Navigating Section 199A: New, Big and Complex · Ⅰ A CPA firm (SSTB) has ownership in a real...

Navigating Section 199A:New, Big and ComplexLeon LaBrecque, JD, CPA, CFP®, CFA

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Ⅰ Profound changes to business taxes• C-corp. rules changed • Pass-though rules changed

(massively)• Small business changes• Depreciation changes• Interest changes• Loss deductions (NOL and Excess

Losses) changed• Relevant remaining credits are

R&D and low-income housing credit

• Territorial tax• Deemed repatriation of

accumulated foreign earnings

| Individual taxes changed• Std. deduction increased• Itemized deductions limited• Child credit increased• Personal exemptions eliminated• AMT greatly reduced

| Estate and gift changed• Estate and gift exemption amount

doubled to $11.2M• Step-up basis retained

Tax Cuts and Jobs Acts:Tectonic Shift

Business Taxes:C-Corps

| Giant change: rate is now flat 21%| Personal Service Corporations (C-

corps) are taxed at the 21% flat rate!| Qualified small business (QSB) stock

eligible for capital gain exclusion• 100% exclusion• Non-service business (except

engineers and architects)• $10M gain limit

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QUESTIONS TO ASK:• Should I change my pass-

through to a C-corp?• Is my service business over

$315K(mfj) or $157.5K (all other) of income?

• Can I use the QSB exemption?• Will I retain earnings in my

trade or business?

See full set of rules for additional detail.

The Big Kahuna: §199A

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Ⅰ Qualified Business Income (QBI deduction) for pass-throughs

Ⅰ Up to 20% of QBI can be deducted from taxable income

Ⅰ Deduction is from taxable income not AGI

Ⅰ Any non-C corp. is pass-through


Why They Did It

Ⅰ Top C corp. rate was dropped from 35% to 21% to make the US more competitive

Ⅰ Made C-corps more attractive than pass-through

Ⅰ 20% deduction lowers maximum pass-through rate (non service business) to 29.6%

Ⅰ PSC C-corp. issuesⅠ §1202 issues

1/14/2019 5See full set of rules for additional detail.

Ⅰ Definition: All trade or businesses not C-corp:

• S-Corp• Partnerships (LLC taxed as

partnership)• Sole proprietorship• Trusts• Estates• REITs• MLPs

Ⅰ Entity-by-entity evaluation: each pass-though is separate

Ⅰ Annual basis

Ⅰ Deduction is from taxable incomeⅠ Applies at the partner or

shareholder levelⅠ C-corps that own pass-throughs

can’t use the deductionⅠ Does not reduce Net Investment

Income TaxⅠ Appears to be an itemized

deduction under §§ and 63(b), but itemized limitations do not apply

Basic Rules: Pass-Through


Basic Rules

Ⅰ Basic idea is that there is a deduction for the lesser of:

• 20% deduction of Qualified Business Income (QBI), or

• 20% of taxable ordinary incomeⅠ Example: Sue has $100,000

profit (sch C) as a CPA. Taxable income is $88,000 (standard deduct.)

• Deduction is $17,600Ⅰ Service business exception

Ⅰ W-2 exception:• (50% of W-2 wages)

Ⅰ Unadjusted Basis exception:• (2.5% of unadjusted basis in

qualified property + 25% of W-2 wages)

Ⅰ Income ‘exception to the exceptions’ on taxable income lower than $315K (mfj) or $157.5K (all others)

Ⅰ Income phase-out by $415,000 (mfj) or $207,500


QBI Exclusions

Ⅰ REIT, Coop or publicly trade partnership dividends;

Ⅰ Reasonable compensation paid to the taxpayer;

Ⅰ Guaranteed payments under §707(c);

Ⅰ Payments to partner for services rendered to business;

Ⅰ Capital gains and losses;

Ⅰ Dividends or equivalents;Ⅰ Interest income other than

interest income properly allocable to a trade or business;

Ⅰ Foreign personal holding company income;

Ⅰ Annuity income;Ⅰ Deductions or losses in regard

to any preceding item.


