But those mistakes shouldn’t surprise. The new Section 199A tax law complicated tax returns. Massively.
And there’s good news connected to the trouble taxpayers experienced in 2018. They can learn from the first year and maybe get larger deductions the second year.
A Quick Review of the Section 199A Deduction
If you already understand how the Section 199A deduction works, skip to the next section. If you’re still unclear, though, let’s review the basics.
The Section 199A deduction gives sole proprietors, partners in partnerships, shareholders in S corporations and then some real estate investors an extra deduction.
That deduction equals 20 percent of the income earned in a trade or business. If a business earns $100,000 in profits, for example, the owner probably gets a $20,000 tax deduction.
But the deduction comes with complications.
First, the ultimate deduction equals the lesser of 20 percent of the “qualified” business income or 20 percent of the taxable income reduced for any capital gains.
Second, for high income taxpayers, the formula adds other requirements for taking the deduction.
For example, above taxable income thresholds ($210,700 for single taxpayers and $421,400 for married taxpayers), the deduction can’t exceed 50 percent of the wages paid or the sum of 25 percent of the wages paid plus 2.5 percent of the depreciable property’s original cost.
And then even more significant, for people over those thresholds, the Section 199A deduction doesn’t shelter income earned from a “specified service trade or business.” The “specified service trade or business” category includes doctors, lawyers, investment bankers, consultants, athletes, actors and a bunch of other high-income often white-collar-y professionals.
Note: A phase-out range exists (from $160,700 to $210,700 for single individuals and from $321,400 to $421,400 for married folks.) In that range, stuff like W-2 wages, depreciable property and “specified service trade or business” status only partially affects the Section 199A deduction.
And now let’s talk about the common Section 199A rookie mistakes…
Section 199A Rookie-year Mistake #1: Mislabeled “Specified Service Trade or Business”
A first painful mistake we saw several times over the last year: Someone mistakenly assumed some business fell into the “specified service trade or business” category. Then, based on that mistake, the business owner didn’t take the 20 percent Section 199A deduction.
A common example of this misfortune? Situations where some entrepreneur describes his or her business as “consulting.”
In the past, this imprecision didn’t matter. All that really happened? The CPAs within the tax return classified the firm as a”consulting” business.
Note: Some of these firms may also use the word “consultants” or “consulting” in their business name.
Here’s the problem, though. Very possibly, these firms don’t count as consulting firms. Which means they shouldn’t lose their Section 199A deduction due to classification as a specified service trade or business.
The programmer who calls herself a consultant, for example? She’s not a consultant according to the law. She’s a programmer.
The engineer? Yeah, not a consultant. He’s an engineer.
The trainer? Again, not a consultant. But a trainer.
A consultant, per the Section 199A regulations, provides advice and counsel. Or does political lobbying
If you’re a tax accountant, you want to understand, precisely, the trades and businesses falling into each specified service trade or business category.
And then, this unfortunate reality if you’re a taxpayer: You want to verify you’ve been correctly classified. (The tax return will disclose this status.)
You don’t want to lose the deduction because your tax accountant doesn’t know the law. Or because you’ve been sloppy describing to your accountant what your firm does.
And this tip: Talk with your accountant about amending your 2018 if you made this error.
Section 199A Rookie-year Mistake #2: Not Recognizing “Specified Service Trade or Business” Taint
A related mistake we saw some large CPA firms making? A “specified service trade or business” (aka “SSTB”) tainting other affiliated businesses that share 50 percent or more common ownership.
Here’s the rule, by the way. If two businesses share 50 percent or more common ownership and the “non-SSTB” business provides services or goods to the “SSTB” business, a percentage of the “non-SSTB” business’s income doesn’t count as “qualified” business income that plugs into the Section 199A formula.
Example: A group of surgeons operate as a C corporation. The same group of doctors owns a partnership that owns the building the surgical center operates in. Because the partnership rents its building to the C corporation providing surgical services, the real estate office building partnership gets tainted as an SSTB. That SSTB taint means its income doesn’t plug into the Section 199A formula.
Make this error and a taxpayer overstates his or her Section 199A.
Section 199A Rookie-year Mistake #3: Not Creating Separable Businesses When One is SSTB
Let me mention one other rookie mistake related to specified service trades and businesses, or SSTBs.
If a business combines both non-SSTB and SSTB business income, Section 199A probably treats the entire business as a specified service trade or business.
Example: A group of attorneys both practice law and provide continuing legal education seminars. If the attorneys treat all of this activity as a single business, probably the entire business gets treated as an SSTB due to the law firm activity tainting the continuing legal education activity.
What business owners can do, however, is separate the two businesses into the potentially disqualified SSTB (the law firm) and then the probably qualified non-SSTB (the continuing legal education business). This saves the Section 199A deduction on at least the eligible part of the business.
How to separate the two businesses? The treasury regulations provide good examples of how this works. But as I remarked in another blog post, if you want to separate out activities into their own trades or businesses, you want things like “separate employees” and for the activities to be treated in the real world as “separate trades or businesses.” You also need separable financial records and books.
Section 199A Rookie-year Mistake #4: Labeling Partnership Distributions as Guaranteed Payments
One of the worst mistakes we saw? The partnership returns that mistakenly labeled distributions to partnership partners as guaranteed payments.
The problem here? Section 199A says guaranteed payments don’t count as qualified business income. As a result, guaranteed payments don’t get partially sheltered by the Section 199A deduction.
Example: A partnership generates $200,000 in profits for each of its three partners. The partnership pays out $180,000 of this profit to each partner. If the partnership categorizes the $180,000 of money paid to each partner as a guaranteed payment, individual partners get the 20 percent Section 199A deduction only on the leftover $20,000 of business income.
