and limitations, such as wage or wage and capital limitations. The basis for such statement is the absence of anything to the contrary in the new statute and its legislative history and the absence of any amendments in this regard in the AMT statute.
There is a “side note” statutory provision in the new 199A that apparently amends the minimum tax rules in prescribing how this new provision relates to those rules. It is headed “Coordination with Minimum Tax” and provides, “For purposes of determining alternative minimum taxable income under section 55, qualified business income shall be determined without regard to any adjustments under sections 56 through section 59.” ((Sec. 199A (f) (2); Conf. Rep., p. 17. Sections 56 through 59 are within the minimum tax rules.)) The legislative history says, “Qualified business income is determined without regard to any adjustments prescribed under the rules of the alternative minimum tax.” ((Senate report at Conf. Rep. p.220.)) The trail here is short and terse but remembering the multitude of items entering into “qualified business income,” the implication seems to be to re-compute the Sec. 199A deduction separately for AMT purposes but when it comes to measuring “qualified business income,” don’t re-compute its elements when the measure for AMT purposes is different than for regular income tax purposes. We gather the new Sec. 199A deduction is a potential benefit in so far as the AMT but there may be a regular tax vs. AMT tax difference in measuring the deduction.
The legislative history has some broadly-worded anti-abuse language:
“In the case of property that is sold, for example, the property is no longer available for use in the trade or business and is not taken into account in determining the limitation. The Secretary is required to provide rules for applying the limitation in cases of a short taxable year where the taxpayer acquires, or disposes of, the major portion of a trade or business or the major portion of a separate unit of a trade or business during the year. The Secretary is required to provide guidance applying rules similar to the rules of section 179(d) (2) to address acquisitions of property from a related party, as well as in a sale-leaseback or other transaction as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital. Similarly, the Secretary shall provide guidance prescribing rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W–2 wages and capital.” ((Conf. Rep. p.223. See also Sec. 199A (b) (5).))
THE BASIC 20% MATH AND THE “IF-LESS RULE”
As discussed below, special rules may apply to certain service providers.
The computation measures the deduction looking to “combined qualified business income amount” or if less, 20 percent of any excess of taxable income over any net capital gain as defined in Section 1(h). ((Sec. 199A (a).)) The latter might be termed the “if less rule.”
In general, the “if less” component introduces a new complexity to planning. In the opinion of the authors, the statute here refers to taxable income from all sources, not just business income. ((One author opines, “It is unclear whether the taxpayer’s taxable income refers to the taxpayer’s taxable income from all sources or just income from all qualified trades or businesses. My best guess is that it refers to all sources.” “Qualified Business Deduction Under New Section 199A,” Teresa Rankin Klenk, Gentry, Tipton, McLemore, 12/20/17, http://www.tennlaw.com/12/can-you-qualify-for-the-sec-199a-qualified-business-deduction/.)
The concept of “combined” qualified business income nets income and losses. For example, one of only two examples in the Senate Report shows one spouse with a business loss and another spouse with business income, and the loss offsets income in figuring the net business income that gives rise to the 20% deduction in a joint return. ((The conferees were relatively terse in their explanations but they made some very significant changes while basically following the Senate version. Conf. Rep., p. 221, 222.))
We noted above that there is a concept of carrying forward a loss within the Section 199A rules from a previous year. Within this concept of a loss related to Section 199A calculation, presumably such a carryover could only be post-2017; i.e., couldn’t precede the Section 199A rules.
But query the impact of a net operating loss carryover from 2017 or earlier on the calculations under Section 199A? The issues here should be considered in deciding whether to elect to carryover any NOL incurred in 2017.
First, how does an NOL carryover affect the basic 20% of business income computation? The 20% is applied to “qualified business income with respect to the qualified trade or business,” subject to some limitations, or more specifically, “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business.” ((Sec. 199A (b) (1) (A) and 199A(c).)) We also note Section 199A(c) (3) defining the relevant items as “effectively connected with the conduct of a trade or business within the United States…” It goes on to ask if such amounts are “included or allowed in determining taxable income for the taxable year.” ((Sec. 199A(c) (3) (A) (ii).)) One could argue the language here includes an NOL deduction arising even from pre-enactment years, at least as it relates to business losses.