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Specified Service, Trade, or Business (SSTB)

Ⅰ In general, §199A doesn't apply to specified service trades or businesses (with income rule exceptions)

• Health• Law• Accounting• Actuarial science• Performing arts• Consulting• Athletics• Financial services• Brokerage services• NOT engineering or architecture

Ⅰ Principal asset of trade or business is the reputation or skill of one or more owners or employees

Ⅰ Different from §1202(e)(3)(A), which doesn’t include owners


Ⅰ 12 Categories - see chart on next slides

Ⅰ Reputation or skill catch-all -significant limits:

• Endorsements• Personal Appearances• Use of image, likeness, name,

signature, voice, symbols.Ⅰ De Minimis rules (how much SSTB

activity can there be?)• up to 10% of gross receipts if total

$25M or less• up to 5% of gross receipts if total

>$25M

Ⅰ SSTB treatment if allowed percentage is exceeded

Ⅰ Trade/Business of being an employee:

• Once an employee, always an employee presumption

• Ignore employer classification as determinative

Ⅰ Look for changes in facts/circumstances (ex. law firm partner)

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Specified Service, Trade, or Business (SSTB)


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Section 199A Activity Chart for Specified Service, Trade or Business Changes

Source: https://www.cohencpa.com/CohenSite/Media/CohenRedesign/resources/Sec199A_Specified-Services-Chart_CohenCo.pdf

https://www.cohencpa.com/CohenSite/Media/CohenRedesign/resources/Sec199A_Specified-Services-Chart_CohenCo.pdf

Section 199A Activity Chart for Specified Service, Trade or Business Changes

1/14/2019 12Source: https://www.cohencpa.com/CohenSite/Media/CohenRedesign/resources/Sec199A_Specified-Services-Chart_CohenCo.pdf

https://www.cohencpa.com/CohenSite/Media/CohenRedesign/resources/Sec199A_Specified-Services-Chart_CohenCo.pdf

Ⅰ Anti-Cracking I –[Service Provider]: forced aggregation with SSTB if:

• 50% common ownership (using §267(b)/707(b)) with SSTB;

• 80% property or services provided to same SSTB:

• If <80%, then partial SSTB treatment

Ⅰ Anti-Cracking II -[Incidental]: forced aggregation with SSTB if:

• 50% common ownership (using §267(b)/707(b)) w/SSTB

• Shared expenses with same SSTB (wages/overhead); and

• Gross receipt not over 5% of combined gross receipts

SSTB Anti-Cracking


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De Minimis Example Ⅰ A construction company with $20

million in revenue with $1.5 million (or 7.5%) of revenue coming from consulting is not considered a SSTB, but they would be if they had over $2 million of consulting work (or over 10%).

Cracking Example Ⅰ A CPA firm (SSTB) has ownership in a real

estate brokerage company (non-SSTB). The brokerage is in a different physical location with separate payroll and accounting, although a common paymaster. The CPA firm’s revenues are $50M, (over the $25) and the brokerage revenues are $10M (over 10%). If the brokerage firm has less than 50% common ownership and derives less than 80% of revenues from the CPA firm, then the brokerage can “crack” off from the CPA firm and be considered a standalone entity for §199A deduction purposes.

Specified Service, Trade, or Business (SSTB) Example

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Aggregation

Aggregation allowed (not required) if:1. Ownership same group of persons own 50% or

more (directly or indirectly)a) S Corp- by issued & outstanding sharesb) Partnership- capital OR profitsc) Indirect-spouse, children, grandparents,

parents2. Ownership as above for majority of taxable year3. Trades/Businesses use same taxable year (ignore

short year issues)4. Trades/Businesses are NOT Specified Services,

Trades, or Businesses (SSTBs)5. Meet 2 of 3 tests:

a) Provide products/services customarily offered together

b) Share facilities or significant business elementsi. Personnelii. Accounting/Legaliii. Manufacturingiv. Purchasingv. HR/IT

c) Operated in coordination with or reliance on groupi. Supply chain interdependencies


Aggregation

Ⅰ Items combined for Aggregated group:1. QBI2. W-2 wages3. UBIA

Ⅰ Must report consistently in subsequent years1. Newly qualified trades/businesses can

be added in future2. De-aggregate in future if facts change

and not eligible3. One-time shot????