Note: The stories we heard about distributions to partners being mis-classified as guaranteed payments often included a modestly skilled bookkeeper unfamiliar with partnership tax accounting.
Section 199A Rookie-year Mistake #5: Not Rewriting the Partnership Agreement to Remove Guaranteed Payments
Another guaranteed payment mistake impacts 2019 and future years…
As just noted, Section 199A says guaranteed payments don’t count as qualified business income and so don’t get partially sheltered by the Section 199A deduction.
A partnership that generates $200,000 of profit for a partner but pays out $10,000 a month as a guaranteed payment—so $120,000 in guaranteed payments over the course of the year—produces $80,000 of “qualified” business income and a $16,000 Section 199A deduction.
But some partnerships may have only used guaranteed payments to simplify the allocation of partnership profits. In those sorts of situations, the partnership may want to rewrite the partnership agreement to use special allocations and distributions in place of guaranteed payments.
For example, say a partnership generates $200,000 in profit for a partner and has been paying $10,000 a month guaranteed payments. Rather than paying out that $10,000 a month as a guaranteed payment, the partnership could make a $10,000 monthly distribution from the profits. This change means the entire $200,000 counts as “qualified” business income and means the partner gets a $40,000 Section 199A deduction.
Section 199A Rookie-year Mistake #6: Not Operating as an S Corporation
High income taxpayers need a business to report either W-2 wages or hold significant depreciable property to get the 20 percent deduction.
Example: Some taxpayer with a business earning $1,000,000 in profit doesn’t necessarily receive a $200,000 deduction. The actual deduction equals the lesser of the 20 percent of the “qualified” business income, 50 percent of the W-2 wages, or 25 percent of the W-2 wages plus 2.5 percent of the depreciable property. If the firm doesn’t own any depreciable property, the firm would need to pay at least $400,000 in W-2 wages to get a $200,000 Section 199A deduction. Why? Because the Section 199A deduction equals the lesser 20 percent of the $1,000,000 of “qualified” business income or 50 percent of the W-2 wages, whichever is less.
For sole proprietorships and partnerships without employees, this W-2 wages requirement can zero out the Section 199A deduction. No wages? No Section 199A deduction.
Fortunately, a workaround exists to fix this problem. The sole proprietorship or partnership can incorporate and elect Subchapter S status. This tax accounting treatment causes the sole proprietor and partners to be treated as employees and creates owner W-2 wages the taxpayer needs to get the Section 199A deduction.
Note: A sole proprietorship or partnership operating as an LLC can make an election to have the LLC treated for tax purposes as an S corporation. Note that a partnership, however, may not be able to make its partnership profit sharing formula work using an LLC taxed as an S corporation. Therefore, a partnership may need to set up a partnership of S corporations.
Section 199A Rookie-year Mistake #7: Late W-2s or “No W-2” Wage Amounts
Another problem related to W-2s?
Section 199A requires W-2 wages to appear on timely filed W-2s for their amounts to be counted in the deduction formula.
This requirement means that if a taxpayer needs W-2 wages to make the Section 199A deduction work, the business not only needs employee wages. It needs to file W-2s on time.
Further, this requirement means that if a business simply doesn’t file W-2s, the business owners miss out on their Section 199A deduction.
Note: A small but still significant number of small business corporations skip filing W-2s for their shareholder-employees. Instead, these firms use some slapdash approach which means the payroll taxes get paid (or most of them anyway). But then no quarterly 941s or year-end W-2s get filed.
Section 199A Rookie-year Mistake #8: Lost Fixed Assets Detail
A mistake related to a bookkeeping misdemeanor: Not maintaining good fixed assets records. The problem here? Folks sloppy with their fixed assets record-keeping often weren’t able to pass through richly detailed information about depreciable assets necessary for the Section 199A deduction.
As noted, for high income taxpayers, the Section 199A deduction also considers the un-adjusted basis of depreciable property at the time the property was acquired.
Example: A high income taxpayer earning $100,000 in “qualified” business income from a real estate property doesn’t necessarily receive a $20,000 deduction. The actual deduction equals the lesser of the 20 percent of the “qualified” business income, 50 percent of the W-2 wages, or 25 percent of the W-2 wages plus 2.5 percent of the depreciable property. If the firm doesn’t pay any W-2 wages, the firm would need to hold at least $800,000 of depreciable property to get a $20,000 Section 199A deduction. Why? Because the Section 199A deduction equals the lesser 20 percent of the $100,000 of “qualified” business income or 25 percent of the W-2 wages (so $0) plus 2.5 percent of the $800,000 (which equals $20,000)
Note: We saw the “incomplete” fixed assets problem pop up with old partnerships holding fully depreciated property. Prior to 2018, that property sort of didn’t matter for the current year’s tax return. (It mattered only if the property was disposed of during the year in many cases.) But now that detail does matter. A lot.
Section 199A Rookie-year Mistake #8: Failing the Real Estate Safe Harbor Requirement
A final mistake to mention: Real estate investors skipping the Section 199A deduction because they thought the IRS’s real estate safe harbor provides the only way to get a Section 199A deduction on their tax return.
Here is reality: The real estate safe harbor for Section 199A makes it really hard to qualify for Section 199A. Not easy. Therefore, most investors don’t want or won’t be able to take that route to a Section 199A deduction. But these taxpayers have an alternative…
Real estate investors can instead learn and then use the Section 162 “trade or business” standard to get the Section 199A deduction onto their tax returns.
Tip: We have a longer discussion of the Section 162 rule and the safe harbor here: Section 199A Rental Property Trade or Business.
One Final Comment
I don’t want to end without pointing out something. Last year? Hey, we were all rookies with respect to Section 199A. Everybody was learning the law… Let’s not beat ourselves up too badly.
But this next year? We can all do a better job.