Tax-Saving Opportunities for Business Owners
Are any of your business-owning clients curious about the new Section 199A deduction?
Although the deduction became effective on January 1, 2018, guidance on how it would be calculated was delegated to the Internal Revenue Service (IRS) by Congress. For months, financial and tax professionals have speculated about various aspects of this new deduction since Congress gave us little concrete guidance to work with.
New Developments in August 2018
But on August 8, 2018, the IRS released proposed regulations that answered many pressing questions about losses as well as how to account for multiple businesses. We can now more accurately project or estimate how much of a deduction a client is entitled to. Fortunately, these new proposed regulations introduced many new planning options for your clients. Unfortunately, an overabundance of options can lead to confusion and missed opportunities without the help of an expert.
The complexity of the 199A proposed regulations calls for careful, strategic planning alongside colleagues familiar with the ins and outs of this new set of tax guidelines. To help you prepare for such a meeting, here are the highlights to pass along to your business-owning clients:
If your clients own more than one qualifying non-specified service trade or business (non-SSTB), they are faced with the decision of whether or not to aggregate the qualified business income (QBI) from each business. This provides your clients with an opportunity to deduct more depending on which approach they take. These proposed regulations give us a fairly “bright line” test for aggregation, so we can now be confident, in many circumstances, about whether a client can aggregate.
To keep individuals from buying properties for the purpose of gaining a larger deduction, the proposed regulations include a so-called anti-abuse rule excluding “property acquired at the end of the year” in the calculation of unadjusted basis immediately after acquisition if the property was purchased within 60 days of the end of the tax year and sold soon after. Acquiring assets is obviously part of building a business, but added caution must be exercised and some professional guidance obtained to avoid disqualifying those new assets.
Clarification on Losses
The new 199A proposed regulations bring more clarity to the rules around how losses in one or more qualified trade or business are to be treated. Of course, every client wants gains, but clarity on the treatment of losses helps us develop better options for clients whose businesses are struggling.
“Reasonable Method” Allocation
Clients with multiple directly-controlled trades or businesses have a new planning opportunity thanks to the “reasonable method” item allocation. For example, overhead costs may impact multiple businesses owned by a client. Rather than a strict requirement, this lets us work to decide the best method for a client’s business, as long as the method is “reasonable.” Clients with multiple businesses must start this planning discussion right away to maximize the opportunity.
Luckily, the 199A proposed regulations narrow the definition of what businesses count as SSTBs. Unfortunately, there is a SSTB “taint” that extends to trades or businesses over certain gross receipt thresholds if they provide services to an SSTB. Non-SSTB businesses would do well to be extracted from SSTB as soon as possible —particularly if they can bypass the “taint” rule.
The proposed regulations include a problematic rule requiring former employees with a new status (such as partners in a partnership or independent contractors) to be deemed employees for the purposes of 199A if they are providing substantially the same service to the former employer. This is presumably the case even if the new tax status is otherwise allowed under the tax laws. For example, a former employee who becomes a part owner in the business may be denied the 199A deduction even though she’s treated as an owner for all other non-199A purposes. This poor outcome may be overcome with proper planning and documentation. This is one area of the 199A which requires particular attention for affected clients.
There is an additional anti-abuse rule about the treatment of multiple trusts to attempt to get around QBI limits. This is similar to the reciprocal trust doctrine in that the QBI deduction-maximizing arrangement will be disregarded if the trusts are purely for tax reasons rather than reflecting an economic or dispositive strategy of the client.
Underpayment of Tax Penalty
IRC § 6662 already imposes a 20% accuracy-related penalty on underpayments of tax attributable to, among other things, negligence or disregard of rules or regulations; and any substantial understatement of income tax. However, Section 199A lowered the threshold for when the 20% substantial understatement penalty kicks in from an understatement of the greater of 10% or $5,000 to the greater of 5% or $5,000 “in the case of any taxpayer who claims the deduction allowed under [IRC §] 199A.” The statute does not state that the understatement must specifically relate to the IRC § 199A deduction for this lower threshold to apply, it applies if the taxpayer merely claims the IRC § 199A deduction, regardless of whether the understatement arose out of the IRC § 199A deduction or some other reporting error.
The Time to Act Is Now!
These new proposed regulations fill in many missing details from the Tax Cuts and Jobs Act of 2017 that added the new 199A deduction, but these rules are complex and easy to mishandle. Getting help as early as possible is essential, as this is one area in which going it alone is not likely to yield optimum results.
Your business-owning clients should immediately review their situation with their trusted advisors and determine whether any changes need to be made to their entity or operations to take advantage of the new regulations. Please call us for more details, and we’ll discuss the best ways to make the most out of the 199A deduction.