Ⅰ Required annual disclosure1. Description of each trade/business2. Name/EIN3. Dates of interest (formed, ceased, sold,

etc.)4. Other as required5. Failure to disclose- IRS can de-

aggregate

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F, an unmarried individual, owns 100 percent of three trades or businesses as a sole proprietor: Business X, Business Y, and Business Z. None of the businesses hold qualified property. F does not aggregate the trades or businesses under §1.199A-4. For taxable year 2018, Business X generates $1 million of QBI and pays $500,000 of W-2 wages with respect to the business. Business Y also generates $1 million of QBI but pays no wages. Business Z generates $2,000 of QBI and pays $500,000 of W-2 wages with respect to the business. F also has $750,000 of wage income from employment with an unrelated company. After allowable deductions unrelated to the businesses, F’s taxable income is $2,722,000.

Aggregation Example

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Source: Sequoia Financial Group.

Qualified Property

Ⅰ Tangible;Ⅰ Depreciable;Ⅰ Held by or used in trade or

business at close of the year;Ⅰ Used at any time for the

production for QBI;Ⅰ Not fully depreciated;

Ⅰ IRS to prescribe anti-abuse rules to manipulate depreciation period;

Ⅰ IRS to prescribe rules to property acquired in like-kind exchange;

Ⅰ Unadjusted basis is basis immediately after acquisition, unreduced by depreciation.


Income Rule

Ⅰ If taxable income is under the stated thresholds, neither the W-2 rule, the unadjusted basis rule nor the specified service business rules apply

Ⅰ Phase-out if under thresholdⅠ Over phase-out, rules apply

Ⅰ Example: Thelma and Louis own a bump shop. It makes $325,000 of business income. They pay $100,000 in wages. Their taxable income is $310,000

• QBI (.2 * $325K) = $65,000• W-2 limit (.5 * $100K) = $50,000• $65,000 deduction, W-2 doesn’t

apply


Pass-Through Income Exceptions

| Married filing joint: $315,000 of taxable income (24% bracket)

| Married filing separately: $157,500

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Ⅰ Single: $157,500Ⅰ Child (including a kiddie tax

child): $157,500Ⅰ Non-grantor completed gift

trust: $157,500Ⅰ Non-grantor incomplete gift

trust: $157,500Ⅰ Estates: $157,500

W-2 rules, property basis rule or service business rules do not apply.

Per IRS rule.

1/14/2019 21Based on IRS rule.Source: Sequoia Financial Group.

Pass-Through: The ‘Poor CPA’

| Gail is a single CPA, self-employed, earns net income from her practice of $150,000

| Her taxable income is about $128,000

| She gets a deduction of 20% of her taxable income, or $25,600

| Being in a service business doesn’t matter, since she has income under $157,500

1/14/2019 22Based on IRS rule.

Pass-Through: The ‘Rich CPA’

| Gail, from our previous example, gets a nice project on December 12, 2018 and her income goes up by $80,000, to $230,000

| Her taxable income is about $208,000| She loses her deduction and is in a

higher bracket| She made more than $207,500| Her bracket went way up (from

19.2%)

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She can get the deduction back by:• Possibly using a 401(k) plan and

employer contribution, she could put $55,000 ($61,000 if she’s over age 50).

• She could make a charitable donation to her charity or to a donor advised fund.

• Making the plan deduction saves her taxes on the deduction ($17,600) plus a QBI deduction of $27,724.

Bracket shifts from 32% through the level and down to 19.2%.

Per IRS rule.

Pass-Through: Real Estate Tycoon

| You can get a QBI deduction on real estate if you have basis in the property (not fully depreciated)

| 2.5% of the unadjusted basis is limit| Example: Scrooge owns a property

he bought in 2008 worth $5M. It generates about $400k of rental income

| He will get a deduction for $80,000, since 20% of income is more than 2.5% of $5M

1/14/2019 24Per IRS rule.

Pass-Through:Splitting with Trusts

| Suppose Scrooge owns some fully depreciated property worth $5M that generates $500K of income

| No pass-through deduction, since it is fully depreciated

| He sets up non-grantor trusts for each of his three nephews, spinning $100K each to them

| They get pass-through, since the trusts get a $157,500 income exception

1/14/2019 25Per current IRS rules.