Computing the NOL under Section 172 is complicated but it basically works from taxable income with adjustments, such as removing personal exemptions and nonbusiness deductions except to the extent of nonbusiness income. So it is roughly true that an NOL carryover would reflect losses from a trade or business. Yet an added complication is that it is possible an NOL would reflect non-business casualty losses as all or part of the NOL, which could also raise issues of order of absorption if the NOL also includes business losses.
When losses of non-corporate taxpayers exceed $250,000 or $500,000 in a joint return in tax years beginning after 2017, there is a new rule which can add such losses to the NOL carryover rather than allow such losses to offset non-business income. ((Conf. Rep. p.19, 238-239, amending Sec. 461 (l) for losses in tax years beginning after December 31, 2017.)) A possible argument for including consideration of the NOL deduction in Section 199A is that due to new Section 461(f), there are some scenarios where business losses don’t seem to get deducted except as NOL carryovers. The express language of the statute refers to “disallowance.” ((Conf. Rep., p. 19; Act Sec. 11012.)) Rather than press an argument based on such an unusual provision, one could also argue for special computations but that would also raise issues of order of use when the figures include such amount as only one of the NOL components.
One could also argue that to include the NOL deduction in measuring business income under Section 199A runs counter to the focus of the statute on the results of the particular year and whose goal was to encourage business and reward post-enactment results.
One could add the following argument, emphasizing that pre-2018 law permitted NOL carryovers up to twenty years and the new law permits indefinite carryforwards. Congress envisioned a new concept which focuses on trade or business income post-2017 and it added rules that in some circumstances can even require separating such income into the income or loss of “each” separate trade or business. An NOL deduction arising from carryovers from many distant years could require analyzing such figures to segregate losses into separate trades or businesses when the returns and records may no longer even be available, and require practically impossible calculations looking to absorptions of such losses in years after they were incurred. The years of absorption may also be very distant. One would reasonably argue that Congress did not contemplate integrating an NOL carryover deduction into this mix of considerations within Section 199A.
Also, Section 199A has its own carryover rule which focuses on post-2017 net losses that arise within its rules. ((Sec. 199A (c’) (2).)) Seemingly this raises the question of duplication. How would the taxpayer apply the carryover rule within the new code section and also the normal NOL carryover rules?
Within the Section 199A rules, there is statutory provision dealing with carryover of unused, excess loss, but not carryback, which may raise such questions as this: Does the taxpayer losing $100,000 in year 1 and earning $100,000 in year 2 get no 20% deduction in either year, but as to the person who earns $100,000 and then loses $100,000 in the second and last year of the business, does this person, whom we assume retires, get to deduct 20% of $100,000 in year 1 and the $100,000 loss from the discontinued business just carries over until his/her death, then disappears? This would seem to be the result given the new law contemplates carryover of unused losses but no carryback.
As to the basic question of whether the NOL deduction should reduce the base of the 20% of business income calculation, we would argue that this particular deduction should not reduce the base, and this should hold true of NOLs from pre-enactment and post-enactment years.
On the other hand, the authors would anticipate that the IRS will likely conclude an NOL carryover, even though from a year or years before enactment of the Section 199A concept, would reduce taxable income under the “if less” portion of the calculation. This figure is just basically taxable income with certain adjustments times 20%, and the list of adjustments doesn’t include any NOL carryover deduction. For example, if a taxpayer elects to carryover a large NOL from 2017 to 2018, we would caveat that this would likely have a significant detrimental effect on any benefit under the new Section 199A rules.
Planning point: In deciding whether to carryback an NOL from 2017, consider that as an NOL carryover, it may have a detrimental effect in so far as accessing the 20% of business income deduction.
Planning point: Not to suggest that a couple will often opt out of a joint return because of these rules but it may arise in some circumstances; e.g., if one spouse has a business loss that offsets business income of the other spouse that might otherwise benefit from the 20% deduction. It is not impossible the regulations may try to limit such planning.
As one reads the statute, the term “qualified business income amount” doesn’t have a “20%” beside it, but it is a 20% figure. ((See Sec. 199A (a) (1) (A), (b) (1) (A), (b) (2) (A).))
Planning point re business expense elections: Assuming the basic computation looks to 20% of qualified business income and the “if less” concept focusing on taxable income doesn’t otherwise apply, one can see that decisions that maximize business expenses have to be viewed from the standpoint of their effect on the Section 199A deduction. For example, if the taxpayer opts to expense a capital expenditure rather than claim normal depreciation, this reduces taxable income and saves tax. But while one can normally calculate tax savings of an incremental deduction by applying the marginal tax rate to the deduction, one needs in these circumstances to factor in the fact that the decision to call a capital expenditure an expense will also reduce the 20% of qualified business income deduction directly. By reducing taxable income, it may also bring into play the “If less rule” that focuses on 20% taxable income with adjustments.
