Here's how to seize the new opportunities.
By Stephen L. Nelson
Maximizing Sec. 199A Deductions
The new Section 199A deduction surely counts as both a “good news” and a “bad news” story—at least for tax accountants.
The Bad News First
The bad news about Section 199A? The new deduction, according to the Internal Revenue Service, annually requires 25 million (that's 25,000,000) hours of additional work for the tax returns of 10 million (10,000,000) small businesses and investors. Further, the statute and just the first wave of proposed regulations confront taxpayers with striking complexity. The statute itself takes ten pages just to describe a tax break for unincorporated taxpayers equal to 20% of their business income. And the first wave–just the first wave–of regulations runs nearly 200 pages.
A comparison puts this all into perspective: The Section 121 “Exclusion of gain from sale of principal residence” statute runs just five pages. The Section 121 regulations run 20 pages. And this other reality: The Section 199A regulation relies on small businesses and their tax return preparers to perform good accounting: For example, accurate revenue and cost accounting by individual “trades or businesses” (a definition the statute and regulations blithely fail to supply), truly up-to-date depreciable property records, and then precise accounting for both W-2 wages and partnership guaranteed payments.
My honest guess? This first year unfolds as a slow-motion train wreck for many. Sorry.
But Good News Too
The good news about Section 199A? The flip side of the coin. Probably every small business and active real estate investor client you serve needs two to three hours of additional high-value tax work just to get the right deduction onto their tax return. Further, your high-income and high-net-worth clients will probably each need additional hours of pre-year-end planning, coaching, and maybe just general accounting services. These services should save some of these folks tens of thousands of dollars a year–and let you bill at rates commensurate with the incredibly high value delivered.
Some accountants have even begun to whisper, “Section 199A will be like Sarbanes Oxley, but for tax accountants and small businesses.”
Given the bad news and the good news, what can a CPA or CPA firm do to prepare–other than learning this complicated new law really, really well?
I have five ideas to consider:
Section 199A Practice Tip 1: Size the Revenue Potential
Start by sizing up the revenue potential. The proposed regulations published the first week of August estimate dealing with Section 199A on an individual’s 1040 return takes slightly more than half an hour and that dealing with Section 199A on a “relevant pass-through entity” such as an S corporation or partnership on average takes nearly three hours.
Further, the time required can run as much as 20 hours for a “relevant pass-through entity” return. If your firm (or your set of clients in a partnership) includes, say, 200 individuals with a Schedule C or Schedule E that may include Section 199A, figure that’s an extra 100 hours of work during tax season. If you deal with 100 relevant entity tax returns that include Section 199A, figure that’s nearly an extra 300 hours or so of work.
In summary, the revenue impact should be large: A firm or practice group with 200 individuals and 100 affected “relevant pass-through entities” can look forward to maybe 400 additional hours of work?
At a rate such as $200 or $250 an hour, that’s $80,000 to $100,000 of extra billing.
Section 199A Practice Tip 2: Start Creating Tax Season Extra Capacity Now
Related to the revenue potential, this point: This work surely will mostly occur during the coming tax season and then the “echo” extension season. Accordingly, practitioners want to think now about how to deal with this significant wave of high value but high complexity work.
Two ideas for you. First, look at dumping any penny pincher clients impacted by Section 199A. No, I know. That sounds crazy. But if you or I have got hundreds of hours of extra work to do this coming tax season, we need to find free time wherever we can. And the first “free” place to find the time? Dump the folks who can’t or won’t pay for an extra two or three hours of return work. Rather, focus on the 90% of your clientele who will only thank you (probably profusely) for doing an extra $200 or $500 or $1,000 of work that saves them an extra $5,000 or $10,000 of tax.
A second idea: Talk now to clients about the high likelihood that many returns, perhaps including their own return will need to be extended due to the extra workload required by Section 199A. If you or I can push work out of February and March and into June or July, that may be another way to ease the pressure.
Note: Larger firms may be able to add senior staff, too. For many of us, unfortunately, that won’t be a real option. (And again, note that the talent needed to deal with the new Section 199A probably won’t be easy to identify.)
Section 199A Practice Tip 3: Alert Clients to Benefits and Costs
Well before year-end, we all want to alert affected clients to the giant benefit that Section 199A delivers. Adding a tax deduction equal to roughly 20% of a business owners’ income—subject to complex calculations and limitations—means the business owner simply doesn’t pay income taxes on the last 20% of profit they make. That’s a huge deal. Our and your best clients will save thousands, tens of thousands or more. And annually. So let’s educate clients that this new Section 199A deduction counts as a really big opportunity.
Also, let’s also educate clients that this new deduction burdens taxpayers and their accountants with astonishing complexity. And tons of extra accounting.
Section 199A Practice Tip 4: Set Stage for Price Bumps
From this point forward when talking with clients, I think we all need to set the stage for a price bump given the extra work of Section 199A. Please don’t give away this work for free. Please don’t dial down your inflation adjustment because of a bump due to Section199A. Keep in mind, too, that clients with more complicated situations may need pre-year planning. S corporations probably need help with more appropriate salaries for S corporation shareholder-employees. Partnerships with guaranteed payments or Section 707(a) payments need to update the partnership agreement. Entrepreneurs and investors with interests in multiple trades or businesses may need help identifying the individual trades or businesses they’re in and each individual trade or business’s profit, wages and depreciable property.
And this awkward comment: Think about the fact that we’re going to need clients to do this sort of “better” accounting when many don’t really have the ability to produce a robust balance sheet.
A tangential point: Some practitioners may want to create an “opt-out” for taxpayers who don’t feel they can justify paying $200 or $400 or $800 more for a tax return with a Section 199A deduction. Such an “opt-out” seems like a far better approach than simply doing the work for free. Or trying to take short-cuts so one can charge a cheap price.
Section 199A Practice Tip 5: Count on New Clients
A final comment: Remember the treasury regulations for the tangible property regulations? The ones that for the 2014 tax returns would have required most small businesses and real estate investors to file a Form 3115 to make the accounting method change triggered by the new regulations?
Many, many tax practitioners serving small business and real estate clients weren’t able to get ready in time to deal with those regulations. A goat rodeo ensued. In the end, luckily for these colleagues, the Internal Revenue Service, under pressure from lobbying groups including the American Institute of CPAs, let tax practitioners off the hook. In a mid-February notice (Notice 2015-20), the Internal Revenue Service said small businesses and real estate investors wouldn’t need to file Form 3115; people just needed to comply with the new law. That meant, in the end, that CPAs and other tax accountants didn’t have a tidal wave of complexity and extra work to deal with at the last minute. And everybody survived.
But this time surely will be different. The IRS won’t and can’t give small businesses and tax accountants a mulligan on a statute that creates a special deduction for small businesses. The IRS could change the rules last minute for a regulation. (I guess.) They can’t rewrite a statute.
But I’ve gotten off track. Here’s the reason for this digression: Possibly the tangential property regulations fiasco hints we’ll have tax accountants able and ready to deal with Section 199A. And other tax accountants either not able or not ready.
And the folks who are ready should be able to pick up some great small business and real estate clients this coming year.