Trusts

Ⅰ Taxable Income Tax Rate (accumulated):• $0 - $2550 ............. 10%• $2,551 - $9,150 ..... 24%• $9,151 - $12,500 ... 35%• $12,501+ ................ 37%

Ⅰ Extra bracket to the $12,500 (possible $1,613 tax saving)

Ⅰ $157,500 QBI limitation (possible $11,655 tax effect)

Ⅰ $10,000 SALTⅠ Grantor trusts merely pass through to grantor

and trust rules don’t applyⅠ NG (non grantor) trusts can be used to shift QBI

to the trusts and utilize the income exclusion.• W-2• Unadjusted basis

Ⅰ Incomplete non-grantor (ING) might avoid state tax. (NINGs, SINGs and DINGs) (Not MI resident)

• Can shift possible state taxes on investment income (not RE) by using a nontax situs

• SALT limitation makes INGs more attractive• Stepped-up basis if incomplete gift

Ⅰ §643(f) anti-abuse rules• Substantially same grantor or grantors and

substantially same beneficiary or beneficiaries, and

• Principal purpose is avoidance of tax• H&W are one bennie or grantor• Contingents aren’t enough to be different• Independent purpose OK

1/14/2019 26Per IRS rules.

Pass-Through:Bigger Non Service

| Wally runs a successful travel agency as a Sub-S corporation

| He nets $800,000 in income| He pays wages of $127,500| He would get the lesser of 20% of $800,000

($160,000) or 50% of W-2 wages of ($127,500), $63,750

| He could increase his deduction by paying himself so that 50% of total salaries equal 20% of QBI. Adding $142,500 to wages would generate a $132,500 QBI deduction

1/14/2019 27Per IRS rule.

Pass-Through: Shifting Debt

| Bill and Melinda have rental real estate. It has a basis of $2M, is not fully depreciated and has gross annual rent of $100,000 and interest on a $1.5M note of $75,000

| Net income is $25,000; QBI deduction is $5,000 (20% of $25,000)

| If they can pay off or refinance the debt, the QBI deduction goes up to $15,000

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• If they had bonds or cash, they could pay off the debt, save the $75,000 of interest (replacing the interest lost on the bonds) and garner a larger deduction.

• If they used a pledged asset loan (or margin loan) with securities, they can still deduct the interest as investment interest.

Accuracy-Related Penalty

Ⅰ Old rule on 20% accuracy related penalty was understatement exceeding 10% of tax or $5,000 for an individual

Ⅰ New rule: greater of 5% of tax or $5,000 in the case of a §199A Deduction

Ⅰ Excess of:• Required amount of tax to be

shown on return, over:• Amount of tax actually shown on

return

1/14/2019 29Per IRS rules.

Ⅰ Jim and Linda own a bakery. It is a sole proprietorship, making $200,000.

• They have taxable income of $415,000

• No employees• No Qualified Property• Not Specified Service Business

QBI Wage Planning

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Ⅰ Situation 1: No QBI, over taxable income level:

• 20% of QBI ($40,000), or• > 50% of wages ($0) or 2 ½% of

unadjusted basis ($0)Ⅰ Situation 2: Form LLC, treat as

partnership, pay Linda $50,000 guaranteed payment:

• 20% of QBI ($30,000), or• > 50% of wages ($0) or 2 ½% of

unadjusted basis ($0)

Ⅰ Situation 3: Form Sub-S, pay Linda $50,000 salary:

• 20% of QBI ($30,000) or• > 50% of wages ($25,000) or 2 ½% of

unadjusted basis ($0)• QBI deduction of $25,000

Ⅰ Situation 4: Form Sub-S, pay Linda $57,142 salary (2/7 of QBI):

• 20% of QBI ($28,571) or• > 50% of wages ($28,571) or 2 ½% of

unadjusted basis ($0)• QBI deduction of $28,571

QBI Wage Planning

1/14/2019 31Assume $50-$60K is reasonable comp

Ⅰ Mike (s) owns a moving company and pays his 2 workers on leased trucks $50,000 a year each as Independent Contractors

• He has $250,000 of QBI• $300,000 of TI• No QBI deduction (no W-2)

Ⅰ Converts ICs to employees (assume he negotiates FICA)

• QBI deduction lesser of:• 20% of $250,000, or• 50% of $100,000

QBI IC Planning

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Charitable Contributions: Ⅰ Willard, is a CPA (m) with $300,000 QBI,

$365,000 taxable income• QBI reduced by 50% (over the $315,000)• $30,000 QBI deduction

Ⅰ Makes $50,000 DAF donation:• QBI is still $300,000• No phase-out• Taxable is $315,000• QBI deduction of $60,000• Charitable deduction of $50,000 (assuming

at least $24,000 of other itemized)

401(k): Ⅰ Millicent, is a CPA (m) with $200,000 QBI,

$265,000 taxable income. She contributes $24,500 to her 401(k) and hires her husband, Milt as her office manager for $25,000 a year. He puts $18,500 in his 401(k).