Planning point re Keogh contributions: A Keogh contribution can also bring into play the taxable-income-if-less rule when the deduction would otherwise be based on net business income. Such decisions as whether have a Keogh or whether to maximize the deduction may now have to be weighed against projected or potential long-term reductions in the new Section 199A deduction. It may also be an issue whether or to what degree Keogh or other benefit programs may be considered as directly reducing the 20% of business income calculation, and whether, e.g., one distinguishes payments benefitting owners.
Planning point re nonbusiness expenses and nonbusiness income: Under the basic concept that the deduction is 20% of qualified business income or, if less, 20% of taxable income as reduced by the sum of net long-term capital gains in excess of short-term capital losses and qualified dividends, one can see certain areas where the 20% deduction is pared down by nonbusiness deductions, including the standard deduction, which was increased with the new legislation. For example, under the “if less rule” looking to 20% of taxable income, assuming a taxpayer with just qualified business income and the standard deduction, the standard deduction triggers a reduced 20% deduction, whereas it would not if there were, say, interest income in an amount equal to the standard deduction. One can envision circumstances where if this particular scenario applied, the taxpayer would have been better off investing in high-yield bonds versus low-yield growth stocks.
There can be scenarios in which the 20% of business income deduction goes up with incremental nonbusiness income. Nonbusiness income planning can significantly affect planning here if the deduction looks to taxable income.
Planning point re charitable donations: One can envision the Section 199A rule being a disincentive in some circumstances for charitable donations because the contributions increase itemized deductions and bring into play the “if less rule” looking 20% of taxable income with adjustments rather than 20% of business income. We later show another scenario in which the charitable donation looks to enhance the deduction.
Planning generally gets much more mathematical, particularly considering the breadth of the two components we discuss, one being combined “business income” which includes flow-through income which is often difficult to predict, and the other being “taxable income.”
An IRS exam that adjusts taxable income may well result in a re-computation of this deduction and it could affect either of the two major components that determine the basic deduction. One can envision circumstances where an IRS exam would increase taxable income without adjusting business income and the result would be diminution of the if-less limitation, such that the Section 199A deduction increased and mitigated the tax increase arising from the IRS adjustment.
There is a third rule saying the deduction can never exceed taxable income as reduced by net capital gain as defined in Section 1(h). ((Sec. 199A (a), last sentence.)) As discussed below, net capital gain for this purpose appears to be net long-term capital gains in excess of short-term capital losses plus qualified dividends.
For an even deeper dive into this topic, read the unabridged article here.
The information contained herein is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230, as the content of this document is issued for general informational purposes only, is intended to enhance the reader’s knowledge on the matters addressed therein, and is not intended to be applied to any specific reader’s particular set of facts. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
About the Authors
Bob Rojas, owner of the firm, has a direct hand in practically everything – accounting, auditing, tax and administration. As a smaller regional firm with a tendency to hire and retain more heavily experienced professionals, it is common for the staff to also have a broader range of skills and in-depth insights into both accounting, auditing and tax matters. At work, Bob does everything but wash the dishes. He’s been known to mention that he does wash the dishes at home with his wife. At the office and in the professional community, if not in the kitchen, Bob’s known as an excellent negotiator. He has run a regional CPA firm, audit and tax, for some thirty years. Prior to that, he was an audit manager at a highly respected national firm,and a tax manager at an international CPA firm. During this time Bob earned his MS in taxation. It is rare to rise to the manager level in the big national firms in both audit and tax, but it was an excellent background for running his own regional firm.
J. Michael Pusey, CPA, MSA, is a National Tax Director with Rojas and Associates, CPAs, Los Angeles. He has over forty years experience in tax and finance. Mr. Pusey has written or contributed to four tax books, including an AICPA Tax Study, and a finance book. Mr. Pusey began his career with KPMG before working nine years in “national tax” for Laventhol & Horwath and Grant Thornton. He was V.P., Assistant Tax Director, Manager of Research and Planning for a NYSE financial institution prior to beginning his practice, then joining Rojas and Associates.