Step 1: Tell clients of new complexity – and your extra work.
By Stephen Nelson
Wow. This Sec. 199A deduction… a big deal, right? Lots of opportunity for taxpayers. Lots of complexity for their tax advisors. And basically, no time to first learn and then apply the new law.
Given this, CPA Trendlines suggested I share our firm’s checklist for handling Sec. 199A deduction work for clients this tax season.
Don’t worry, I’ll make this quick. You and I both have tax returns to prepare, review and sign.
Step #1: Alert Clients to New Deduction
A first step? We need to alert our clients to the new deduction.
Specifically, clients need to know the new deduction presents a giant tax opportunity. Not paying income taxes on tentatively the last 20% of an S corporation’s, a partnership’s, or a sole proprietorship’s income will produce thousands of dollars in annual tax savings for most small business owners.
And then just as important, clients need to know that the deduction burdens taxpayers and their advisors with lots of complexity and also extra work to maximize the benefits.
Step #2: Verify 2017 Business Descriptions
For example, a couple of 2017 tax return steps ought to be taken by many tax preparers.
Businesses probably want to verify their business activity code (box “B” at the top of 1120S and 1065 returns and the Schedule C form). Further, partnerships and corporations probably also want to verify Schedule B descriptions of the business activity and product or service (box 2 “a” and “b”.)
The reason? Some businesses get disqualified from using the Sec. 199A deduction (principally white-collar professionals.) Accordingly, we tax advisors need to be careful about these descriptions and the risk they communicate to us or the IRS the wrong description of the taxpayer’s business.
Step #3: Use New Deduction for Estimated Tax Calculations
Another step tax preparers will want to take for 2017 tax returns? We’re going to need to use the new deduction in our calculations of estimated tax payments for the 2018 1040ES vouchers we supply with the 2017 tax returns.
Fortunately, the 2017 tax software seems to now address this requirement, allowing preparers to tag pass-thru information with the extra bits of data needed to make the calculation: type of business, qualified business income amount, wages and depreciable property. We do need to remember to use these boxes and buttons however.
Step #4: Update Partnership Agreements
The new deduction doesn’t apply to all of the income a business owner earns from a pass-thru entity. For example, partner guaranteed payments don’t count as qualified business income, while partnership distributive shares do.
This differentiation suggests tax advisors need to work with partnership clients early in 2018 to explore whether guaranteed payments can be replaced with distributions.
A small partnership where each partner earns $100,000 mostly in the form of guaranteed payments generates basically zero qualified business income for partners.
That same partnership, if it replaces guaranteed payments with same-sized distributions, can generate $100,000 of qualified business income per partner. A $100,000 of qualified business income means tentatively a $20,000 Sec. 199A deduction and probably several thousand dollars of tax savings for each partner.
Step #5: Smarter Transfer Pricing
Small business entrepreneurs juggling multiple ventures often display a casual attitude about intercompany transactions, self-rental agreements, and cost accounting for shared resources.
But that could be a problem.
If an entrepreneur enjoys income that is only partly qualified business income or finds herself subject to entity level thresholds (like the requirement to have W-2 wages double the size of the deduction), better transfer pricing may save a taxpayer thousands annually.
One quick example: Suppose a taxpayer owns two businesses both making (say) $200,000. If for reasons of simplicity, the taxpayer runs all of the payroll through the first business, that means the second business generates no Sec. 199A deduction.
The answer? An arrangement that moves wages from the first business to the second business. Something as simple as common paymaster arrangement may double the size of the Sec. 199A deduction.
Step #6: Convert Portfolio Income to Qualified Business Income
A similar, early-in-the-year opportunity may also present itself for some investors.
A taxpayer may be able to increase qualified business income by moving assets out of an investment portfolio and into a leveraged business.
Suppose, for example, a taxpayer owns a break-even real estate investment with a $1,000,000 mortgage. Further suppose the taxpayer holds $1,000,000 in bonds. (To keep the comparison “apples-to-apples”, assume the interest rates on the mortgage and the bonds equal each other.)
In this situation, the taxpayer receives no Sec. 199A deduction. However, if he uses the bonds to pay down the mortgage, voila, he now has qualified business income and should get a Sec. 199A deduction.
Step #7: Push Down Taxable Income
Single taxpayers with income less than $157,500 and married taxpayers with taxable income less than $315,000 easily take the Sec. 199A deduction. These taxpayers don’t need to worry about whether they earn the income in a specified service business, pay enough wages or own enough depreciable property.
For example, a married doctor with less than $315,000 of taxable income can take the Sec. 199A deduction in 2018. If she makes more than $315,000, however, she loses part or all of the deduction.
What this suggests is that pass-thru business owners earning incomes above these amounts (like the doctor just described if she actually makes $415,000) may want to re-examine options for dramatically pushing down their taxable income.
A giant $100,000 pension deduction which in the past has not appealed to the doctor, for example, may make more sense if because of the $100,000 pension deduction, she also receives a second $60,000 Sec. 199A deduction.
Step #8: Bump S Corporation Wages
If W-2 wages limit a business owner’s Sec. 199A deduction and the firm operates as an S corporation, tax advisors may want to explore the option of bumping shareholder-employee wages. Of course, the rules say the shareholder-employee compensation must be set to some reasonable amount. (I am not suggesting anything different.)
But probably tax advisors and their clients should know that, roughly, the “optimal” W-2 wages amount equals 28.5714% percent of the profits before wages are paid.
For example, a business that makes “pre-wages” profits of $1,000,000 roughly optimizes by paying $285,714 in wages. That leaves $714,286 of qualified business income.
A 20% deduction on that amount equals $142,857. And that amount doesn’t get limited by the W-2 wages since 50% of the $285,714 also equals $142,857.
Step #9: Issue Caveats Not Promises
The statute, the conference report, and the papers that Congress supplied about the Tax Cuts & Jobs Act provide rich detail about the new Sec. 199A.
As a result, I’m a little discouraged when tax advisors say they are waiting for a technical corrections act or regulations before they give advice. (That seems more like procrastination than professionalism.)
But to be fair, some uncertainty about the details does remain. Not as much as some think. But still, some vagueness exists.
For the obvious reason, then, we need to issue caveats to clients about mechanics of optimizing and the results. Not promises or guarantees.
Step #10: Bill for Value and Talent
Too often over the last decade, tax advisors have taken on new work without being able to easily bill for the extra value created or the additional costs incurred.
A final step then? Gosh, please, please bill clients for the extra work you do related to the Sec. 199A deduction.
You will save your clients thousands of dollars of taxes annually by helping them maximize their Sec. 199A deduction.