• QBI deduction is $40,000 (under SB limits)• $43,000 deferred in 401(k) (taxed later)

Ⅰ Switch to Roth 401(k):• QBI goes up to $48,600• Taxable is $308,000• Roth 401(k) grows tax-free

Ⅰ Consider taking Milt off payroll

QBI Income Modifications

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Ⅰ 401(k) and other qualified plans to reduce income:

• Employer contributions• Cash balance plans

Ⅰ Oil and gas IDCⅠ Gifting of business interest to family

membersⅠ Incurring gains to increase taxable income

• Portfolio• property

Ⅰ Reducing guaranteed payments• Revise operating agreements

Ⅰ Segregating business lines (rental versus other)

Ⅰ Martial status• Single v. married• MFJ v. MFS?

Ⅰ Partnership employees to partners?Ⅰ Full expensing to knock income down to

levels?Ⅰ Biz code important?Ⅰ Depreciation schedules?

QBI Income Modifications

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Ⅰ Choice of entity: C-corp. versus pass-through

Ⅰ Choice of entity: Sole proprietorship v. Sub-S v. LLC/partnership

Ⅰ Employee v. IC (both sides)Ⅰ Filing status (MFS v. MFJ)

Ⅰ Reducing/increasing TIⅠ Reducing/increasing W-2Ⅰ Trusts (NG)

• Threshold• Income shift• Asset protection

Ⅰ Service BizⅠ Aggregation

Strategies

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1/14/2019 36Based on current tax rule. Source: Sequoia Financial Group.

Pass-Through Planning Issues

| Am I subject to the pass-through rules? (Not C-Corp.)

| Am I subject to the service company rules?

| Am I subject to the W-2 rules?| Is my income under the threshold?| Should I do something about my

income?

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| We’re married and one of us has a pass-through. Are we better off filing separately?

| Should we split off businesses to take better advantage of the new rules?

| Should we split ownership to other members of our family or to trusts?

| Should we aggregate, and if so, how?

More QBI Observations

Ⅰ Clearly favors independent contractors over employees for the IC, employees for the employer

Ⅰ §1231 gain is unclear. 1231 is gain from property used in trade or business, net 1231 is treated as long-term capital gain (which is not used in QBI deduction). Guidance needed

Ⅰ QBI losses are carried overⅠ QBI can’t create a NOLⅠ Sub-S basis apparently not reduced by

QBI

Ⅰ Reasonable compensation is S-corps will be an issue

Ⅰ Guaranteed payments are not in the reasonable comp issue, for now

Ⅰ ‘Trade or business’ not defined anywhere despite multiple cites to the section

• Rental of one property can be a trade or business

• Net-net-net leases?

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More

Ⅰ Note C-corp. Rules are permanent and 199A sunsets

Ⅰ §1202 (QSBS) (acquired after 09/27/10, 100%)

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More Business Changes

| Under $25 million 3-year average gross revenue:

• Cash basis• No debt restrictions• Inventory• Completed contract

| Full expensing of non-real estate| Net operating losses: no carryback,

limited carry-forward| New excess loss limitation

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| Entertainment deduction eliminated| Car depreciation changed:

• Under 6,000 pound Gross Vehicle Weight (GVW)

• Over 6,000 pound GVW| Interest deduction limited

Disclosure

The views expressed represent the opinion of Sequoia Financial Group. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment.Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Sequoia believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sequoia’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. Past performance is not an indication of future results.Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.

©2019, Sequoia Financial Group

1/14/2019 41

5480 Corporate Drive l Suite 100 l Troy, Michigan 48098

248.641.7400 www.sequoia-financial.com

Navigating Section 199A: New, Big and Complex · Ⅰ A CPA firm (SSTB) has ownership in a real...

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